Nominal rigidities

What Is Nominal Rigidities?

Nominal rigidities, often referred to as "sticky prices" or "sticky wages," describe the phenomenon in macroeconomics where prices of goods and services, and factor prices like wages, do not adjust immediately or fully to changes in economic conditions. Instead of instantly reaching a new equilibrium in response to shifts in supply and demand or other economic shocks, nominal rigidities cause prices and wages to remain fixed for a period. This stickiness is a central concept in New Keynesian economics, explaining why monetary policy can have real effects on the economy in the short run, influencing factors like output and unemployment.

History and Origin

The concept of nominal rigidities gained prominence with the development of Keynesian economic thought, which emphasized that markets do not always clear instantly. Early work on price and wage stickiness often focused on implicit or explicit contracts. Influential papers in the late 1970s and 1980s, such as those by Stanley Fischer and John B. Taylor, formalized models where prices and wages were set in advance for a period, leading to staggered adjustments. A significant contribution to the understanding of nominal rigidities was the "menu cost" theory, which posits that the real costs associated with changing prices (like reprinting menus, updating catalogs, or reprogramming price systems) can prevent firms from adjusting prices frequently, even when underlying costs or demand shift. Research by the Federal Reserve Bank of Cleveland in the early 1990s explored how nominal contracts could create monetary non-neutrality, where changes in the money supply have real economic effects rather than just affecting the price level.⁶

Key Takeaways

• Nominal rigidities refer to the slow adjustment of prices and wages to economic changes.
• They are a cornerstone of New Keynesian macroeconomic models, explaining the short-run effectiveness of monetary policy.
• Causes include "menu costs," long-term contracts, and informational frictions.
• Nominal rigidities can lead to temporary deviations from full employment and potential output during business cycles.
• Understanding nominal rigidities is crucial for policymakers in managing inflation and stabilizing the economy.

Interpreting the Nominal Rigidities

The presence of nominal rigidities implies that an economy may not always operate at its full potential. When prices and wages are sticky, an unexpected change in aggregate demand or supply and demand cannot be fully absorbed by immediate price adjustments. For instance, if aggregate demand falls due to a negative economic shock, and firms face nominal rigidities, they may be slow to lower prices. This can lead to a buildup of unsold inventory, prompting firms to reduce output and employment rather than simply adjusting prices. This sluggish adjustment can amplify fluctuations in business cycles and contribute to periods of recession or recovery.

Hypothetical Example

Consider "Smoothie King," a local smoothie shop. Due to nominal rigidities, such as the cost of reprinting their physical and digital menus (a "menu cost"), the owner has set a fixed price of $7 for their popular Berry Blast smoothie for the next quarter.

One month into the quarter, the cost of fresh berries, a key ingredient, unexpectedly doubles. If prices were perfectly flexible, Smoothie King would immediately raise the price of the Berry Blast to maintain its desired profit margin. However, due to the nominal rigidity (menu costs), the owner decides against an immediate price change.

For the remainder of the quarter, Smoothie King continues to sell the Berry Blast for $7, even though their marginal cost has significantly increased. This results in a reduction of their profit margin per smoothie. If the situation persists or worsens, the owner might eventually reduce the quantity of berries in each smoothie, decrease production, or even lay off staff, rather than absorb the higher costs indefinitely or incur the costs of immediately changing the menu price. This delay in price adjustment illustrates how nominal rigidities can lead to temporary inefficiencies and real economic consequences for the business.

Practical Applications

Nominal rigidities have profound practical implications for monetary policy and fiscal policy in macroeconomics. Central banks, like the Federal Reserve, consider nominal rigidities when setting interest rates and managing the money supply. In an economy with perfectly flexible prices, changes in the money supply would only affect the price level, without altering real variables like output or employment. However, because of nominal rigidities, a central bank's actions can influence real economic activity in the short run. For example, lowering interest rates can stimulate aggregate demand, and if prices are sticky, this can lead to an increase in real output and employment rather than just higher inflation. Policymakers often design interventions based on the understanding that these rigidities exist, allowing for a window where policy can stabilize the economy during business cycles. Recent research by the Federal Reserve Bank of St. Louis, for example, explores how optimal monetary policy can address distortions caused by such rigidities in credit markets.⁵

Limitations and Criticisms

While nominal rigidities are a cornerstone of modern macroeconomic models, particularly New Keynesian economics, they are not without limitations and criticisms. A key debate revolves around the empirical evidence for the widespread nature and economic significance of sticky prices. Some critics argue that while "menu costs" exist, they may not be substantial enough to explain large-scale aggregate [output] fluctuations or persistent deviations from full employment. Research has indicated that firms' stock returns may show greater volatility after monetary policy announcements for firms with stickier prices, suggesting that these rigidities can indeed be costly for businesses.⁴

Furthermore, some models propose that price stickiness can arise even without explicit menu costs, due to other factors like search frictions or the desire of firms to provide a service to customers by maintaining stable prices.³ Another area of critique concerns the relative importance of different types of nominal rigidities, such as sticky prices versus sticky wages. Some studies suggest that wage rigidities might be more critical in explaining the inertia of inflation and persistence of output in response to monetary policy shocks than price rigidities alone.² Economists continue to refine models to better capture the complexities of price-setting behavior and the interplay between nominal and real frictions.¹

Nominal Rigidities vs. Real Rigidities

Nominal rigidities refer to the resistance of prices and wages to change in nominal terms. This means that a dollar price or a dollar wage might stay fixed even if the purchasing power of that dollar changes due to inflation or deflation. The underlying cause is typically a friction in the nominal adjustment process, such as the direct costs of changing prices (menu costs) or long-term contracts denominated in nominal currency.

In contrast, real rigidities refer to the resistance of relative prices or real wages to change. This means that even if nominal prices are flexible and can adjust, firms or individuals might still resist changes in their prices relative to others, or their wages relative to productivity. Real rigidities can arise from factors like efficiency wages (where firms pay above-market wages to boost productivity), imperfect competition leading to large markups, or strong linkages in input-output relationships between firms that make relative price adjustments difficult. Both nominal and real rigidities are important in understanding how economic shocks propagate through the economy, with nominal rigidities often explaining the short-run non-neutrality of monetary policy, and real rigidities influencing the size and persistence of those effects.

FAQs

Why are prices sticky?

Prices are sticky due to various factors, including "menu costs" (the physical or administrative costs of changing prices), long-term contracts between buyers and sellers, and informational frictions where firms may not immediately know the optimal new price level or react slowly to changes. Psychological factors, such as consumer aversion to frequent price changes, can also contribute.

How do nominal rigidities affect the economy?

Nominal rigidities prevent prices and wages from adjusting quickly to economic shocks. This means that changes in aggregate demand can lead to temporary fluctuations in real variables like output and unemployment, rather than just affecting the price level. This makes the economy less efficient in adapting to new conditions and allows monetary policy to have real effects in the short run.

Are all prices equally sticky?

No, the degree of price stickiness varies significantly across different goods and services. For instance, prices of highly standardized commodities like gasoline tend to be more flexible, while prices for services, medical care, or items with high menu costs (like restaurant meals) tend to be stickier. The duration between price changes can range from days to many months, impacting how different sectors respond to economic shifts.

What is the opposite of nominal rigidities?

The opposite of nominal rigidities is perfect price and wage flexibility. In a theoretical world with perfect flexibility, all prices and wages would adjust instantly and fully to any change in supply and demand or other economic conditions, immediately returning the economy to its equilibrium levels of output and employment. In such a world, monetary policy would only affect the price level and inflation, without influencing real economic activity.