Vipin P. Veetil

Empirical evidence shows monetary shocks have two temporary effects on the distribution of prices. One, the dispersion of cross-section of prices increases in response to monetary shocks. Two, some prices change in the ‘wrong’ direction: some prices decrease in response to positive monetary shocks, and increase in response to negative monetary shocks. We present a model that generates the two effects of monetary shocks on the distribution of prices as an out-of-equilibrium phenomena. Firms are related to each other through a production network. Monetary shocks change the working capital of a subset of firms and percolate to other firms through buyer-seller linkages. Price dispersion increases because the percolation of a monetary shock through the production network causes prices to differentially deviate from their steady state values. Some prices change in the wrong direction because a shift in one firm's demand causes a shift in another firm's supply (and vice-versa), thereby generating complicated chains of bi-directional price changes. Monetary shocks can significantly disturb relative prices even when all prices are fully flexible.

Most business cycle theories originate from a paradigmatic vision with a two fold simplicity. The first of which is that firms are bound through simple relations in which they influence each other anonymously via prices but not directly through non-price rivalrous competition. And the second is that firms have immutable and transparent cores. These presumptions yield an economy whose natural state is one of stability. Macroeconomic dynamics, or change more generally, is brought about by exogenous shocks. This paper develops an alternate vision for understanding business cycle dynamics. We consider the dynamics that emerge from micro changes that originate from deep within firms. Each firm is surprised by externally visible innovations of other firms because they cannot observe each others’ high dimensional interiors. Innovations can cascade because of the complex microeconomic interrelations between the plans of firms. The interaction between external-observable attributes and internal-unobservable active cores of firms is capable of generating change without exogenous shocks.

We develop a tractable model of price dynamics in a general equilibrium economy with cash-in-advance constraints. The dynamics emerge from local interactions between firms that are governed by the production network underlying the economy. We analytically characterise the influence of network structure on the propagation of monetary shocks. In the long run, the model converges to general equilibrium and the quantity theory of money holds. In the short run, monetary shocks propagate upstream via nominal changes in demand and downstream via real changes in supply. Lags in the evolution of supply and demand at the micro level can give rise to arbitrary dynamics of the distribution of prices. Our model provides an explanation of the price puzzle: a temporary rise in the price level in response to monetary contractions. In our setting, the puzzle emerges under two assumptions about downstream firms: they are disproportionally affected by monetary contractions and they account for a sufficiently small share of the wage bill. Empirical evidence supports the two assumptions for the US economy. Our model calibrated to the US economy using a data set of more than fifty thousand firms generates the empirically observed magnitude of the price level rise after monetary contractions.

This paper develops a simple simulation model to study the relation between the nature of knowledge and the architecture of economic systems. The market and the firm are different mechanisms for coordinating economic activity in a system where knowledge is widely dispersed. While the market solves coordination problems by decentralizing decision-making, the firm solves coordination problems by centralizing knowledge. The market incurs the cost of finding potential exchange partners and agreeing on terms of trade, while the firm incurs the cost of centralizing dispersed knowledge. The market therefore has an advantage over the firm in coordinating activities in which knowledge is difficult to centralize. The nature of knowledge involved in an economic activity influences not only the choice of the institution through which it is coordinated but also the internal structure of the institution. More specifically, the more hierarchical the firm, the better it is at using changing knowledge, but the worse it is at using knowledge which is difficult to transfer from one individual to another. Therefore, the number of layers in the hierarchy of the firm is influenced by the rate at which knowledge changes relative to the difficulty associated with communicating it.