Academic journal article Economic Inquiry

Price Flexibility and Aggregate Stability: New Evidence and Implications

Academic journal article Economic Inquiry

Price Flexibility and Aggregate Stability: New Evidence and Implications

Article excerpt


Is increased price flexibility stabilizing? The importance of this question can be easily established by observing the number of recently published papers in which this question, or a slight modification of it, has appeared in their titles.(1) While most economists would answer this question affirmatively, a strand of macroeconomic thought that questions the wisdom of too much price flexibility has recently regained some attention.(2) In the most widely discussed of this recent literature, DeLong and Summers [1986b] question the wisdom of too much price flexibility.

Their work was motivated by some of the ideas expressed by Keynes [1936] and formally articulated by James Tobin [1975]. Low prices work to move the economy to full employment but falling prices, to the extent that they lead to expectations of deflation, raise the real interest rate (through the Mundell effect) and move the economy away from full employment. In a version of Taylor's [1979] wage-setting model, DeLong and Summers show that instability is likely to occur if expectations of inflation adjust rapidly to actual inflation and the real interest rate effect is large.

This view presents a direct challenge to mainstream Keynesian models of business cycles.(3) According to these models, sluggish wages and prices are generally the culprits of unemployment and business fluctuations. An exogenous (institutional) increase in the degree of price inflexibility increases the size of quantities adjustment in response to aggregate demand shocks in the current period and over time.

The assumption of exogeneity is consistent with the view that wage and price rigidity are the result of an institutional structure that is relatively unresponsive to changes in the underlying economic conditions. In Gray and Kandil [1991], we find this view unappealing considering recent efforts to rationalize nominal rigidities as the outcome of explicit optimization exercises.(4) It is for this reason that we examine the relationship between price flexibility and output variability in a framework in which both are endogenously determined.

In the model we develop, price rigidity is attributed to the length of contractual wage agreements. An increase in contract length will occur if the costs of negotiating contracts rise or the amount of uncertainty impinging on the economy declines. In the first case, declines in wage and price flexibility will be accompanied by decreased stability of output. In the latter case, the opposite will occur: the reduction in the size of stochastic disturbances impinging on the economic system has a direct stabilizing impact on real output. Concurrently, the reduction in the degree of uncertainty increases agents' incentives to write longer contracts. The increased rigidity is destabilizing. This destabilizing impact is dominated, however, by the direct stabilizing impact.

The implications of the alternative views can be contrasted in many respects. In Kandil [1991b], I test the relation between measures of wage and price flexibility and the size of macroeconomic fluctuations across a group of ten major industrial countries. The analysis of this paper extends this research in several directions. First, the analysis provides a formal illustration of the channels through which price flexibility may differentiate the real effects of specific shocks underlying aggregate demand and, in turn, aggregate variability. The framework approximates the key relationships for the theoretical debate under consideration. These relationships are replicated empirically to establish the validity of the hypotheses that differentiate the alternative views. Second, the analysis provides a more formal attempt towards quantifying the structural shocks underlying aggregate demand. These shocks are the driving forces of economic instability and, in turn, they are crucial to the debate on the stabilizing effects of price flexibility. …

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