Asymmetric Nominal Flexibility and Economic Fluctuations

Abstract

Recent research has produced strong evidence that supports the asymmetric effects of positive and negative money supply shocks. Using quarterly data for the United States, the evidence of Cover [10] suggests that positive money supply shocks do not have an effect on output while negative money-supply shocks do. The asymmetric impact of demand shocks on real output growth is not addressed in the context of mainstream business-cycle theories which include the equilibrium explanation pioneered by Lucas [21] and neo-Keynesian models emphasizing nominal wage rigidity [14; 15] or price rigidity [2]. In the context of Lucas's paradigm, agents are scattered in informationaly isolated islands across the economy. An unexpected, positive or negative, change in aggregate demand may be misperceived by agents as being specific to their markets. In the case of a positive demand shock, producers and workers expand the output and labor supplied to take advantage of the perceived increased demand in their island. Similarly, agents are expected to contract the output produced in response to a perceived reduction in the demand for their output. This scenario does not provide an obvious theoretical channel through which the slope of the short-run supply curve can be differentiated depending on the direction of the change in aggregate demand. In the context of a contractual wage rigidity framework, the nominal wage is fixed for a duration that is determined by contractual agreements. According to this framework, a change in aggregate demand deviates the real wage from its market clearing value for a duration that is determined by the contract length. A positive demand shock will raise the price level, decrease the real wage and, in turn, cause an expansion in labor demand and the output produced in the short-run. A negative demand shock, in contrast, raises the realized real wage which has a negative impact on labor demand and the output produced in the short-run. In the absence of any stipulation in contracts that differentiates the degree of wage rigidity in response to a positive and negative demand shock, the slope of the short-run supply curve is not likely to be differentiated based on the direction of change in aggregate demand. In the context of the sticky-price explanation of business cycles, the price level across sectors of the economy is fixed for a specific duration. A change, positive or negative, in aggregate demand will be absorbed in output as long as the price level remains fixed in the short-run. In the absence of any stipulation that differentiates the upward and downward stickiness of the price