The asymmetric stabilizing effects of price flexibility: historical evidence and implications
The evidence of business cycles across a sample of industrial countries indicates asymmetry in the output and price adjustments to aggregate demand shocks in the pre- and post-war periods. Upward price flexibility is significant in moderating output fluctuations across countries in the pre- and post-war periods. Nonetheless, the effect of upward price flexibility in accelerating trend price inflation is more evident across countries in the post-war period compared to the pre-war period. The combined evidence is consistent with a steeper supply curve in the face of expansionary demand shocks that increases the stabilizing effect of upward price flexibility. In contrast, a flatter supply curve in the face of negative demand shocks has countered the stabilizing function of downward price flexibility, which appears insignificant across countries in the pre- and post-war periods. In addition, a slower demand response to price change during recessions has further reinforced the contractionary effect on output despite a large reduction in price inflation across countries in the pre-war period. Apparent differences in the implications of upward and downward price flexibility point to the importance of policy intervention to moderate output contraction during recessions and price inflation during expansions.