Working Paper: NBER ID: w2171
Authors: Laurence Ball; David Romer
Abstract: This paper shows that small costs of changing nominal prices can lead to rigidities that cause highly inefficient fluctuations in real variables. As a result, aggregate demand stabilization can be very desirable even though the frictions that cause fluctuations in aggregate demand to have real effects are slight. Inefficient price rigidity arises because rigidity has a negative externality: rigidity in one firm's price increases the variability of real aggregate demand, which hurts all firms. The externality can be arbitrarily large relative to the private costs of rigidity.
Keywords: nominal rigidity; menu costs; aggregate demand stabilization; welfare losses
JEL Codes: E31; E32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| small costs of changing nominal prices (E31) | nominal price rigidity (D41) |
| nominal price rigidity (D41) | inefficient fluctuations in real variables (E32) |
| nominal price rigidity (D41) | negative externality affecting aggregate demand (D62) |
| price stickiness increases variability of aggregate demand (C54) | adverse effects on all firms (L49) |
| reduction in average welfare due to fluctuations (D69) | can be arbitrarily large compared to private costs of rigidity (H49) |
| nominal shocks (E39) | welfare effects vary (D69) |
| nominal price rigidity (D41) | significant social losses (Z13) |
| small frictions (F12) | substantial welfare losses (D69) |
| aggregate demand stabilization (E63) | desirable (Y60) |