Abstract: This paper studies the nature of countercyclical price change dispersion and revisits the real effects of monetary policy over the business cycle. Using Nielsen Retail Scanner data, I show that the increase in the dispersion of price changes during the Great Recession is largely driven by the diverging price adjustment between goods of different qualities. Prices of low-quality goods drop dramatically, while those of high-quality goods remain stable. Conversely, the contribution of increasing volatility of individual prices is negligible. By linking Nielsen Consumer Panel with Retail Scanner data, I find that households who purchase a larger fraction of low-quality goods during the recession become more price-sensitive, suggesting that sellers of low-quality goods face increasing demand elasticity. Motivated by the empirical findings, I develop a quantitative multi-sector menu cost model incorporating countercyclical elasticity of demand in the sector of low-quality goods. The model successfully replicates the countercyclical dispersion of price changes and the price change distribution of goods in different quality groups. In terms of the effectiveness of monetary policy, time-varying demand elasticity affects monetary non-neutrality mainly through the selection effect. Quantitatively, contrary to models driven by second-moment shocks, monetary policy is still very effective during recessions: the cumulative output response to a monetary policy shock is only 4% smaller in recessions.
Abstract: This paper investigates the optimal monetary policy in a two-sector model with imperfect common knowledge between firms due to limited attention. A welfare criterion based on the utility of consumers is derived to evaluate the real effects of monetary policy. When sectoral productivity shocks are symmetric, complete price stabilization is optimal. However, with asymmetric sectoral productivity shocks, price stabilization is no longer optimal. When responding to these shocks, central banks face trade-offs between output and price stabilization. The optimal monetary policy places more weight on price stabilization when firms have more information processing capacity.