Is price flexibility destabilizing? Evidence for the open economy

Increased price flexibility causes temporary output deviations to be eliminated more quickly, but it also makes the effects of inflationary expectations on aggregate demand larger, so it can lead to increased output variability. This trade-off is assessed for an open economy, and only limited support is found for Keynes' concern that increased price flexibility is destabilizing. The dependence of this issue on exchange rate policy, and on alternative specifications for sticky prices, is emphasized.