Working Paper: NBER ID: w19886
Authors: Saroj Bhattarai; Gauti Eggertsson; Raphael Schoenle
Abstract: We study the implications of increased price flexibility on output volatility. In a simple DSGE model, we show analytically that more flexible prices always amplify output volatility for supply shocks and also amplify output volatility for demand shocks if monetary policy does not respond strongly to inflation. More flexible prices often reduce welfare, even under optimal monetary policy if full efficiency cannot be attained. We estimate a medium-scale DSGE model using post-WWII U.S. data. In a counterfactual experiment we find that if prices and wages are fully flexible, the standard deviation of annualized output growth more than doubles.
Keywords: price flexibility; output volatility; monetary policy
JEL Codes: E31; E32; E52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| increased price flexibility (D41) | higher output volatility (E39) |
| increased price flexibility (D41) | higher output volatility (for demand shocks) (E39) |
| increased price flexibility (D41) | higher output volatility (for supply shocks) (E39) |
| central bank's aggressive response to inflation (E52) | lower output volatility (for demand shocks) (E39) |
| increased price flexibility (D41) | destabilization (C62) |
| increased price flexibility (D41) | reduced welfare (I38) |