Price Inertia and Inflation: Evidence and Theoretical Rationale

In this paper we look at some empiricel evidence of and theoretical rationale for price inflexibility in the face of a decrease in short run demand in the Western-type industrialized economies. The empirical evidence suggests that price sluggishness is pervasive but varies across markets, industries and countries. There are different reasons for the price inertia. The response of firms to uncertainty, the cost of adjusting prices, the contents of the long- term contracts in the goods and input markets, the extent and variability of excess demand may differ among firms and industries. The structure of the industry, the degree of heterogeneity of the products in a market, the network of input-output relationship among industries, the nature of international competition, the process of forming expectations about the future, shocks from monetary and fiscal policies and input price shocks, all interact and create the ever changing environment of the firms. In these changing circumstances there are incentives for prices to be sluggish and thus arises the dilemma of achieving price stability at a high cost of unemployment. The ability of governments to achieve stable prices is probably endogenous in the system and may depend on a threshold rate of inflation. A number of policy options are discussed to address the issue of price inertia which would reduce the adjustment burden of anti-inflationary policies.