What Are Price Rigidities?
Price rigidities, also known as nominal rigidities, refer to the phenomenon in macroeconomics where the prices of goods, services, and inputs (like nominal wages) do not adjust immediately or fully to changes in supply and demand shocks. Instead of fluctuating freely to clear markets, prices remain fixed or change sluggishly for a period, which has significant implications for economic stability and the effectiveness of monetary policy. This stickiness can lead to short-run deviations of output from its potential level, affecting overall economic activity.
History and Origin
The concept of price rigidities gained prominence with the advent of Keynesian economics. John Maynard Keynes, in his seminal work "The General Theory of Employment, Interest and Money," challenged classical economic assumptions of perfectly flexible prices and wages, arguing that rigidities could lead to prolonged periods of unemployment and underutilization of resources. In the late 20th century, New Keynesian economists sought to provide microeconomic foundations for these rigidities, developing models that incorporated factors like menu costs and informational frictions. Researchers like Emi Nakamura and Jón Steinsson have extensively reviewed evidence on price rigidity from the macroeconomic literature, noting that the conventional wisdom in the 1990s and early 2000s suggested prices changed roughly once a year. 4Their work, and that of others, demonstrated that while price changes might be more frequent than once thought, significant rigidities still exist.
Key Takeaways
- Price rigidities describe the slow adjustment of prices in response to changes in economic conditions.
- They are a central concept in macroeconomics, explaining why monetary and fiscal policy can have real effects on output in the short run.
- Common sources of price rigidities include menu costs, information costs, and coordination failures.
- Price rigidities can lead to fluctuations in output and employment, as markets do not instantly clear.
Interpreting Price Rigidities
Understanding price rigidities involves recognizing that, in the real world, prices do not constantly equilibrate markets. When positive or negative supply shocks hit an economy, or when aggregate demand shifts, the response of prices is often delayed. This delay means that quantity adjustments (in production, employment, and sales) occur before, or alongside, price adjustments. For instance, if aggregate demand falls unexpectedly, rather than immediately lowering prices, firms might first reduce production and lay off workers. This behavior can lead to an output gap, where actual output falls below potential output. The degree of price rigidities varies across different goods and services, influencing how quickly an economy adjusts to new equilibria.
Hypothetical Example
Consider a sudden, unexpected drop in consumer confidence leading to a significant decrease in overall aggregate demand for goods and services. In a world without price rigidities, prices would instantly fall to reflect the lower demand, encouraging consumers to buy more and preventing a downturn in production.
However, with price rigidities, businesses face various reasons not to immediately lower their prices. A clothing retailer, for example, might have printed new price tags, updated their online catalog, and invested in advertising based on existing price levels. Changing all these elements immediately to reflect the lower demand would incur substantial menu costs. Consequently, the retailer might initially respond to reduced sales by cutting back on orders from manufacturers, laying off staff, or reducing store hours, rather than slashing prices. This leads to a buildup of unsold inventory and a slowdown in economic activity, demonstrating how price rigidities can contribute to a recessionary environment, even if only temporarily.
Practical Applications
Price rigidities are crucial for understanding how macroeconomic policies influence the economy. Central banks, for instance, exploit these rigidities when implementing monetary policy. When the Federal Reserve adjusts interest rates, it aims to influence aggregate demand. If prices were perfectly flexible, an increase in the money supply would only lead to immediate inflation without affecting real output. However, because of price rigidities, changes in the money supply can temporarily affect real variables like investment, employment, and production. 3For example, research indicates that the impact of monetary policy on economic activity responds more strongly and prices more slowly in periods of rigid prices compared to flexible ones.
2
Governments also consider price rigidities when designing fiscal policy measures. A fiscal stimulus, such as increased government spending or tax cuts, is more effective at boosting output and employment in the short run when prices and wages are slow to adjust. In the context of business cycles, the presence of price rigidities helps explain why demand-side policies have real effects and why economies can experience periods of high unemployment or underutilized capacity.
Limitations and Criticisms
While price rigidities are a cornerstone of modern macroeconomics, they are not without limitations and criticisms. One area of debate centers on the exact causes and magnitudes of these rigidities. While menu costs and informational frictions offer microfoundations, empirical studies often find that these costs alone might not fully explain the observed persistence of price stickiness. Some critics also point to factors like rational expectations and the endogeneity of price-setting behavior, arguing that firms might strategically keep prices rigid even without explicit costs, anticipating similar behavior from competitors.
Furthermore, the degree of price rigidity can vary significantly over time and across different sectors, making aggregate analysis complex. Recent research suggests that price rigidities in the U.S. have shown substantial volatility over medium-term economic cycles, and that inaccurate repricing (firms only partially closing price gaps when adjusting) plays a significant role, challenging conventional wisdom on how nominal rigidities impact monetary stabilization policy. 1This dynamic nature implies that the effectiveness of policies relying on these rigidities can change, particularly during periods of high inflation or deflation.
Price Rigidities vs. Sticky Prices
The terms "price rigidities" and "sticky prices" are often used interchangeably in economic discourse, and for most practical purposes, they refer to the same underlying concept: the resistance of prices to instantaneous adjustment in response to market forces. Both terms describe the sluggishness or inflexibility of prices.
However, "price rigidities" can sometimes imply a broader theoretical framework encompassing various reasons for this stickiness, such as contractual agreements, coordination failures among firms, or even efficiency wages that prevent nominal wages from falling. "Sticky prices," while fundamentally the same, might be used more colloquially or specifically to refer to the observed phenomenon of prices remaining fixed for a period, without necessarily delving into the microeconomic reasons behind it. In essence, "sticky prices" is a common descriptor for the outcome of "price rigidities."
FAQs
Why are price rigidities important in economics?
Price rigidities are crucial because they explain how changes in aggregate supply or aggregate demand can lead to real economic effects, such as fluctuations in employment and output, in the short run. Without price rigidities, markets would adjust instantly, and macroeconomic policies like monetary and fiscal policy would only affect price levels, not real economic activity.
What causes price rigidities?
Several factors contribute to price rigidities. These include menu costs (the actual costs associated with changing prices, like printing new labels or updating systems), information costs (the cost of gathering and processing information about market conditions), and coordination failures (firms being hesitant to change prices unless they are sure competitors will do the same).
Do price rigidities last forever?
No, price rigidities are generally considered a short-run phenomenon. In the long run, economists typically assume that all prices are fully flexible and adjust to reflect underlying economic fundamentals. The duration of price rigidities can vary, however, from a few months to several quarters, depending on the specific market and economic conditions, including the overall rate of inflation.