Oligopolistic Pricing and the Effects of Aggregate Demand on Economic Activity

We construct a dynamic general equilibrium model in which the typical industry colludes by threatening to punish deviations from an implicitly agreed upon pricing path. We argue that models of this type explain better than do competitive models the way in which the economy responds to aggregate demand shocks. When we calibrate a linearized version of the model using methods similar to those of Kydland and Prescott (1982), we obtain predictions concerning the economy's response to changes in military spending which are close to the response we estimate with postwar US data.