Can Wage and Price Stickiness Account for Sizeable Costs of Business Cycle Fluctuations?

Bonn Econ Discussion Paper No. 18/2004

34 Pages Posted: 12 Nov 2004

See all articles by Matthias O. Paustian

Matthias O. Paustian

Board of Governors of the Federal Reserve System

Date Written: October 2004

Abstract

This paper asks the following two questions: First, can a model with nominal rigidities in wage and price setting account for the average welfare costs of business cycle fluctuations identified in Gali, Gertler, and Lopez-Salido (2003)? Second, do we need to agree on a particular scheme for nominal rigidities to answer that question? We compute a quadratic approximation to agents expected lifetime utility and evaluate welfare for different modeling schemes of nominal rigidities that all have the same average duration of contracts. Calvo (1983) wage and price contracts can deliver sizeable welfare costs, but other contracts of the same average stickiness cannot. Calvo (1983) contracts can imply welfare costs that are up to 4 times higher than those implied by overlapping contracts in the spirit of Taylor (1980) or Wolman (1999). Furthermore, the sticky information framework of Mankiw and Reis (2002) may generate welfare costs that are even smaller. This paper calls for more research into the origins of wage and price stickiness.

Keywords: welfare, Calvo, Taylor, Wolman, sticky information, costs of nominal rigidities

JEL Classification: E52, E32

Suggested Citation

Paustian, Matthias O., Can Wage and Price Stickiness Account for Sizeable Costs of Business Cycle Fluctuations? (October 2004). Bonn Econ Discussion Paper No. 18/2004, Available at SSRN: https://ssrn.com/abstract=614402 or http://dx.doi.org/10.2139/ssrn.614402

Matthias O. Paustian (Contact Author)

Board of Governors of the Federal Reserve System ( email )

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