Debt, Price Flexibility and Aggregate Stability

In conventional macroeconomic thought, price flexibility stabilizes thc economy. The more quickly prices fall (or inflation decreases) in a demand-induced recession, the faster output returns to its full-employment level. An alternative tradition, however, suggests that price flexibility can be destabilizing. If a recession reduces expectations of Jitlzre prices, this can raise current real interest rates and dampen aggregate demand. In addition, as actual current prices fall in a recession, real debt burdens rise which can reduce aggregate demand due to financial distress or the response of capital markets. This paper presents simulations from a dynamic macroeconomic model designed to examine the empirical effects of price flexibility. Our results show that, for credible specifications and parameter values7 the destabilizing effects of greater price flexibility can be larger than the conventional stabilizing channels. Therefore, it is possible that greater price flexibility magnifies the severity of economic contractions initiated by negative demand shocks.