Are Prices Too Sticky?

Abstract

Nominal price rigidity has a negative externality: rigidity in one firm's price increases the variability of aggregate real spending, which harms all firms. This paper investigates whether this externality is large, which would imply that stabilization policy can be highly beneficial even if the costs of making prices flexible are small. There are three conclusions. First, both the private cost of price rigidity and the externality are second order in the size of fluctuations. Second, the externality can nonetheless be arbitrarily large. Third, in a simple model the externality is small for plausible parameter values.