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Is Increased Price Flexibility Stabilizing? Redux

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Author Info

  • Saroj Bhattara

    (Penn State University)

  • Gauti Eggertsson

    (Federal Reserve Bank of New York)

  • Raphael Schoenle

    ()
    (Department of Economics, Brandeis University)

Abstract

We study the implications of increased price flexibility on aggregate output volatility in a dynamic stochastic general equilibrium (DSGE) model. First, using a simplified version of the model, we show analytically that the results depend on the shocks driving the economy and the systematic response of monetary policy to inflation: More flexible prices amplify the effect of demand shocks on output if interest rates do not respond strongly to inflation, while higher flexibility amplifies the effect of supply shocks on output if interest rates are very responsive to inflation. Next, we estimate a medium-scale DSGE model using post-WWII U.S. data and Bayesian methods and, conditional on the estimates of structural parameters and shocks, ask: Would the U.S. economy have been more or less stable had prices been more flexible than historically? Our main finding is that increased price flexibility would have been destabilizing for output and employment.

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File URL: http://www.brandeis.edu/departments/economics/RePEc/brd/doc/Brandeis_WP41.pdf
File Function: First version, 2012
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Bibliographic Info

Paper provided by Brandeis University, Department of Economics and International Businesss School in its series Working Papers with number 41.

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Length: 48 pages
Date of creation: Jan 2012
Date of revision:
Handle: RePEc:brd:wpaper:41

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Postal: MS032, P.O. Box 9110, Waltham, MA 02454-9110
Web page: http://www.brandeis.edu/departments/economics/
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Related research

Keywords: Increased price exibility; Aggregate volatility; Systematic monetary policy; DSGE model; Bayesian estimation;

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References

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  1. Kimball, Miles S, 1995. "The Quantitative Analytics of the Basic Neomonetarist Model," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 27(4), pages 1241-77, November.
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  4. Lawrence Christiano & Martin Eichenbaum & Sergio Rebelo, 2009. "When is the government spending multiplier large?," NBER Working Papers 15394, National Bureau of Economic Research, Inc.
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  9. Gauti B. Eggertsson, 2008. "Great Expectations and the End of the Depression," American Economic Review, American Economic Association, vol. 98(4), pages 1476-1516, September.
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  12. Igor Evstigneev & Thorsten Hens & Klaus Reiner Schenk-Hoppé, 2003. "Evolutionary Stable Stock Markets," Discussion Papers 03-39, University of Copenhagen. Department of Economics.
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Cited by:
  1. Gauti Eggertsson & Marc P. Giannoni, 2013. "The inflation-output trade-off revisited," Staff Reports 608, Federal Reserve Bank of New York.
  2. Kiley, Michael T., 2014. "Policy Paradoxes in the New Keynesian Model," Finance and Economics Discussion Series 2014-29, Board of Governors of the Federal Reserve System (U.S.).
  3. Jordi Galí & Tommaso Monacelli, 2013. "Understanding the Gains from Wage Flexibility: The Exchange Rate Connection," Working Papers 746, Barcelona Graduate School of Economics.
  4. Jae Sim & Raphael Schoenle & Egon Zakrajsek & Simon Gilchrist, 2014. "Inflation Dynamics During the Financial Crisis," 2014 Meeting Papers 206, Society for Economic Dynamics.
  5. Jordi Galí & Tommaso Monacelli, 2013. "Understanding the gains from wage flexibility: The exchange rate connection," Economics Working Papers 1408, Department of Economics and Business, Universitat Pompeu Fabra.

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