Price Selection, Monetary Non-neutrality, and Sticky-Price Models

We propose a new decomposition of monthly inflation into components varying with the fraction of individual prices that change, and with their levels before and after the change, which we call a reset and a preset price components. We use the decomposition to learn about inflation dynamics and assess different models of price setting. To that end, we apply our decomposition to the U.K. CPI inflation, using its underlying micro price data, and to artificial micro data generated by calibrated versions of three canonical models of price setting. Empirically, we find the preset price component to be strongly negatively correlated with inflation, explaining almost half of its variance. This finding points to the existence of "selection" effects in price setting that are important for inflation dynamics. However, using model simulations, we also show that preset price component is silent on the degree of monetary non-neutrality. We are currently exploring a moment that maps one-to-one into the degree of monetary non-neutrality in the models, and which can be computed directly from micro price data.