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Nominal rigidity, also known as price-stickiness or wage-stickiness, is a situation in which a nominal price is resistant to change. Complete nominal rigidity occurs when a price is fixed in nominal terms for a relevant period of time. For example, the price of a particular good might be fixed at $10 per unit for a year. Partial nominal rigidity occurs when a price may vary in nominal terms, but not as much as it would if perfectly flexible. For example, in a regulated market there might be limits to how much a price can change in a given year.
If one looks at the whole economy, some prices might be very flexible and others rigid. This will lead to the aggregate price level (which we can think of as an average of the individual prices) becoming "sluggish" or "sticky" in the sense that it does not respond to macroeconomic shocks as much as it would if all prices were flexible. The same idea can apply to nominal wages. The presence of nominal rigidity is an important part of macroeconomic theory since it can explain why markets might not reach equilibrium in the short run or even possibly the long run. In his The General Theory of Employment, Interest and Money , John Maynard Keynes argued that nominal wages display downward rigidity, in the sense that workers are reluctant to accept cuts in nominal wages. This can lead to involuntary unemployment as it takes time for wages to adjust to equilibrium, a situation he thought applied to the Great Depression.
The General Theory of Employment, Interest and Money of 1936 is the last and most important book by the English economist John Maynard Keynes. It created a profound shift in economic thought, giving macroeconomics a central place in economic theory and contributing much of its terminology – the "Keynesian Revolution". It had equally powerful consequences in economic policy, being interpreted as providing theoretical support for government spending in general, and for budgetary deficits, monetary intervention and counter-cyclical policies in particular. It is pervaded with an air of mistrust for the rationality of free-market decision making.
John Maynard Keynes, 1st Baron Keynes, was a British economist, whose ideas fundamentally changed the theory and practice of macroeconomics and the economic policies of governments. Originally trained in mathematics, he built on and greatly refined earlier work on the causes of business cycles, and was one of the most influential economists of the 20th century. Widely considered the founder of modern macroeconomics, his ideas are the basis for the school of thought known as Keynesian economics, and its various offshoots.
Involuntary unemployment occurs when a person is willing to work at the prevailing wage yet is unemployed. Involuntary unemployment is distinguished from voluntary unemployment, where workers choose not to work because their reservation wage is higher than the prevailing wage. In an economy with involuntary unemployment there is a surplus of labor at the current real wage. This occurs when there is some force that prevents the real wage rate from decreasing to the real wage rate that would equilibrate supply and demand. Structural unemployment is also involuntary.
There is now a considerable amount of evidence about how long price-spells last, and it suggests that there is a considerable degree of nominal price rigidity in the "complete sense" of prices remaining unchanged. A price-spell is a duration during which the nominal price of a particular item remains unchanged. For some items, such as gasoline or tomatoes, prices are observed to vary frequently resulting in many short price spells. For other items, such as the cost of a bottle of champagne or the cost of a meal in a restaurant, the price might remain fixed for an extended period of time (many months or even years). One of the richest sources of information about this is the price-quote data used to construct the Consumer Price Index (CPI). The statistical agencies in many countries collect tens of thousands of price-quotes for specific items each month in order to construct the CPI. In the early years of the 21st century, there were several major studies of nominal price rigidity in the US and Europe using the CPI price quote microdata. The following table gives nominal rigidity as reflected in the frequency of prices changing on average per month in several countries. For example, in France and the UK, each month on average, 19% of prices change (81% are unchanged), which implies that an average price spell lasts about 5.3 months (the expected duration of a price spell is equal to the reciprocal of the frequency of price change if we interpret the empirical frequency as representing the Bernoulli probability of price change generating a negative binomial distribution of durations of price-spells).
Champagne is a French sparkling wine. Many people use the term Champagne as a generic term for sparkling wine but in the EU and some other countries it is illegal to label any product Champagne unless it comes from the region Champagne and is produced under the rules of the appellation.. This alcoholic drink is produced from specific types of grapes grown in the Champagne region of France following rules that demand, among other things, specific vineyard practices, sourcing of grapes exclusively from designated places within in the Champagne region, specific grape-pressing methods and secondary fermentation of the wine in the bottle to cause carbonation.
In probability theory and statistics, the Bernoulli distribution, named after Swiss mathematician Jacob Bernoulli, is the discrete probability distribution of a random variable which takes the value 1 with probability and the value 0 with probability that is, the probability distribution of any single experiment that asks a yes–no question; the question results in a boolean-valued outcome, a single bit whose value is success/yes/true/one with probability p and failure/no/false/zero with probability q. It can be used to represent a coin toss where 1 and 0 would represent "heads" and "tails", respectively, and p would be the probability of the coin landing on heads or tails, respectively. In particular, unfair coins would have
In probability theory and statistics, the negative binomial distribution is a discrete probability distribution of the number of successes in a sequence of independent and identically distributed Bernoulli trials before a specified (non-random) number of failures occurs. For example, if we define a 1 as failure, all non-1s as successes, and we throw a dice repeatedly until 1 appears the third time, then the probability distribution of the number of non-1s that appeared will be a negative binomial distribution.
|Country (CPI data)||Frequency (per month)||Mean Price Spell duration (months)||Data Period|
|Eurozone||Various, covering 1989–2004|
The fact that price spells last on average for 3.7 months does not mean that prices are not sticky. That is because many price changes are temporary (for example sales) and prices revert to their usual or "reference price".Removing sales and temporary price cuts raises the average length of price-spells considerably: in the US it more than doubled the mean spell duration to 11 months. The reference price can remain unchanged for an average of 14.5 months in the US data. Also, it is prices that we are interested in. If the price of tomatoes changes every month, the tomatoes price will generate 12 price spells in a year. Another price that is just as important (for example, canned tomatoes) might only change once per year (one price spell of 12 months). Looking at these two goods prices alone, we observe that there are 13 price spells with an average duration of (12+13)/13 equals about 2 months. However, if we average across the two items (tomatoes and canned tomatoes), we see that the average spell is 6.5 months (12+1)/2. The distribution of price spell durations and its mean are heavily influenced by prices generating short price spells. If we are looking at nominal rigidity in an economy, we are more interested in the distribution of durations across prices rather than the distribution of price spell durations in itself. There is thus considerable evidence that prices are sticky in the "complete" sense, that the prices remain on average unchanged for a prolonged period of time (around 12 months). Partial nominal rigidity is less easy to measure, since it is difficult to distinguish whether a price that changes is changing less than it would if it were perfectly flexible.
Linking micro data of prices and cost, Carlsson and Nordström Skans (2012), showed that that firms consider both current and future expected cost when setting prices.The finding that the expectation of future conditions matter for the price set today provides strong evidence in favor of nominal rigidity and the forward looking behavior of the price setters implied by the models of sticky prices outlined below.
Economists have tried to model sticky prices in a number of ways. These models can be classified as either time-dependent, where firms change prices with the passage of time and decide to change prices independently of the economic environment, or state-dependent, where firms decide to change prices in response to changes in the economic environment. The differences can be thought of as differences in a two-stage process: In time-dependent models, firms decide to change prices and then evaluate market conditions; In state-dependent models, firms evaluate market conditions and then decide how to respond.
In time-dependent models price changes are staggered exogenously, so a fixed percentage of firms change prices at a given time. There is no selection as to which firms change prices. Two commonly used time-dependent models are based on papers by John B. Taylorand Guillermo Calvo. In Taylor (1980), firms change prices every nth period. In Calvo (1983), price changes follow a Poisson process. In both models the choice of changing prices is independent of the inflation rate.
John Brian Taylor is the Mary and Robert Raymond Professor of Economics at Stanford University, and the George P. Shultz Senior Fellow in Economics at Stanford University's Hoover Institution.
Guillermo Antonio Calvo is an Argentine-American economist who is Director of Columbia University's mid-career Program in Economic Policy Management in their School of International and Public Affairs (SIPA).
The Taylor model is one where firms set the price knowing exactly how long the price will last (the duration of the price spell). Firms are divided into cohorts, so that each period the same proportion of firms reset their price. For example, with two-period price-spells, half of the firms reset their price each period. Thus the aggregate price level is an average of the new price set this period and the price set last period and still remaining for half of the firms. In general, if price-spells last for n periods, a proportion of 1/n firms reset their price each period and the general price is an average of the prices set now and in the preceding n-1 periods. At any point in time, there will be a uniform distribution of ages of price-spells: (1/n) will be new prices in their first period, 1/n in their second period, and so on until 1/n will be n periods old. The average age of price-spells will be (n+1)/2 (if you count the first period as 1).
In the Calvo staggered contracts model, there is a constant probability h that the firm can set a new price. Thus a proportion h of firms can reset their price in any period, whilst the remaining proportion (1-h) keep their price constant. In the Calvo model, when a firm sets its price, it does not know how long the price-spell will last. Instead, the firm faces a probability distribution over possible price-spell durations. The probability that the price will last for i periods is (1-h)(i-1), and the expected duration is h−1. For example, if h=0.25, then a quarter of firms will rest their price each period, and the expected duration for the price-spell is 4. There is no upper limit to how long price-spells may last: although the probability becomes small over time, it is always strictly positive. Unlike the Taylor model where all completed price-spells have the same length, there will at any time be a distribution of completed price-spell lengths.
In state-dependent models the decision to change prices is based on changes in the market and is not related to the passage of time. Most models relate the decision to change prices to menu costs. Firms change prices when the benefit of changing a price becomes larger than the menu cost of changing a price. Price changes may be bunched or staggered over time. Prices change faster and monetary shocks are over faster under state dependent than time.Examples of state-dependent models include the one proposed by Golosov and Lucas and one suggested by Dotsey, King and Wolman.
In macroeconomics, nominal rigidity is necessary to explain how money (and hence monetary policy and inflation) can affect the real economy and why the classical dichotomy breaks down.
If nominal wages and prices were not sticky, or perfectly flexible, they would always adjust such that there would be equilibrium in the economy. In a perfectly flexible economy, monetary shocks would lead to immediate changes in the level of nominal prices, leaving real quantities (e.g. output, employment) unaffected. This is sometimes called monetary neutrality or "the neutrality of money".
For money to have real effects, some degree of nominal rigidity is required so that prices and wages do not respond immediately. Hence sticky prices play an important role in Keynesian macroeconomic theory and new Keynesian thought. Keynesian macroeconomists suggest that markets fail to clear because prices fail to drop to market clearing levels when there is a drop in demand.
Since prices and wages cannot move instantly, price- and wage-setters become forward looking. The notion that expectations of future conditions affect current price- and wage-setting decisions is a keystone for much of the current monetary policy analysis based on Keynesian macroeconomic models and the implied policy advice.
Economists[ who? ] have also looked at sticky wages as an explanation for why there is unemployment.
Huw Dixon and Claus Hansen showed that even if only part of the economy has sticky prices, this can influence prices in other sectors and lead to prices in the rest of the economy becoming less responsive to changes in demand.Thus price and wage stickiness in one sector can "spill over" and lead to the economy behaving in a more Keynesian way.
To see how a small sector with a fixed price can affect the way rest of the flexible prices behave, suppose that there are two sectors in the economy: a proportion a with flexible prices Pf and a proportion 1-a that are affected by menu costs with sticky prices Pm. Suppose that the flexible price sector price Pf has the market clearing condition of the following form:
where is the aggregate price index (which would result if consumers had Cobb-Douglas preferences over the two goods). The equilibrium condition says that the real flexible price equals some constant (for example could be real marginal cost). Now we have a remarkable result: no matter how small the menu cost sector, so long as a<1, the flexible prices get "pegged" to the fixed price. Using the aggregate price index the equilibrium condition becomes
which implies that
What this result says is that no matter how small the sector affected by menu-costs, it will tie down the flexible price. In macroeconomic terms all nominal prices will be sticky, even those in the potentially flexible price sector, so that changes in nominal demand will feed through into changes in output in both the menu-cost sector and the flexible price sector.
Now, this is of course an extreme result resulting from the real rigidity taking the form of a constant real marginal cost. For example, if we allowed for the real marginal cost to vary with aggregate output Y, then we would have
so that the flexible prices would vary with output Y. However, the presence of the fixed prices in the menu-cost sector would still act to dampen the responsiveness of the flexible prices, although this would now depend upon the size of the menu-cost sector a, the sensitivity of to Y and so on.
In macroeconomics, sticky information is old information used by agents as a basis for their behavior—information that does not take into account recent events. The first model of sticky information was developed by Stanley Fischer in his 1977 article.He adopted a "staggered" or "overlapping" contract model. Suppose that there are two unions in the economy, who take turns to choose wages. When it is a union's turn, it chooses the wages it will set for the next two periods. In contrast to John B. Taylor's model where the nominal wage is constant over the contract life, in Fischer's model the union can choose a different wage for each period over the contract. The key point is that at any time t, the union setting its new contract will be using the up-to-date latest information to choose its wages for the next two periods. However, the other union is still setting its wage based on the contract it planned last period, which is based on the old information.
The importance of sticky information in Fischer's model is that whilst wages in some sectors of the economy are reacting to the latest information, those in other sectors are not. This has important implications for monetary policy. A sudden change in monetary policy can have real effects, because of the sector where wages have not had a chance to adjust to the new information.
The idea of sticky information was later developed by N. Gregory Mankiw and Ricardo Reis.This added a new feature to Fischer's model: there is a fixed probability that you can replan your wages or prices each period. Using quarterly data, they assumed a value of 25%: that is, each quarter 25% of randomly chosen firms/unions can plan a trajectory of current and future prices based on current information. Thus if we consider the current period, 25% of prices will be based on the latest information available, and the rest on information that was available when they last were able to replan their price trajectory. Mankiw and Reis found that the model of sticky information provided a good way of explaining inflation persistence.
Sticky information models do not have nominal rigidity: firms or unions are free to choose different prices or wages for each period. It is the information that is sticky, not the prices. Thus when a firm gets lucky and can re-plan its current and future prices, it will choose a trajectory of what it believes will be the optimal prices now and in the future. In general, this will involve setting a different price every period covered by the plan.
This is at odds with the empirical evidence on prices.There are now many studies of price rigidity in different countries: the US, the Eurozone, the UK and others. These studies all show that whilst there are some sectors where prices change frequently, there are also other sectors where prices remain fixed over time. The lack of sticky prices in the sticky information model is inconsistent with the behavior of prices in most of the economy. This has led to attempts to formulate a "dual stickiness" model that combines sticky information with sticky prices.
The sticky inflation assumption states that "when firms set prices, for various reasons the prices respond slowly to changes in monetary policy. This leads the rate of inflation to adjust gradually over time."Additionally, within the context of the short run model there is an implication that the classical dichotomy does not hold when sticky inflation is present. This is the case when monetary policy affects real variables. Sticky inflation can be caused by expected inflation (e.g. home prices prior to the recession), wage push inflation (a negotiated raise in wages), and temporary inflation caused by taxes. Sticky inflation becomes a problem when economic output decreases while inflation increases, which is also known as stagflation. As economic output decreases and unemployment rises the standard of living falls faster when sticky inflation is present. Not only will inflation not respond to monetary policy in the short run, but monetary expansion as well as contraction can both have negative effects on the standard of living.
Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of an economy as a whole. This includes regional, national, and global economies.
New Keynesian economics is a school of contemporary macroeconomics that strives to provide microeconomic foundations for Keynesian economics. It developed partly as a response to criticisms of Keynesian macroeconomics by adherents of new classical macroeconomics.
The Phillips curve is a single-equation economic model, named after William Phillips, describing an inverse relationship between rates of unemployment and corresponding rates of rises in wages that result within an economy. Stated simply, decreased unemployment, in an economy will correlate with higher rates of wage rises. Phillips did not himself state there was any relationship between employment and inflation; this notion was a trivial deduction from his statistical findings. Samuelson and Solow made the connection explicit and subsequently Milton Friedman and Edmund Phelps put the theoretical structure in place. In so doing, Friedman was to successfully predict the imminent collapse of Phillips' a-theoretic correlation.
Neo-Keynesian economics is a school of macroeconomic thought that was developed in the post-war period from the writings of John Maynard Keynes. A group of economists, attempted to interpret and formalize Keynes' writings and to synthesize it with the neoclassical models of economics. Their work has become known as the neoclassical synthesis and created the models that formed the core ideas of neo-Keynesian economics. These ideas dominated mainstream economics in the post-war period and formed the mainstream of macroeconomic thought in the 1950s, 1960s and 1970s.
A macroeconomic model is an analytical tool designed to describe the operation of the problems of economy of a country or a region. These models are usually designed to examine the comparative statics and dynamics of aggregate quantities such as the total amount of goods and services produced, total income earned, the level of employment of productive resources, and the level of prices.
Neutrality of money is the idea that a change in the stock of money affects only nominal variables in the economy such as prices, wages, and exchange rates, with no effect on real variables, like employment, real GDP, and real consumption. Neutrality of money is an important idea in classical economics and is related to the classical dichotomy. It implies that the central bank does not affect the real economy by creating money. Instead, any increase in the supply of money would be offset by a proportional rise in prices and wages. This assumption underlies some mainstream macroeconomic models. Others like monetarism view money as being neutral only in the long-run.
Ricardo A. M. R. Reis is a Portuguese economist and the A. W. Phillips professor of economics at the London School of Economics. In a 2013 ranking of young economists by Glenn Ellison, Reis was considered the top economist with a PhD between 1996 and 2004., and in 2016 he won the Germán_Bernácer_Prize prize for top European-born economist researching macroeconomics and finance. He writes a weekly op-ed for the Portuguese newspaper Jornal de Noticias and participates frequently in economic debates in Portugal.
The policy-ineffectiveness proposition (PIP) is a new classical theory proposed in 1975 by Thomas J. Sargent and Neil Wallace based upon the theory of rational expectations, which posits that monetary policy cannot systematically manage the levels of output and employment in the economy.
In economics, a menu cost is the cost to a firm resulting from changing its prices. The name stems from the cost of restaurants literally printing new menus, but economists use it to refer to the costs of changing nominal prices in general. In this broader definition, menu costs might include updating computer systems, re-tagging items, and hiring consultants to develop new pricing strategies as well as the literal costs of printing menus. More generally, the menu cost can be thought of as resulting from costs of information, decision and implementation resulting in bounded rationality. Because of this expense, firms sometimes do not always change their prices with every change in supply and demand, leading to nominal rigidity. Generally, the effect on the firm of small shifts in price is relatively minor compared to the costs of notifying the public of this new information. Therefore, the firm would rather exist in slight disequilibrium than incur the menu costs.
New classical macroeconomics, sometimes simply called new classical economics, is a school of thought in macroeconomics that builds its analysis entirely on a neoclassical framework. Specifically, it emphasizes the importance of rigorous foundations based on microeconomics, especially rational expectations.
The AD–AS or aggregate demand–aggregate supply model is a macroeconomic model that explains price level and output through the relationship of aggregate demand and aggregate supply.
Macroeconomic theory has its origins in the study of business cycles and monetary theory. In general, early theorists believed monetary factors could not affect real factors such as real output. John Maynard Keynes attacked some of these "classical" theories and produced a general theory that described the whole economy in terms of aggregates rather than individual, microeconomic parts. Attempting to explain unemployment and recessions, he noticed the tendency for people and businesses to hoard cash and avoid investment during a recession. He argued that this invalidated the assumptions of classical economists who thought that markets always clear, leaving no surplus of goods and no willing labor left idle.
Inflationism is a heterodox economic, fiscal, or monetary policy, that predicts that a substantial level of inflation is harmless, desirable or even advantageous. Similarly, inflationist economists advocate for an inflationist policy.
In macroeconomics, rigidities are real prices and wages that fail to adjust to the level indicated by equilibrium or if something holds one price or wage fixed to a relative value of another. Real rigidities can be distinguished from nominal rigidities, rigidities that do not adjust because prices can be sticky and fail to change value even as the underlying factors that determine prices fluctuate. Real rigidities, along with nominal, are a key part of new Keynesian economics. Economic models with real rigidities lead to nominal shocks having a large impact on the economy.
The new neoclassical synthesis (NNS) or new synthesis is the fusion of the major, modern macroeconomic schools of thought, new classical and New-Keynesianism, into a consensus on the best way to explain short-run fluctuations in the economy. This new synthesis is analogous to the neoclassical synthesis that combined neoclassical economics with Keynesian macroeconomics. The new synthesis provides the theoretical foundation for much of contemporary mainstream economics. It is an important part of the theoretical foundation for the work done by the Federal Reserve and many other central banks.
Disequilibrium macroeconomics is a tradition of research centered on the role of disequilibrium in economics. This approach is also known as non-Walrasian theory, equilibrium with rationing, the non-market clearing approach, and non-tâtonnement theory. Early work in the area was done by Don Patinkin, Robert W. Clower, and Axel Leijonhufvud. Their work was formalized into general disequilibrium models, which were very influential in the 1970s. American economists had mostly abandoned these models by the late 1970s, but French economists continued work in the tradition and developed fixprice models.
The Taylor contract or staggered contract was first formulated by John B. Taylor in his two articles, in 1979 "Staggered wage setting in a macro model'. and in 1980 "Aggregate Dynamics and Staggered Contracts". In its simplest form, one can think of two equal sized unions who set wages in an industry. Each period, one of the unions sets the nominal wage for two periods. This means that in any one period, only one of the unions can reset its wage and react to events that have just happened. When the union sets its wage, it sets it for a known and fixed period of time. Whilst it will know what is happening in the first period when it sets the new wage, it will have to form expectations about the factors in the second period that determine the optimal wage to set. Although the model was first used to model wage setting, in new Keynesian models that followed it was also used to model price-setting by firms.
A Calvo contract is the name given in macroeconomics to the pricing model that when a firm sets a nominal price there is a constant probability that a firm might be able to reset its price which is independent of the time since the price was last reset. The model was first put forward by Guillermo Calvo in his 1983 article "Staggered Prices in a Utility-Maximizing Framework". The original article was written in a continuous time mathematical framework, but nowadays is mostly used in its discrete time version. The Calvo model is the most common way to model nominal rigidity in new Keynesian DSGE macroeconomic models.
Emi Nakamura is Chancellor's Professor of Economics at University of California, Berkeley, a Research Associate and Co-director of Monetary Economics Program of the National Bureau of Economic Research, and a Co-Editor of the American Economic Review. She was awarded the John Bates Clark Medal and elected to the American Academy of Arts and Sciences in 2019. She has been awarded an NSF Career Grant and Sloan Research Fellowship, was the 2014 recipient of the Elaine Bennett Research Prize, and was named one of the top 25 economists under 45 in 2014 by the IMF. She received her PhD in Economics from Harvard and her AB from Princeton.
Jón Steinsson is Chancellor's Professor of Economics at University of California, Berkeley, a Research Associate and Co-Directory of the Monetary Economics program of the National Bureau of Economic Research, and Associate Editor of both American Economic Review: Insights, and the Quarterly Journal of Economics. He received his PhD in Economics from Harvard and his AB from Princeton.