This paper is a sequel to Working Paper No. 3131, "Hypotheses of Sticky
Wages and Prices". My first objective is to re-examine the historical record
of prices and wages. What changes in their behavior are indicated by the data
and how can they be explained? Next, the models that imply that price
flexibility may be destabilizing are identified and assessed. This requires in
particular an analysis of the role of changes in interest rates and price
expectations.
Money wages and prices in general had a predominantly pro cyclical pattern
of movement before World War II, at least during the major fluctuations, but no
declines in the more recent business contractions. Real wages never conformed
closely to business cycles but most of their weak reactions were procyclical.
Depending on the underlying condition and sources of the shifts in the
economy, the departures from flexibility mayor may not be destabilizing. The
main contrast, though, is between the stabilizing potential of flexible
relative prices and the dectabilizing potential of major general price
movements.
Major deflations of the past had strong and adverse expectational and
distributional effects. So had the recent inflation as it accelerated and grew
increasingly volatile. But moderate fluctuations in the price level or the
rate of inflation are not necessarily detrimental to the growth in real
economic activity.
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