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Another look at sticky prices and output persistence

  • Pengfei Wang
  • Yi Wen

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 themselves can effectively propagate business cycles in general equilibrium. We show that price rigidity in fact can (by itself) give rise to a strong propagation mechanism of the business cycle in standard New Keynesian models, provided that investment is also subject to a cash-in-advance constraint. 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, even if investment is only partially cash-in-advance constrained. Hence, whether or not price rigidity is responsible for output persistence (and the business cycle in general) may not be a theoretical question, but an empirical one.

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Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 2005-051.

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Date of creation: 2005
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Publication status: Published in Journal of Economic Dynamics and Control, December 2006, 30(12), pp. 2533-52
Handle: RePEc:fip:fedlwp:2005-051
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