Three Essays on the Macroeconomic Consequences of Prices by DongIk Kang A dissertation submitted in partial fulfillment of the requirements for the degree of Doctor of Philosophy (Economics) in the University of Michigan 2018 Doctoral Committee: Professor Christopher L. House, Chair Professor Julio A. Blanco Professor Joshua K. Hausman Professor Miles S. Kimball, University of Colorado Professor John V. Leahy DongIk Kang [email protected] ORCID ID 0000-0003-2716-9853 © DongIk Kang 2018 ACKNOWLEDGMENTS First and foremost, I would like to thank my advisor Chris House for his contin- ued guidance and support throughout my Ph.D. I was privileged to have him as my advisor. I also thank my committee members, John Leahy, Andres Blanco, Joshua Hausman and Miles Kimball for their insightful comments and sup- port. Alberto Arredondo, Jacob Bastian, Aakash Mohpal, Richard Ryan and Andrew Usher provided moral support as well as academic insights. Finally, I am heavily indebted to my family, in particular to my wife Naewon, for their unconditional support. The first chapter of this dissertation is co-authored with Andrew Usher. The second chapter is co-authored with Miles S. Kimball. ii TABLE OF CONTENTS Acknowledgments ....................................... ii List of Figures ......................................... v List of Tables .......................................... vii List of Appendices ....................................... viii Abstract ............................................. ix Chapter 1 Product Revenue and Price Setting: Evidence and Aggregate Implications ...... 1 1.1 Introduction.....................................1 1.2 Revenue and Price Setting.............................5 1.2.1 Data.....................................5 1.2.2 Empirical Findings.............................7 1.2.3 A Menu Cost Interpretation........................ 14 1.3 State-Dependence of Monetary Policy....................... 18 1.3.1 The Revenue Effect............................. 18 1.3.2 Revenue Distribution and Unemployment................. 20 1.3.3 Quantitative Model............................. 22 1.3.4 Calibration and Results........................... 28 1.3.5 Extending the Model............................ 36 1.4 Empirical Evidence of State-Dependence..................... 38 1.5 Conclusion..................................... 42 1.6 References...................................... 44 2 Seniority ........................................... 47 2.1 Introduction..................................... 47 2.2 Model........................................ 51 2.3 The Optimal Contract................................ 63 2.4 Extensions and Applications............................ 68 2.4.1 Variable Monitoring............................ 69 2.4.2 Amenities.................................. 70 2.4.3 Earnings Loss................................ 73 iii 2.5 The Steady State Equilibrium............................ 75 2.5.1 Equilibrium................................. 75 2.5.2 The Steady State.............................. 76 2.6 Conclusion..................................... 81 2.7 References...................................... 83 3 System Wide Runs and Financial Collapse ........................ 85 3.1 Introduction..................................... 85 3.2 Model........................................ 88 3.2.1 The Credit Market............................. 94 3.2.2 Equilibrium................................. 103 3.2.3 A Numerical Example........................... 108 3.2.4 Properties of the Model.......................... 109 3.3 Policy Implications................................. 113 3.3.1 Perfect Information Benchmark...................... 114 3.3.2 Government Clearing House for Loans.................. 116 3.3.3 Counter-Cyclical Borrowing Limits.................... 118 3.4 Discussion...................................... 120 3.5 Related Literature.................................. 121 3.6 Conclusion..................................... 123 3.7 References...................................... 125 Appendices ........................................... 128 iv LIST OF FIGURES 1.1 Revenue and probability of price adjustment......................8 1.2 Revenue and size of price adjustment..........................9 1.3 Revenue and price setting: compare data and model................... 32 1.4 Impulse response function of output to a one standard deviation monetary shock in low versus high output states. The results are scaled to reflect a one percentage point monetary shock...................................... 34 1.5 Impulse response function of the cross-sectional frequency of price adjustment to a one standard deviation monetary shock in low versus high output states......... 35 1.6 Hump shaped impulse response function of output to a one standard deviation mon- etary shock in a model with habit formation and persistent monetary shocks. The results are scaled to reflect a one percentage point monetary shock............ 37 1.7 State-dependence of aggregate output.......................... 38 1.8 State-dependence in durable and non-durable consumption............... 40 2.1 Optimal contract in (∆; π) ................................ 63 2.2 Optimal contract in (s; π) ................................ 66 2.3 Optimal contract in (s; ∆) ................................ 67 2.4 Wage vs productivity................................... 68 2.5 Wage loss......................................... 73 2.6 Probability of job loss.................................. 75 2.7 Steady state equilibrium................................. 80 2.8 Increase in unemployment benefits............................ 81 3.1 Separating equilibrium in the credit market....................... 103 3.2 Equilibrium fire sale prices for values of δ and 1 − φ .................. 110 3.3 Equilibrium fire sale prices for values of a and B .................... 112 3.4 A potential credit market equilibrium with counter-cyclical borrowing limits...... 119 A.1 Inference into the selection effect............................ 135 A.2 Revenue and Price Setting: Extended model....................... 138 A.3 Impulse response function of the cross-sectional frequency of price adjustment to a one standard deviation monetary shock in low versus high output states......... 140 A.4 TFP shocks (Industrial Production)........................... 142 A.5 Persistent Federal Funds rate changes (Industrial Production).............. 142 A.6 Robustness check: TFP shocks.............................. 143 v A.7 Robustness check: Federal Funds rate changes..................... 143 vi LIST OF TABLES 1.1 Summary statistics....................................6 1.2 Probability of price adjustment.............................. 11 1.3 Size of price change................................... 13 1.4 Revenue distribution over the business cycle....................... 22 1.5 Target moments...................................... 29 1.6 Parameter values..................................... 30 1.7 Revenue and adjustment probability by quantile (Model)................ 35 A.1 Product categories.................................... 129 A.2 Designated market areas................................. 132 A.3 Revenue distribution: 30 product categories....................... 133 A.4 Revenue distribution: market-product category fixed effect............... 133 A.5 Target moments...................................... 137 A.6 Parameter values..................................... 139 A.7 Revenue and adjustment probability by quantile (Model)................ 141 vii LIST OF APPENDICES A Product Revenue and Price Setting: Evidence and Aggregate Implications ...... 128 B System Wide Runs and Financial Collapse ........................ 144 viii ABSTRACT To understand the workings of the macroeconomy, it is not enough to simply focus on the move- ments of the aggregate variables of the economy. It is necessary to also understand the behavior of its various components and their interactions. In this thesis, I study three important components of macroeconomic behavior; prices, wages, and the financial system and their connection to the behavior of the aggregate economy. In the first chapter (joint work with Andrew Usher), we use retail scanner data to show two pre- viously unknown empirical facts about prices. First, the probability of price adjustment increases with product revenue. Second, the absolute size of price adjustment decreases with revenue. These facts are consistent with a menu cost model where the fixed cost of adjustment does not scale with product revenue. Taken together, these facts suggest that prices of products with higher revenues respond more to monetary policy than prices of products with lower revenues. Over the business cycle, both the mean and variance of the (log) revenue distribution across goods decrease with the unemployment rate. These empirical facts imply that monetary policy should have stronger effects on the economy in recessions than in expansions. We verify this property using a quantitative menu cost model, and we provide additional evidence of the state-dependence of monetary policy using aggregate data. In the second chapter (joint work with Miles S. Kimball), we study the optimal wage structure of a firm with imperfect monitoring of worker effort. We find that when firms can commit to (implicit) long-term contracts, imperfect monitoring leads to optimal wage profiles that reflect ix worker seniority. We provide a precise definition of seniority as a measure of worker value to the firm rather than the length of service by a worker.