Is Price Flexibility De-Stabilizing? A Reconsideration

Using a New Neoclassical Synthesis model of monetary policy for a small open economy, this paper explores the impact of an increased degree of price flexibility on output volatility. Previous analysis of this question – based on the earlier generation of descriptive macro systems with model-consistent expectations – offered mixed conclusions, especially in an open economy context. We update that literature by reconsidering the issue within models that involve optimization-based behavioural equations. We find clear support for Keynes’ concern that a higher degree of price flexibility raises output volatility – but only under flexible exchange rates. We discuss the implications of our findings for current macro policy discussions in both European and other economies.