Another Look at Sticky Prices and Output Persistence

Price rigidity is the key mechanism for propagating business cycles in traditional Keynesian theory. Yet the New Keynesian literature has failed to show that sticky prices by themselves can e¤ectively propagate business cycles in general equilibrium. We show that price rigidity in fact can (by itself) give rise to a strong propagation mechanism of the business cycle in standard New Keynesian models, provided that investment is also subject to a cash-in-advance constraint. In particular, we show that reasonable price stickiness can generate highly persistent, humpshaped movements in output, investment and employment in response to either monetary or non-monetary shocks, even if investment is only partially cash-in-advance constrained. Hence, whether or not price rigidity is responsible for output persistence (and the business cycle in general) may not be a theoretical question, but an empirical one. Keywords: Business Cycle; Money; Sticky Prices; Output Persistence; New-Keynesian Models; Cash-in-Advance; Money-in-Utility; Financing Constraints and Investment. JEL Classi…cation: E52, E41, E32. We would like to thank Jess Benhabib, Bill Gavin, Patrick Kehoe, Karl Shell, two anonymous referees and the editor, Wouter Denhaan, for helpful comments. The views expressed in the paper and any errors that may remain are the authors’alone. Correspondence: Yi Wen, Research Department, Federal Reserve Bank of St. Louis, St. Louis, MO, 63144. Email: [email protected].