The Cyclical Behavior of Prices and Employee Compensation

Are prices procyclical? For many economists, they clearly are. As Lucas (1976, 104) put it, “The fact that nominal prices and wages tend to rise more rapidly at the peak of the business cycle than they do in the trough has been well recognized from the time when the cycle was first perceived as a distinct phenomenon.” More recently, however, other researchers have challenged the prevailing view. According to Kydland and Prescott (1990, 17), “[T]he U.S. price level has clearly been countercyclical in the post–Korean War period.” The issue is of particular importance to macroeconomists who must choose a model to work with. A monetary sector was an integral part of equilibrium dynamic macro models that gained popularity in the 1970s, such as Lucas (1972). Monetary misperceptions could then give rise to procyclical movements in prices. In contrast, the real business cycle models that later gained popularity, such as Prescott (1986), did not have that property. If the behavior of prices over the business cycle were a clearly established empirical regularity, that information would help choose the type of model to use for economic analysis. This paper attempts to better understand how respected economists can hold such seemingly divergent views of the same data. By closely examining the data on aggregate price measures, I will try to clarify why each view could be correct under specific definitions of important terms. In doing so, I will propose a way of viewing the data that may be useful in other circumstances.