Price and Quantity Responses to Cost and Demand Shocks.

When prices are inflexible, real variables like production and inventories must bear the brunt of responding to cost and demand shocks. In these circumstances, one expects to observe rather more variation in quantities than in prices, and that is, in fact, what we observe in the data. To explain this observation, one must explain why prices are inflexible. Our goal in this paper is to ascertain whether it is selectively in response to demand shocks or just a more extensive smoothing of prices than quantities which accounts for the relatively higher variation in quantities which we observe. We conclude that selectively in response is clearly evident in the data: demand shocks have only very week effects on prices, but they have substantial (if rather transitory) effects on quantities. Copyright 1995 by Blackwell Publishing Ltd