How sticky are prices?
- Nominal Rigidity and why macroeconomists can’t agree.
Suggested Response
The following response sets out in note-form what I consider to be the key points of the activity –
you may have presented your answers differently, focused on other aspects of the problem or
included relevant material not presented below.
Introduction
 In microeconomics, equilibrium is achieved by movements in prices.
o Demand increase / Supply falls → Prices rise
o Demand falls / Supply increases → Prices fall
 Does this same mechanism apply in macroeconomics to achieve equilibrium?
Business Cycles
 Modern industrial economies experience two phenomena
o There is a long-run increase in potential output or aggregate supply
o Actual output or aggregate demand fluctuates around potential output leading to
changes in the difference between actual and potential output (the output gap)
 These variations in the output gap are called the business cycle
o The troughs often (but not always) constitute recessions when actual output falls
for two or more consecutive quarters
o The peaks often (but not always) lead to periods of over-heating when actual
output may exceed potential output – leading to inflation etc.
Notation
 To illustrate the points, I am going to make I will introduce some notation
 𝑄 will denote real output of goods
 𝑃 will denote the price of goods and 𝑊nominal wages
𝑊
o
will denote real wages






𝑃
𝑌 will denote real demand for goods
𝑀 will denote nominal money and 𝑀 𝑆 the money supply and 𝑀𝐷 demand for money
𝑀
o 𝑃 will denote real money
𝐶, 𝐺, 𝐼will denote real consumption, government expenditure and investment respectively;
𝑆will denote savings;
𝐾, 𝐿will denote capital and labour respectively;
𝑟will be the real interest rate
Classical Economics
 Classical Economics of the sort thought to have existed before Keynes1 has the following
characteristics:
o 𝑄is determined by supply-side factors namely
 Supply of factors of production such as labour and capital;
 Technology which determines how the factors combine to produce output;
1
Although there is some truth to the notion that classical economics as Keynes described it in the General
Theory was a caricature invented by Keynes.
1
o
o

Supply of labour is determined by the preferences of the work-force;
Relative prices are flexible and bring the goods and labour market into
equilibrium;
o Savings and Investment are brought into equilibrium by the interest rate;
o The Business Cycle is not well explained;
The Labour and Output Markets are perfectly competitive
𝑊
o 𝑃 represents the trade-off between leisure and consumption
 Workers are paid a wage to give up their leisure and work;
 They use that wage to purchase goods at the price of goods;
𝜕𝑄
o Demand for Labour depends on the Marginal Product of Labour ( ) or their
𝜕𝐿
productivity
𝜕𝑄
 𝜕𝐿 is the production of the extra worker. In the Classical World,
𝜕𝑄
𝜕𝐿

More workers means more goods -

The extra amount produced decreases as the number of workers
>0
increases due to diminishing returns to scale

A firm will hire workers such that
=
𝑊
𝑃
𝜕𝐿2
<0


The firm pays workers 𝑊and gets 𝑃
𝜕𝑄
Each worker produces

Paying more than

Paying less than
it cannot do in equilibrium in perfect competition;

The Demand for Labour is downward sloping because
𝜕𝐿
𝜕𝑄
would
mean the firm makes a loss
𝜕𝐿
𝜕𝑄
would mean the firm was making a
𝜕𝐿
profit which
𝜕2 𝑄
𝜕𝐿2
<0
The level of output of the firm will be determined by 𝐿the number of
employees which is determined by the real wage and productivity;
 Hence 𝑄is determined in the labour market;
o Supply of Labour is determined by preferences over goods and leisure
 Consumers desire leisure and consumption goods;
 If they work more they can purchase more goods but give up leisure;
 If they work less they can purchase fewer goods but have more leisure;
 The Supply of Labour is upward sloping because workers will be willing to
𝑊
work more as rises as they get more consumer goods;
𝑃
 Consumption is determined by the labour supply – which depends on the
Real Wage and preferences;
 This assumes that there is always sufficient demand for labour at
the current real wage
o Thus, Employment, Output and Consumption are determined entirely by
 Productivity of workers;
 Preferences of workers;
 The number of workers;
o Fiscal Policy cannot effect these factors
 It will just lead to crowding out of private consumption and investment
(i.e. output will not increase but will change its composition only);
Aggregate Saving and Aggregate Investment
o Saving is the foregoing of present consumption for future consumption;
 The rate at which present consumption is traded for future consumption is
𝑟 which is the real interest rate;


𝜕𝑄
𝜕𝐿
𝜕2 𝑄
2

o
o


Supply of Savings is determined by the trade-off between present and
future consumption – it is an inter-temporal decision;
 𝑆(+𝑟 ) - savings are a positive function of the real interest rate;
Investment is the use of savings to increase 𝐾
𝜕𝑄
 This increases 𝜕𝐿 as workers are now more productive;
 The rate which must be paid for savings is 𝑟
 The willingness to pay will be determined by the marginal product of
𝜕𝑄
capital 𝜕𝐾
 𝐼(−𝑟 ) - investment are a negative function of the real interest rate;
In equilibrium (in a closed economy) - 𝐼 −𝑟 = 𝑆(+𝑟 )
 The real interest rate brings them into equilibrium;
Prices
o 𝑀𝐷 - demand for money – depends on 𝑄
 It is transactional demand for money;
 The Quantity theory of money states that 𝑀𝐷 = 𝑄𝑃
 Demand for money is equal to the nominal value of output;
o In equilibrium, 𝑀 𝑆 = 𝑀𝐷 = 𝑄𝑃
 𝑀 𝑆 is fixed and determined by the central bank;
 We have already shown how 𝑄is determined – it is fixed in the labour
market;
 The only free variable to bring them into equilibrium is 𝑃the price level
o In the Classical Model, prices are determined by the 𝑀 𝑆 and 𝑀 𝑆 determines only
prices;
 This is the Classical Dichotomy or ‘money doesn’t matter’;
 The real-side of the model is determined without reference to money;
 Money only matters for determining prices;
 Monetary Policy is ineffective except to control inflation
The old-school classical model has been supplemented but its key characteristics still
drive modern Classical thinking and economic views about the long-run
o In the long-run, potential output or aggregate supply is determined by
fundamental microeconomic factors such as
 Supply of factors of production (particularly capital);
 Productivity of factors of production (particularly labour and capital);
o In the long-run, Money does not influence real variables;
o In the long-run, Fiscal Policy only leads to crowding out;
o Policy should be supply-side orientated;
o Unemployment is caused either by
 People preferring leisure to work at the current real wage – it is hence the
result of a rational choice; or
 Alternatives to work such as unemployment insurance which make
unemployment unattractive – hence another rational choice;
Keynesian Economics
 The Classical Theory cannot explain
o Persistent involuntary unemployment;
o Persistent deviations from the full employment level of output;
 The key assumption that Keynes made was that nominal wages are downwardly rigid –
this is an assumption of price stickiness
o This assumption was not justified by any formal microeconomic theory;
o It is an ad hoc assumption but one that was justified by appeal to the idea that
workers would resist erosions in their nominal wages (although not real wages)
 Workers are assumed thus to care about nominal and not real values;
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



It is not clear that in the face of massive unemployment that this
assumption is really justifiable – would you prefer a cut in nominal wages
or to become unemployed?
In a Keynes’ model as later formalised into the IS-LM-AS framework, three relationships
are important
o IS – The goods market equilibrium relationship;
o LM – The real money balances equilibrium relationship;
o AS – aggregate supply;
The IS relationship is derived as follows
𝑌
𝐴 2
o In equilibrium, 𝑄 = 𝑌 = 𝐶(+
) + 𝐺 + 𝐼(−𝑟 , +
)
 If 𝑄 > 𝑌, firms will reduce production as they will not be able to sell their
goods and their stocks of goods will be building up;
 If 𝑄 < 𝑌, firms will increase production as their stocks will be depleting;
o Unlike in the Classical model, consumption depends on income and not the real
wage as some people may be involuntarily unemployed at the current wage;
 This means that their actual consumption will be less than their preferred
level of consumption but they will not be able to do anything about it;
 This creates a multiplier effect as an increase in income from any factor
will lead to a consequent increase in consumption;
 Savings are determined by a fixed marginal propensity to consume;
o Investment continues to depend on interest rates but also on some other factor
which can be called ‘Animal Spirits’ which reflects business views on the future;
 It is not brought into equilibrium with savings as in this model consumption
does not depend on the interest rate;
o Government expenditure is exogenous;
 An increase in Government expenditure increases output;
o The IS curve (see figure below) denotes all the points in interest-rate, output
space for which the goods market equilibrium relationship holds;
 It is downward sloping because
 A higher 𝑟leads to lower investment which leads to lower output;
 A lower 𝑟 leads to higher investment which leads to higher input;
 The curve rotates as the multiplier alters;
 The curve shifts (but the gradient remains the same) if 𝐺changes as for
every interest rate the level of output is higher;
o The IS curve in the classical model is horizontal at a certain interest rate which is
determined by consumer inter-temporal preferences and marginal product of
capital;
The LM relationship
𝑀𝑆
𝑃
=
𝑀𝐷
𝑃
o
In equilibrium,
o
𝑀 𝑆 continues to be fixed by the central bank;
o
𝑀𝐷 𝑄 𝑟
( , )
𝑃 + −
- real money demand – depends in this model not only on output but
also on 𝑟
 This is the speculative demand for money;
 People distribute their assets between money balances and bonds;
 The price of bonds varies inversely with the interest rate
 At high interest rates the price is low
 At low interest rates the price is high
 People buy bonds when they expect the price to rise (i.e. when interest
rates are high) - this leads to lower money balances;
2
We are abstracting from problems of exports and imports.
4

𝑀𝑆
𝑀𝐷
In order for 𝑃 = 𝑃 –
 Transactional demand for money must be higher when interest rates are
higher – to make up for the lost speculative demand for money;
 Transactional demand for money must be lower when interest rates are
lower – to make space for the extra speculative demand for money;
 Hence, for each interest rate there is a unique level of output which is
consistent with equilibrium in the market for real money balances
o The LM curve is upward sloping in interest-rate, output space
 It is upward sloping because
 A higher 𝑟means more output is necessary to reach equilibrium;
 A lower 𝑟 means less output is necessary to reach equilibrium;
 The LM shifts when the money supply changes;
 The LM rotates when investment patterns change;
This is the IS-LM depicted
o
r
LM
IS
Q



Since the curves slope in opposite directions, there is only one combination of r,Q for
which equilibrium is achieved
o This equilibrium can be shifted using fiscal policy which shifts IS
o Monetary policy shifts LM
From this diagram we can derive an AD curve which depicts the relationship of 𝑄and𝑃
o A higher price level will shift LM by eroding real money supply (𝑀 𝑆 )
o LM will shift to the left because less transactional demand for money will be
necessary at each 𝑟 and hence there will be lower 𝑄
o The reverse argument also holds
The AS relationship is derived in the labour market
o As in the Classical model,
 The labour market is perfectly competitive but as we have indicated the
nominal wage is downwardly rigid;
 The only wage for employment to increase is for there to be a
𝑊
reduction in real wages 𝑃 ;
 At any 𝑃 this requires there to be a reduction in 𝑊;
5
o
Hence, the AS curve is upward sloping in price output space – subject to the fact
that at high levels of employment it is not possible for supply to increase
P
AS
AD
Q






The equilibrium price-level occurs when AS and AD intersect;
This price stickiness means that it is possible that some people may want to work at the
current real wage but cannot
o In the Classical Model, this would be fixed by a reduction in 𝑊 which would bring
the labour market into equilibrium;
o Because this reduction is not possible, the only way to reduce unemployment is
to increase 𝑃 but during a recession prices may actually fall which only
exacerbates the problem;
In Keynes formulation, an increase in 𝑃 can only be achieved by an increase in AD which
can be achieved by the use of fiscal or monetary policy as we discussed above
The results are thus in striking contrast to the Classical Model – owing to the
price rigidity discussed above
o Fiscal and Monetary Policy are effective
 Perhaps, the only effective policy during a depression;
o Volatility in investment can lead to a business cycle owing to the multiplier
effect which can exacerbate the effect of a downturn in investment;
o Unemployment can exist which is not involuntary;
However, this model is not satisfying for various reasons
o The behaviour of the real wage in a recession is not as predicted above;
o The assumption of nominal wage stickiness is ad hoc;
 What microeconomic reasons exist for this?
o The result changes if consumption is allowed to depend also on wealth
 Falling prices during a recession will increase the value of real wealth;
 People will consume more and this will lead to a return to equilibrium
without the use of policy;
Nevertheless, much of the post-war period was dominated by this model as a short-run
with a classical model of the long-run (known as the Keyneisan NeoClassical Synthesis)
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New Classical Economics
 New Classical Economics arose as part of the counter attack to what was perceived to
be the failed Keynesian policies of the postwar period – it seeks to maintain the classical
message but to reconcile it with
o The notion that business cycles exist;
o Monetary policy appears to have real effects – at least in the short run;
 The models were developed in part as response to attempts to use monetary policy to
increase output (at the cost of higher inflation) due to the Philips’ curve;
o The Philips curve demonstrates that higher inflation is consistent with lower levels
of unemployment;
o Attempts to rely on this apparent trade-off at first appeared successfully but soon
degenerated into ever accelerating inflation even when unemployment stopped
falling;
 Consider the Classical Model demonstrated above
o In this model,
 Lower real wages alone lead to higher output/employment;
 But lower real wages meant lower labour supply;
 Classical dichotomy held;
o In order for monetary policy to have had an effect,
 Real wages must have appeared lower and higher at the same time;
 The solution offered by the New Classical Economics is very simple
o Suppose you are a worker offered a nominal wage increase of ∆𝑊and you
expect the change in the price level to be ∆𝑃𝑒 = 𝜋 𝑒 you will supply consistent with
your preferences and the expected real wage;
o Suppose instead of 𝜋 𝑒 , the actual rate of inflation was 𝜋 ∗ > 𝜋 𝑒 , the real wage
you would get would be less than you had expected;
 This could be because the money supply was increased by the
government as monetary policy;
o Suppose the employers are better able to measure the price level than the
workers (because they supply the goods in question3),
 They would see a lower real wage;
 The workers would see a higher real wage;
 Output / Employment would increase;
o Eventually, the workers would realise they were conned and in order for this
higher level to continue they would need to be tricked again;
 Whether the government could con the workers again would depend on how their
expectations changed,
o This explains the break-down in the Philips curve;
o If workers between to expect higher inflation – or greater volatility in inflation –
they will demand higher real wages for more labour;
o In order for the government to trick them with its monetary policy, they would
need to deliver an even higher level of inflation;
o In any case, inflation expectations have increased;
 Under Milton Freidman’s formulation of this model, expectations were adaptive – they
took time to catch up which meant that monetary policy would also work but would also
lead to ever higher inflation;
 Under later formulations, expectations were rational – workers would see the
government increasing inflation and adjust their expectations accordingly;
o The limit of this argument is the policy ineffectiveness proposition –
3
The formal Lucas information model has the characteristic that employers view some prices but not
others (because they do not work in all sectors). Workers buy goods from all sectors.
7


Since policy only works by tricking people, rational people will not be
capable of being tricked (except by random things) because they will
expect higher inflation owing to the government’s announcements;
 Monetary policy will not work at all under this argument;
The New Classical Economists are thus able to explain the effectiveness of policy
without price stickiness although these conclusions are unable to explain
o Apparently demand-side unemployment;
o The business cycle
 A Classical school of thought known as Real Business Cycle theory tries
to explain fluctuations through real variations such as technology shocks
although I personally find this hard to swallow;
o The apparent effectiveness of fiscal policy;
New Keynesian Economics
 New Keynesian Economics tries to accept the teachings of New Classical Economists to
explain the fundamental Keynesian concepts using
o Explicit microeconomic explanations (as opposed to ad hoc suppositions);
o Expectations;
 An important feature of New Keynesian Models is often price stickiness to explain the
effects of monetary policy – various explanations have been offered for this sort of rigidity
o Staggered Pricing –
 Price and Wage decisions occur over a period of time and different firms
will change their prices on different dates and at different times;
 Because of this staggering changes in the money supply will affect the
prices of some firms faster than those of other firms;
 Some wages will also be affected while otherwise will not;
 Monetary policy is thus capable of changing relative (or real) prices;
o Menu Costs –
 There is some cost to altering prices – new price lists / menus have to be
issued etc.
 Although the money supply may have changed, it may not be worth it for a
given firm to alter its price in response to the changed circumstance;
 This is because there is an externality to changing prices – changing
prices has a small benefit to the firm but a larger benefit to the economy
as a whole;
 Akerloff suggests that firms may set their prices according to a standard of
‘quasi-rationality’ which means that their prices are ‘close enough’ but not
perfect;
o Coordination failures –
 Price and wage setters need to form expectations of each other’s
behaviour;
 These expectations can lead to nominal rigidity if there is a mutual
expectation of price stickiness even when this is not the best outcome;
o Efficiency Wages –
 It is well known that firms often pay higher than the marginal revenue
product of labour in order to motivate workers (or discourage them from
shirking);
 This creates a nominal rigidity as wages may not be reduced even though
demand has fallen or the price level has changed;
 The effects of these nominal rigidities can be (at least in theoretical models)
o Markets do not clear – there is no reason to expect the full employment outcome;
o Demand determines the level of employment;
o Monetary and fiscal policy can be effective;
8
Monetary policy works because of nominal rigidity – relative prices are
changed by monetary policy leading to real effects;
 Fiscal policy works because it alters the level of demand;
Research is inconclusive as to whether small nominal rigidities are sufficient to cause
large enough real effects to explain the business cycle;
Another key characteristic of New Keyensian is imperfect competition in the labour and
output market
o Price Setters use some form of mark-up pricing with the mark-up depend on the
position in the cycle
 i.e. When output/employment is high the mark-up is larger;
o Wage bargaining or efficiency wages leads to wages greater than the marginal
revenue product;
 When output/employment is higher, the divergence is larger;
o This allows monetary supply / fiscal policy to have an effect;
Just as in the New Classical model, the New Keynesians accept that there is a level of
employment below which there will be accelerating inflation. However, in the New
Keynesian model this is not the full employment level but the NAIRU (non-accelerating
inflation rate of unemployment) at which there may be involuntary unemployment;




A New Synthesis
In recent years such sharp distinctions have become less important with dynamic general
equilibrium models including both classical and Keynesian features.
9