Evaluation of Price Setting Models at Retail Level: Bayesian Dynamic Factor Model Approach

In this paper, following Maćkowiak, Moench and Wiederholt (2009), the reaction of sectoral price indexes to aggregate and idiosyncratic shocks has been evaluated using Bayesian Dynamic Factor Model. The separation of the reaction of prices to these two types of shocks has been done in order to identify the pricing model that is more compatible with Iranian economy. In case of existence of any significant difference in speeds and sizes of price reaction with respect to these shocks, we can conclude that some of the conventional price setting models such as Calvo could not be able to explain the differences. Therefore, for the purpose of explaining the price setting behavior in Iran, alternative pricing models should be evaluated. The results of this study clearly show that there is a significant difference between the reaction of price indexes to aggregate and sectoral shocks. Based on the results, rational inattention model of Mackowiak and Wiederholt (2009a) is more consistent with the stylized facts of Iran’s economy in comparison with the conventional pricing models.