Is Increased Price Inflexibility Stabilizing?

THIS PAPER EXAMINES A BASIC QUESTION: the link between the degree of price flexibility and the variability of output. The two standard intermediate macroeconomic textbook models are the classical and the Keynesian model. In the Keynesian model, prices are assumed to be perfectly rigid and output adjusts. On the other hand, in the classical model prices are completely flexible and output is perfectly stable. The two models suggest that as prices become more flexible output should become less variable. Now, since Mundell (1963) pointed it out, it has been well known that the price level and the expected rate of change of the price level, that is, the expected inflation rate, exert opposing forces on the level of output in a static Keynesian model. Since inflation is an essentially dynamic phenomenon, the static Mundell effect prompts a natural consideration of the link between the degree of price flexibility and the variability of output in a dynamic context. Tobin (1975) presents a formal model where lower prices work to move the economy toward full employment but an expectation of falling prices raises the real interest rate and moves the economy away from full employment. Recently DeLong and Summers (1986a, 1986b), Driskill and Sheffrin (1986), and King (1988) have rejuvenated interest in the question of whether increased price flexibility/inflexibility will stabilize or destabilize output. While Driskill