1.

aggregate price under Calvo-constraint

Assumption 1.1. There is a continuum of intermediate firms indexed by i [0, 1]. The intermediate goods prices
are set in a staggered fashion la Calvo (1983) [1]: each period every firm has the opportunity to adjust its price
with probability 1 , independent of the time elapsed since the last adjustment. The unlucky firms just follow
their previous period price rate. When a firm has the opportunity to adjust its price, it sets the new price Pt .
The aggregate price index Pt is
Pt1 =

Z 1
0

Z 1

Pt (i )1 di =

= (1 ) Pt1 +

0
Z 1

Z 1

Pt1 di +

Pt11 (i )di

Pt11 (i )di

(1.1)

where > 1 is the elasticity of substitution between intermediate goods. The problem lies in the second term
R1
1
1 Pt1 (i )di, since each firm is heterogeneous, and we will show that the Calvo mechanism allows us to
integrate out the heterogeneity.
In the first prove, we keep track of what each firm is doing. Considering the measure of 1 (1 ) =
unlucky firms who cannot optimize their price in period t, also, a fraction 1 of these firms can optimize
their price in period t 1 and fraction can not. Hence
Z 1
1

what is x1 ? we have
Z 1
1

x1 (1 )

Pt11 (i )di =

Pt11 (i )di =

Z x
1
1

Pt11 di +

Z 1
x1

Pt12 (i )di

= 1 x1 = 1 2 , hence
Z 1 2
1

Pt11 di +

Z 1
1 2

Pt12 (i )di = (1 ) Pt11 +

Pt1 = (1 ) ( Pt1 + Pt11 ) +

Z 1
1 2

Z 1
1 2

Pt12 (i )di

Pt12 (i )di

again, considering the measure of 1 (1 2 ) = 2 unlucky firms who cannot optimize their price in
period t 1, also, a fraction 1 of these firms can optimize their price in period t 2 and fraction can
not. Hence
Z 1
1 2

what is x2 ? we have
Z 1
1 2

x2 (1 2 )
2

Pt12 (i )di =

Pt12 (i )di =

Z x2
1 2

Pt12 di +

Z 1
x2

Pt13 (i )di

= 1 x2 = 1 3 , hence
Z 1 3
1 2

Pt12 di +

Z 1
1 3

Pt13 (i )di = 2 (1 ) Pt12 +

Pt1 = (1 ) ( Pt1 + Pt11 + 2 Pt12 ) +

Z 1
1 3

Pt13 (i )di

inductively using this argument, we have

Pt1 = (1 )

j Pt1j +

j =0

Z 1
1 J

Pt1J (i )di

as J (the initial period approaches ), the last term becomes

lim

Z 1

J 1 J

Pt1J (i )di = 0

Z 1
1 3

Pt13 (i )di

the intuition is that as time goes to infinity, the friction of firms that can never reset their prise shrinks to
zero every firm has the opportunity to reset its price. Therefore:
Pt1 = (1 )

j =0

j =1

j Pt1j = (1 ) Pt1 + (1 ) j Pt1j

(1 ) Pt1

(1 )

j =0

!
j

Pt1j1

{z

= Pt11

The second prove reveal Gals words the distribution of prices among firms not adjusting in period t
corresponds to the distribution of effective prices in period t 1, though with total mass reduced to .
Definition 1.2. Assume (S, S ) is an arbitrary measurable space and x S, B S , the Dirac measure x
is defined as
(
0, x
/B
x ( B) =
1, x B
Considering the following example: there are 4 firms and the Calvo probability = 1/2, therefore, each
period half of firms can adjust its price. In this finite firm case the aggregate price index is defined as
Pt1 = 14 4i=1 Pt1 (i ). Assume that initially in period 0, all firms charge the same price p (0, ). The
price evolves as the following table shows:
firm
periods
0
1
2
..
.

Pt

P0 (1) = p
P1 (1) = p 1
P2 (1) = p 1

P0 (2) = p
P1 (2) = p 1
P2 (2) = p 2

P0 (3) = p
P1 (3) = p
P2 (3) = p 2

P0 (4) = p
P1 (4) = p
P2 (4) = p

p
1 1
2 p1
1 1
4 p1

+ 12 p1
+ 12 p 12 + 14 p1 = 12 p 12 + 12 P11

iid

P0 (i ) F0 = p

I0 = { p}
1
1
P1 (i ) F1 = 2 p 1 + 2 p I1 = { p, p 1 }
iid
F2 = 14 p 1 + 21 p 2 + 14 p I2 = { p, p 1 ,
iid

distribution
P2 (i )

p 2 }

Table 1-1: price evolvement, an example

Since the probability that a generic firm i can reoptimize its price is independent over time and also indeiid

pendent across firms, each period t, Pt (i ) Ft with the support of It (0, ) each firm faces the same
price distribution, but will result in different draws from the distribution. First consider i N N be
finite or countable. According to the law of large numbers, we have
lim

1
N

Pt (i) =

i =1

Z
It

pt Ft (dpt )

note that the lower case letter p denote the realization of some random variable Pt (i ).
Now consider i [0, 1], according to Uhlig (1996) [2] , we can eliminate the lim and have
Z 1
0

Pt (i )di =

Z
It

pt Ft (dpt )

Z 1
0

Pt1 (i )di =

Z
It

p1t Ft (dpt )

 what is Ft ?
(
Pt (i ) =

Pt (0, )
Pt1 (i ) Ft1

with probability 1

Ft = (1 ) p t + Ft1

with probability

Pt is a degenerated random variable Pt = p t (0, )

what is It ?
It = { p t } It1
Therefore,
Z
It

p1t

Ft (dpt ) = (1 )

Z
It

p 1t p t (dpt ) +

Z 1
0

Z
It

p1t Ft1 (dpt )

Pt1 (i )di = (1 ) Pt1 +

= (1 )

Z 1
0

p 1t

Z
It1

p1t Ft1 (dpt )

Pt11 (i )di

rewrite Eq. (1.1) here

Z 1
0

Pt1 (i )di = (1 ) Pt1 +

Z 1
1

Pt11 (i )di

comparing the two expressions, we have:

Z 1
1

Pt11 (i )di =

Z 1
0

Pt11 (i )di

Now, here is the beauty of the Calvo mechanism. Because the firms who get to update their prices are randomly chosen, and because there are a large number (continuum) of firms, the integral (sum) of individual
R1
prices over some subset of the unit interval ( 1 ) will simply be proportional to the integral over the entire
R1
unit interval ( 0 ), where the proportion is equal to the subset of the unit interval over which the integral
is taken 1 (1 ) = we have gotten rid of the heterogeneity. The Calvo mechanism allows us to
integrate out the heterogeneity.
References

[1] Guillermo A Calvo. Staggered prices in a utility-mathetamizing framework. Journal of Monetary Economics,
1983, 12: 383398.
[2] Harald, Uhlig. A law of large numbers for large economies. Economic Theory, 1996, 8(1): 4150.