Another Look at Sticky Prices and Output Persistence

Price rigidity is the key mechanism for propagating business cycles in traditional Keynesian theory. Yet the New Keynesian literature has failed to show that sticky prices by itself can effectively propagate business cycles in general equilibrium. This situation may be a direct consequence of the notion that money-in-utility (MIU) and cash-in-advance (CIA) are equivalent mechanisms for generating money demand. They are not. We show that price rigidity in fact can (by itself) give rise to a powerful propagation mechanism of the business cycle under CIA constraint in standard New Keynesian general equilibrium models. In particular, we show that reasonable price stickiness can generate highly persistent, hump-shaped movements in output, investment and employment in response to either monetary or non-monetary shocks. Hence, whether or not price rigidity is responsible for output persistence (and the business cycle in general) is not a theoretical question, but an empirical one.