Is increased price flexibility stabilizing? Redux

Abstract

What are 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. Our results extend to a model with both sticky information and wages. We estimate a quantitative DSGE model using Bayesian methods and using counterfactual experiments show that our results from the simple model continue to apply.