The stabilizing effects of price flexibility in contract-based models

Abstract

This paper shows that the destabilizing effects of price flexibility due to the increased sensitivity of contract wages to labor market tightness depend on the assumption of a restriction on the information available to wagesetters who are negotiating contract renewals. If these agents are put on the same footing as investors and the monetary authorities by being given access to current information, then increased price flexibility can reduce the magnitude of economic fluctuations in the face of demand shocks. Contrary to other recent papers, this result is derived completely within a staggered contracts framework.