Are Prices Too Sticky?

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.