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Is increased price flexibility stabilizing? Redux

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  • Saroj Bhattarai
  • Gauti Eggertsson
  • Raphael Schoenle

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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Bibliographic Info

Paper provided by Federal Reserve Bank of New York in its series Staff Reports with number 540.

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Date of creation: 2012
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Handle: RePEc:fip:fednsr:540

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Keywords: Prices ; Productivity ; Equilibrium (Economics) ; Monetary policy ; Inflation (Finance);

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References

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  1. Peter J. Klenow & Oleksiy Kryvtsov, 2007. "State-Dependent or Time-Dependent Pricing: Does It Matter for Recent U.S. Inflation?," Discussion Papers 07-007, Stanford Institute for Economic Policy Research.
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  9. Klenow, Peter J. & Malin, Benjamin A., 2010. "Microeconomic Evidence on Price-Setting," Handbook of Monetary Economics, in: Benjamin M. Friedman & Michael Woodford (ed.), Handbook of Monetary Economics, edition 1, volume 3, chapter 6, pages 231-284 Elsevier.
  10. James Tobin, 1975. "Keynesian Models of Recession and Depression," Cowles Foundation Discussion Papers 387, Cowles Foundation for Research in Economics, Yale University.
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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. Jordi Galí & Tommaso Monacelli, 2013. "Understanding the Gains from Wage Flexibility: The Exchange Rate Connection," Working Papers 746, Barcelona Graduate School of Economics.
  3. 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.
  4. 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.).
  5. Jae Sim & Raphael Schoenle & Egon Zakrajsek & Simon Gilchrist, 2013. "Inflation Dynamics During the Financial Crisis," 2013 Meeting Papers 826, Society for Economic Dynamics.

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