Nominal rigidity

What Is Nominal Rigidity?

Nominal rigidity, often referred to as price stickiness or wage stickiness, describes a situation in macroeconomics where nominal prices or wages are resistant to change, even in the face of shifts in aggregate demand or aggregate supply. This resistance means that prices and wages do not immediately adjust to their equilibrium levels following an economic shock. The presence of nominal rigidity is a crucial concept within Keynesian economics and New Keynesian economics, as it helps explain why monetary policy can have real effects on output and employment in the short run. Without nominal rigidity, prices and wages would adjust instantly, leading to monetary neutrality where changes in the money supply would only affect nominal values, leaving real economic variables unaffected.

History and Origin

The concept of nominal rigidity has roots in the observations of John Maynard Keynes, particularly in his analysis of the Great Depression. Keynes argued that nominal wages, in particular, exhibit downward rigidity, meaning workers and firms are reluctant to accept cuts in nominal wages even during periods of high unemployment. This wage stickiness could prevent the labor market from clearing, contributing to persistent unemployment¹².

Later, in the 1980s, New Keynesian economists sought to provide microeconomic foundations for nominal rigidity. Key contributions focused on "menu costs," the literal costs associated with changing prices, such as reprinting menus, updating catalogs, or reprogramming pricing systems. Gregory Mankiw, among others, demonstrated in 1985 that even small menu costs could lead to significant aggregate price stickiness. While these costs themselves might seem minor at the individual firm level, their cumulative effect across an economy can be substantial, preventing prices from adjusting smoothly to changing economic conditions.

Key Takeaways

• Nominal rigidity refers to the resistance of nominal prices and wages to immediate adjustment in response to economic changes.
• It is a core concept in Keynesian and New Keynesian economics, explaining how monetary policy can influence real economic variables like output and employment.
• Common explanations for nominal rigidity include menu costs, long-term contracts (for wages), and informational or psychological factors.
• The degree of nominal rigidity affects the short-run trade-offs between inflation and unemployment, often depicted by the Phillips Curve.
• Understanding nominal rigidity is vital for policymakers determining appropriate fiscal policy and monetary policy responses to economic fluctuations.

Formula and Calculation

Nominal rigidity is not typically represented by a single, universal formula, as it describes a behavioral phenomenon rather than a direct quantitative measure. However, its implications are often modeled using equations that describe price-setting behavior. In New Keynesian models, for instance, the aggregate price level's adjustment to shocks might be represented by a forward-looking Phillips Curve, which incorporates the degree of price stickiness.

A common approach to modeling price adjustment is the Calvo model, where a fraction of firms are able to re-optimize their prices in any given period. If (\alpha) represents the probability that a firm cannot change its price in a given period (i.e., the degree of nominal rigidity), then (1-\alpha) is the probability that a firm can change its price. The aggregate price level (P_t) in a simplified Calvo-style setup can be expressed as a weighted average of past prices and newly optimized prices:

$P_t = (1-\alpha)P_t^* + \alpha P_{t-1}$

Where:

• (P_t) = Aggregate price level at time (t)
• (P_t^*) = The optimal price level desired by firms that are able to adjust their prices at time (t)
• (P_{t-1}) = Aggregate price level at time (t-1)
• (\alpha) = Probability of a firm not adjusting its price (degree of nominal rigidity)

This formula illustrates that the higher the value of (\alpha), the greater the nominal rigidity, and the slower the overall price level adjusts to new information or shocks. This framework underpins how monetary policy impulses can transmit to the real economy.

Interpreting Nominal Rigidity

Interpreting nominal rigidity involves understanding how sticky prices and wages affect the economy's response to various shocks. When nominal prices and wages are rigid, a change in nominal money supply or demand shocks can lead to changes in real economic variables like output and employment in the short run. For example, if there's a sudden decrease in aggregate demand, and prices and wages don't immediately fall to clear markets, firms may reduce production and lay off workers, leading to a recession.

Conversely, if prices and wages were perfectly flexible, they would adjust instantly to maintain full employment and output levels, and monetary policy would only affect the price level, not real economic activity. Therefore, the degree of nominal rigidity is crucial for determining the effectiveness of stabilization policies. Studies have shown that while some prices change frequently, others remain fixed over time, contributing to overall sluggishness in the aggregate price level¹¹. The concept of "reference prices" suggests that nominal rigidities can also manifest as inertia in the most common prices quoted over time, even if weekly prices fluctuate more frequently around these reference points¹⁰.

Hypothetical Example

Consider a hypothetical economy facing a sudden, unexpected drop in consumer confidence, leading to a significant decrease in aggregate demand.

Scenario A: No Nominal Rigidity (Flexible Prices and Wages)
If prices and wages were perfectly flexible, firms would immediately lower their prices, and workers would accept lower wages to maintain employment. The fall in demand would instantly translate into lower prices, and the economy would quickly return to its full employment output level without a significant disruption to real production or employment.

Scenario B: With Nominal Rigidity
In an economy with nominal rigidity, prices for goods and services, as well as wages, do not adjust downward instantaneously. Restaurants might hesitate to change their menu prices due to the perceived costs and potential customer confusion. Similarly, many workers might be on annual contracts, meaning their sticky wages cannot be cut immediately.

As demand falls, firms find themselves with excess inventory and higher-than-equilibrium prices relative to the reduced demand. Because they cannot cut prices or wages easily, their profitability declines. To cope, firms reduce production and may lay off workers, leading to an increase in unemployment and a contraction in real economic output. This period of depressed economic activity persists until prices and wages gradually adjust, or until policymakers intervene to stimulate demand. The presence of nominal rigidity is what allows this short-run deviation from full employment.

Practical Applications

Nominal rigidity has significant implications for how economists understand and policymakers manage business cycles.

• Monetary Policy Effectiveness: Central banks rely on nominal rigidity for their monetary policy tools to be effective. If prices were perfectly flexible, changes in the money supply would only lead to proportional changes in prices, leaving real output unchanged. However, with nominal rigidity, a central bank's actions—such as lowering interest rates to stimulate demand—can genuinely impact employment and production in the short run by influencing real spending before prices fully adjust.
• ⁹ Inflation Targeting: The concept informs central bank decisions on inflation targeting. Some degree of price flexibility is desirable, but too much nominal rigidity can make it harder to achieve inflation targets or cause significant real effects from price level changes.
• Understanding Economic Shocks: Nominal rigidity helps explain why real output and employment fluctuate in response to nominal shocks (e.g., unexpected changes in the money supply). These fluctuations would be much smaller or non-existent in an economy with perfectly flexible prices and wages.
• Labor Market Dynamics: Downward nominal wage rigidity is a key factor in explaining persistent unemployment. If nominal wages are sticky downwards, firms might respond to reduced demand by reducing hiring or laying off workers rather than cutting wages, leading to higher unemployment rates. Evidence suggests that the speed with which real wages adjust to changes in warranted real wages significantly impacts the duration of unemployment following adverse shocks.
• ⁸ Financial Market Interactions: Research indicates that financial frictions can influence the degree of nominal price rigidity, causing it to vary over the business cycle. This implies that central banks should consider financial market conditions when evaluating the effectiveness of their policies, as these frictions can make aggregate supply flatter.

#⁷# Limitations and Criticisms

While nominal rigidity is a cornerstone of modern macroeconomics, it faces several limitations and criticisms:

• Microfoundations Debate: Early criticisms questioned whether the microeconomic costs (like menu costs) were sufficiently large to explain the observed aggregate price stickiness. While small individual costs can indeed lead to significant aggregate rigidity due to strategic complementarities among firms, empirical studies continue to refine the understanding of these costs. So⁶me research suggests that other factors, such as "reference prices" or internal firm dynamics, might be more significant sources of price inertia than traditional menu costs.
• ⁵ "Real Rigidities" vs. "Nominal Rigidities": Economists often distinguish between nominal and real rigidity. Real rigidities refer to factors that make firms reluctant to change their relative prices by large amounts, even if nominal prices could adjust. Examples include customer search costs or efficiency wages. Some argue that small nominal frictions only generate substantial nominal rigidity when combined with significant real rigidities. Wi⁴thout real rigidities, nominal frictions alone might not generate enough stickiness to explain observed macroeconomic phenomena.
• Measurement Challenges: Quantifying the exact degree of nominal rigidity across an entire economy is challenging. While studies using microdata (like scanner data for consumer prices) provide insights into price-setting behavior and the frequency of price changes, they often show that prices change more frequently than implied by some simple sticky-price models. Th², ³e debate continues on how to best reconcile these micro-level observations with macro-level evidence of stickiness.
• Optimal Policy Debate: The presence and nature of nominal rigidities have profound implications for the design of optimal monetary policy. Different models of nominal rigidity can lead to different policy prescriptions, particularly regarding the trade-off between output stabilization and price stability.

Nominal Rigidity vs. Price Stickiness

The terms "nominal rigidity" and "price stickiness" are often used interchangeably to describe the same phenomenon: the resistance of nominal prices to adjust quickly to changes in economic conditions.

While technically "nominal rigidity" is the overarching concept, "price stickiness" is a very common and intuitive way to refer to the rigidity of individual product prices within the broader framework of nominal rigidities. The underlying causes and macroeconomic implications are fundamentally the same.

FAQs

Why is nominal rigidity important in macroeconomics?

Nominal rigidity is crucial because it explains why changes in the money supply or demand shocks can affect real economic activity (like output and employment) in the short run. Without it, the economy would always be at full employment, and monetary policy would be ineffective at stabilizing the economy.

What causes nominal rigidity?

Several factors contribute to nominal rigidity, including "menu costs" (the physical and logistical costs of changing prices), long-term wage and price contracts, information costs (firms not constantly monitoring all relevant economic data), and psychological factors (firms fearing customer dissatisfaction from frequent price changes).

#¹## How does nominal rigidity affect monetary policy?
Nominal rigidity allows monetary policy to influence real economic variables. For example, when a central bank cuts interest rates, it stimulates demand. Because prices don't immediately fall, the increased nominal demand translates into higher real demand, boosting output and employment. If prices adjusted instantly, interest rate cuts would only lead to immediate price increases with no real effect.

Is nominal wage rigidity different from price rigidity?

Nominal wage rigidity refers specifically to the resistance of nominal wages to change, especially downwards. Price rigidity refers to the stickiness of the prices of goods and services. Both are forms of nominal rigidity, and both have similar macroeconomic implications, often leading to involuntary unemployment or output fluctuations in response to shocks.

What is the opposite of nominal rigidity?

The opposite of nominal rigidity is perfect nominal flexibility, where all prices and wages adjust instantaneously and fully to any change in economic conditions. In a perfectly flexible economy, nominal shocks would only affect nominal variables (like the price level) and would have no impact on real variables (like output or employment).