This paper uses John Taylor's model of overlapping contracts to show that increased wage and price flexibility can easily be destabilizing because of the Mundell effect. While lower prices increased output, the expectation of falling prices decreases output. Simulations based on realistic parameter values suggest that increases in price flexibility might well increase the cyclical variability of output in the United States.

In macroeconomic models with flexible wages and prices, whether a tax is levied on producers or consumers does not affect its ultimate incidence. This equivalence breaks down in the presence of short-run nominal rigidities. Using both British and American data, we provide evidence against complete wage and price flexibility.