Working Paper no. 127
By Martin Ellison and Andrew Scott
We examine the effect of introducing a specific type of price stickiness into a stochastic growth model subject to a cash in advance constraint. As in previous studies we find the introduction of price rigidities provides a substantial source of monetary non-neutrality, which contributes significantly to output volatility. We show that the introduction of this form of sticky prices improves the model’s performance at explaining inflation but worsens it for output. The most dramatic failure of the model is the extremely high-frequency fluctuations in output that it generates. Sticky prices not only fail to produce persistent business cycle fluctuations but they generate extreme volatility at very high frequencies.