Price Shocks in General Equilibrium: Alternative Specifications

Smets and Wouters (2003) find that at short- and medium-term horizons stochastic variations in the goods market mark-up are the most important source of inflation variability in the euro area. This article shows that an empirically plausible alternative interpretation is that the estimated price mark-up shocks represent relative price (e.g. productivity) shocks in a flexible-price sector. Such an interpretation is consistent with recent micro findings that prices are very flexible in some sectors such as the food and energy sector, while they are very sticky in other sectors such as services. (JEL codes: E1, E2, E3) Copyright 2006, Oxford University Press.