Price Rigidity and the Granular Origin of Aggregate Fluctuations

Project Outcomes Statement

Understanding the drivers of aggregate fluctuations is a central question in economics, because identifying these can allow fiscal and monetary authorities to better stabilize business cycles and hence, increase aggregate welfare. The profession has struggled for decades identifying these driving forces, resulting in the negative outlook by Cochrane (1993): 'we will forever remain ignorant of the fundamental causes of economic fluctuations'. A recent literature argues that shocks to specific firms or sectors might be the source of aggregate fluctuations. Traditionally, this possibility has been ignored, because shocks to specific firms or sectors should wash out in the aggregate. Yet, if some firms are large at any level of disaggregation or some sectors are central in the production network as producers of general purpose technology, then shocks hitting these might not average out and matter in the aggregate.

This analysis so far has studied these questions in models in which firms can adjust prices instantaneously and costless to shocks. Yet, a key building block in macroeconomics is the fact that the output prices of firms do not adjust all the time, they are sticky, and large heterogeneity is present in the degree of stickiness across firms and industries. We first show that if prices are equally sticky across sectors, shocks to specific firms or sectors are an unlikely driving force of aggregate fluctuations. Yet, allowing for heterogeneous degrees of price stickiness and their interactions with other heterogeneous features of the economy such as size and the position in the input-output structure empirically substantially amplifies the power of sectoral shocks to drive aggregate fluctuations relative to the equal price stickiness economy. A central bank that aims to stabilize sectoral prices of ‘big’ or ‘central’ sectors might make systematic policy mistakes if it does not take into account the ‘frictional’ origin of aggregate fluctuations that heterogeneity in price stickiness generates. Overall, our results suggest that heterogeneity in nominal price rigidity is a quantitatively strong amplifier of the aggregate effect of idiosyncratic shocks. Our paper further documents that idiosyncratic shocks are able to jointly rationalize fluctuations at the aggregate and sectoral level, whereas aggregate shocks cannot.

We also provide an anatomy of the universe of U.S. federal procurement spending over the last 20 years and show that similar to private sector consumption, government spending, ‘G’, is granular and heterogeneous. It not a single policy instrument that can be easily adjusted to fine tune the business cycle, contrary to what most models of the business cycle assume. Instead, ‘G’ is composed of many little ‘gs’. This fact presents policy makers with an opportunity because the aggregate effects of altering the level of purchases ultimately depend on the firms or sectors in which the fiscal adjustment takes place. This aspect is key for the design of optimal fiscal policy and hence welfare.