Inflexible Relative Prices and Price Level Inertia
NBER Working Paper No. 1147
A decrease in aggregate demand at given prices and wages decreases output and employment. The decrease in employment exerts downward pressure on real wages. The decrease in production exerts downward pressure on markups. With perfectly synchronized price and wage decisions, nominal wages and prices decrease instantaneously until equilibrium is reestablished at a lower price level and the initial relative prices. If, however, price and wage decisions are a synchronized, this process can not take place instantaneously but rather takes place over time. If real wages and markups are rather insensitive to shifts in demand, the process of adjustmentis slow, the effects of money on output are strong and lasting.The paper formalizes this intuitive argument and characterizes the implications of asynchronization for the joint behavior of relative and nominal prices.