The Calvo Model of price rigidity refers to the positive probability that a firm’s nominal price may be used for more than a single period. According to this model, economies are made up of growing firms that set their prices (Iania et al., 2023). These prices by the firms are represented using different parameters of a probability density function. Companies around the world use the Calvo model for different functions. For instance, it is widely used to determine the New Keynesian Philips Curves (Luo & Villar, 2021). It allows for simplicity during analysis as it can be reconciled with different stylized facts. Most importantly, it provides highly accurate approximations at fairly low information costs. Due to its several strengths, the Calvo Model has been widely embraced as the ideal approach to modelling nominal rigidity.
The model is fully heterogeneous, which allows firms to set staggered prices. This heterogeneity allows for companies to set their prices across different dimensions an infinite number of times (Alvarez & Burriel, 2010). The individual set prices by the companies are often based on the Calvo mechanism to ensure that each hazard and individual function is represented by two key equations (Iania et al., 2023). In addition, the model uses a wide range of price setters with different adjustment parameters. Each Calvo parameter is bound between 0 and 1 to allow for flexibility in the shapes accommodated.
One of the major assumptions of using the Calvo Model is that the nominal prices of commodities and prices are sticky. This key assumption aligns with the New Keynesian version of aggregate supply, which advocates for models with sticky prices and wages (Alvarez & Burriel, 2010). Sticky prices, according to the Calvo Model, imply that during times of different shocks impacting company environments, they remain resilient and do not change their prices (Luo & Villar, 2021). The main reason for using this model in providing a macroeconomic rationale for the New Keynesian theory is that it leads to policies that raise the money supply and lower short-term interest rates, leading to expansion in aggregate economic activities (Elminejad, 2023). Thus, the model is used in economies to set monetary policy that supports the New Keynesian theory.
Another major strength associated with the Calvo Model in providing a macroeconomic rationale for the New Keynesian theory is that it allows for analysis in the long run. One of the main limitations of the old Keynesian theory is that it ignores the long-run effects (Luo & Villar, 2021). This model suggests that firms that are unable to reoptimize their prizes can update their prices based on the following rule: Pjt = ¯πPjt−1 (Auclert et al., 2024). Through the rule, companies are able to estimate long-run effects as the symbol “¯π” represents the long-run average gross rate of inflation.
However, despite the model’s strengths in the provision of macroeconomic rationale for the New Keynesian theory, it has been linked to various limitations by critics. One of the limitations highlighted by critics is that it assumes there is no measurement error in inflation. Measurement errors during inflation calculation can exist due to various reasons. For instance, the overestimation of the average gross rate of inflation can be a contributing factor to measurement error while using the Calvo Model (Elminejad, 2023). Other factors, such as overstatement of price increases, can lead to the understatement of productivity growth and real output, thus negatively influencing inflation calculation. The assumption that their no measurement error in the calculation of inflation contributes to the limitations of the New Keynesian theory, which is also known for failing to accurately account for a period of secular stagnation.
In addition, another major limitation of the Calvo Model in providing a rationale for the New Keynesian theory is that it assumes that demand is constantly elastic. There is no evidence to suggest that the elasticity of demand is similar across all intermediate goods firms’ demand curves (Elminejad, 2023). The elasticity of demand is affected by various factors which are not accounted for by the model (Alvarez & Burriel, 2010). For instance, the availability of substitutes affects demand elasticity as more substitutes lead to an increased elasticity of the demand for commodities. By failing to explain these variable factors that affect demand elasticity, the Calvo Model solution cannot be considered a reliable alternative for providing a microeconomic rationale for the New Keynesian rationale.
References.
Alvarez, L. J., & Burriel, P. (2010). Is a Calvo price setting model consistent with individual price data?. The BE journal of Macroeconomics, 10(1).
Auclert, A., Rigato, R., Rognlie, M., & Straub, L. (2024). New Pricing Models, Same Old Phillips Curves?. The Quarterly Journal of Economics, 139(1), 121-186.
Elminejad, A. (2023). The Calvo parameter revisited: an unbiased insight. Applied Economics Letters, 1-8.
Iania, L., Tretiakov, P., & Wouters, R. (2023). The risk premium in New Keynesian DSGE models: The cost of inflation channel. Journal of Economic Dynamics and Control, 155, 104732.
Luo, S., & Villar, D. (2021). The skewness of the price change distribution: A new touchstone for sticky price models. Journal of Money, Credit and Banking, 53(1), 41-72.
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