Price setting in General Equilibrium: Alternative Specifications

Abstract

This paper compares a number of alternative specifications for price setting in the context of the Smets-Wouters (2003) Dynamic Stochastic General Equilibrium (DSGE) model. We first show that an empirically plausible alternative interpretation of the estimated price mark-up shocks is that they represent relative price (e.g. productivity) shocks in a flexible price sector. We then compare the Calvo model with a standard Taylor contracting model and show that by allowing for sector-specific capital the Taylor contracting model with a relatively short contract length of three quarters is performing as well as the Calvo model.