Price Stickiness in a Cash Dominant Economy: Evidence from Food Prices in India

Can prices be sticky in informal price setting environments where the menu costs are expected to be low? This paper looks at food prices by compiling a novel dataset for India where food constitutes almost half of total CPI. Our results show that there is large heterogeneity across product groups with duration ranging from half a month for vegetables to 5 months for milk, defying the notion of food being a flexible price sector. The degree of price stickiness also goes up substantially if we exclude temporary price changes. Using a set of stylised facts and reduced form evidence, we then show that price setting behaviour broadly matches predictions of sticky price models with menu cost. Using this data, we then structurally estimate a menu cost model by way of Simulated Methods of Moments (SMM) to show that differences in productivity processes, market power and menu costs could account for the differences in price stickiness across product groups. Further, we document evidence of frictions induced by a cash economy which act as a form of menu cost at the micro level. Half of all prices are set at denominations with digits ending at 0 or 5 to ease transactions. A price set at digit ending at 0 is twice more likely to remain constant than a price set at digit ending at an odd digit. Markov Chain transition probabilities indicate that prices are most likely to move from one round digit to another creating a step like adjustments. Using scrapped data from online grocery shop in India, we then show that such bunching of prices is absent in online market validating the hypothesis of cash friction. In terms of policy implications, we show that inflation based on a stickiness re-weighted food price index does not perfectly align with conventional core inflation (excluding food and fuel). This poses the risk of policy error when food prices are altogether neglected in inflation metric for monetary policy.