In a Calvo pricing economy with θ = 0.75, the central bank unexpectedly increases the money supply. In the short run, real output rises. Why?
AFirms are irrational and don't realize the money supply has increased, so they mistakenly expand production
BThe fraction of firms stuck at old prices (75%) cannot immediately raise them, so their goods become temporarily cheap in real terms, boosting demand for their output
CAll firms instantly raise their prices to absorb the extra money supply, leaving real output unchanged
DWorkers immediately renegotiate wages, reducing firms' costs and encouraging them to expand output
In the Calvo model, firms are fully rational — those that can reset their prices do so optimally, looking forward. The key is that most firms (fraction θ = 0.75) are stuck at stale prices and cannot adjust. When the money supply rises, the price level rises for adjusting firms but not for stuck firms — their nominal price is unchanged while the money supply increases. Their goods are now cheaper in real terms, demand for their output rises, and they produce more. Monetary policy has real effects not because of irrationality but because the staggered structure of price adjustment creates unavoidable nominal inertia.
Question 2 Multiple Choice
When a firm 'wins the Calvo lottery' and is allowed to reset its price, it sets a price higher than today's optimal price. Why?
AIt exploits its temporary pricing power to extract monopoly rents before competitors catch up
BIt anticipates being stuck at this price for multiple future periods, so it sets a price optimal on average across expected future conditions including inflation
CCIP priority rules require it to match the highest competitor price in the market
DRegulatory constraints prevent it from setting exactly the current optimal price
The forward-looking nature of Calvo price-setting is critical. The firm knows it may not get another chance to adjust for several periods — on average, 1/(1-θ) periods. If inflation is positive and demand is growing, today's optimal price will be below the optimal price next period. A firm that sets only today's ideal price will be underpricing in future periods when it's stuck. So it rationally sets a higher price now, averaging across the distribution of future periods it may be stuck. This forward-looking behavior is what generates the expectations term in the New Keynesian Phillips Curve.
Question 3 True / False
In the Calvo pricing model, the aggregate price level at any given time reflects a weighted average of prices set across many different past periods, not just the current period's optimal price.
TTrue
FFalse
Answer: True
This is the mechanism that creates nominal inertia. At any moment, the economy contains firms that reset their prices this period (setting prices that reflect current conditions), firms that last adjusted one period ago, two periods ago, and so on. The aggregate price level averages over all of these stale and fresh prices, weighted by the fraction of firms at each vintage. Because old prices from past periods are embedded in the current price level, the price level adjusts sluggishly to monetary shocks — even though each firm that can adjust does so optimally and forward-lookingly.
Question 4 True / False
In the Calvo model, a firm that has been stuck at its current price for many consecutive periods faces a higher probability of being allowed to reset its price in the next period.
TTrue
FFalse
Answer: False
This is the 'memoryless' property — the defining feature of the Calvo assumption. The probability (1 − θ) of receiving permission to adjust is constant each period, regardless of how long the firm has been stuck. Like a fair coin flip, the past does not affect the future probability. This is what makes the Calvo model analytically tractable: the distribution of price vintages in the economy reaches a stationary structure. In contrast, menu-cost models have state-dependent adjustment (firms adjust when the gap between current and optimal price exceeds a threshold), which is more realistic but far harder to aggregate.
Question 5 Short Answer
How does the Calvo pricing mechanism allow monetary shocks to have real effects on output, even when all firms are setting prices rationally?
Think about your answer, then reveal below.
Model answer: In each period, a fraction θ of firms cannot reset their prices regardless of what the central bank does — they are stuck at prices set in previous periods. When the money supply rises, firms that can adjust raise their prices, but stuck firms cannot. The overall price level rises less than the money supply, so real money balances increase. The stuck firms' goods are now cheaper in real terms relative to the new price level — demand for their output rises, and they produce more to meet it. Real output rises even though every firm is behaving rationally. The real effect comes not from confusion but from the structural constraint that not all prices can adjust simultaneously. As contracts expire and more firms adjust, prices catch up and the real effect fades — giving monetary policy a temporary but real impact.
The contrast with a world of fully flexible prices is instructive: if all firms could instantly reset, the money supply increase would immediately raise all prices proportionally, leaving real variables unchanged. Nominal inertia — built into the staggered adjustment structure, not into irrationality — is what creates the non-neutrality of money in the short run.