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A Flexible View on Prices
E31 - Price Level; Inflation; Deflation
E32 - Business Fluctuations; Cycles
This paper argues that the flexible price paradigm is superior to the sticky price paradigm in the context of general equilibrium models. Based on a quarterly data set for six G7 economies, the paper presents two types of evidence showing that prices respond significantly to their underlying fundamentals. First, prices respond contemporaneously and significantly to technology shocks in all countries. Second, the cyclical correlation between prices and unit labor costs is highest contemporaneously and around 0.8 in all cases. This behavior is only consistent with a model where most firms set prices flexibly.