Optimal Price and Inventory Adjustment in an Open-Economy Model of the Business Cycle

Robert P. Flood, Robert J. Hodrick

NBER Working Paper No. 1089 (Also Reprint No. r0690)
Issued in March 1986
NBER Program(s):   ITI   IFM

This paper develops an open-economy macroeconomic model which can be used to interpret the observed fluctuations in output, inventories,prices,and exchange rates in the medium-sized economies of the world. The model is consistent with the major empirical regularities that have been discovered in studies of business cycles as closed-economy phenomena and in empirical studies of prices and exchange rates. The empirical regularities are (i) changes in the nominal money supply cause real output fluctuations, (ii) deviations of output from a "natural rate" show persistence, (iii)exchangerates are more volatile than nominal prices of goods, and (iv) depreciations of the currency coincide with deteriorations of the terms of trade. A controversial aspect of the model is that only unperceived money has real effects. The channel through which these effects arise involves a misperception by rational maximizing firms of the true demand that they will face after having set prices. The firms learn about their environment from equilibrium asset prices, and the dynamics of the model reflect the optimal response of inventory-holding firms rather than ad hoc price dynamics.

(817 K)

Published: Flood, Robert P. and Robert J. Hodrick. "Optimal Price and Inventory Adjustment in an Open-Economy Model of the Business Cycle," Quarterly Journal of Economics, Vol. 100, Supplement 1985, pp. 887-914.

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