PRICE AND QUANTITY RESPONSES TO COST AND DEMAND SHOCKS

When prices are inflexible, real variables like production and invento ries must bear the brunt of responding to cost and demand shocks. In t hese circumstances, one expects to observe rather more variation in qu antities than in prices, and that is, in fact, what we observe in the data. To explain this observation, one must explain why prices are inf lexible. Our goal in this paper is to ascertain whether it is selectiv ity in response to demand shocks or just a more extensive smoothing of prices than quantities which accounts for the relatively higher varia tion in quantities which we observe. We conclude that selectivity in r esponse is clearly evident in the data: demand shocks have only very w eak effects on prices, but they have substantial (if rather transitory ) effects on quantities.