Real rigidity

What Is Real Rigidity?

Real rigidity, a concept in macroeconomics, describes the tendency for real prices and wages in an economy to resist adjustment to their equilibrium levels following a change in underlying economic conditions. Unlike nominal rigidity, which refers to the stickiness of prices and wages in monetary (nominal) terms, real rigidity concerns the sluggish adjustment of relative prices and real wages—prices adjusted for inflation. This phenomenon implies that quantities, such as employment and output, may change more significantly than prices in response to shifts in aggregate demand or aggregate supply. Real rigidities are often attributed to imperfections within markets, including the labor market, product market, and credit markets.

³⁹## History and Origin

The concept of real rigidity emerged and gained prominence within economic models, particularly in New Keynesian economics, to explain why nominal shocks can have persistent real effects on an economy. Early macroeconomic theories, such as classical models, often assumed perfect flexibility of wages and prices, leading to the conclusion that economies would always operate at full employment. H³⁸owever, real-world observations of persistent unemployment and output fluctuations challenged this view, prompting economists to explore various forms of rigidity.

³⁷While initial New Keynesian models focused on nominal rigidities (e.g., "menu costs" associated with changing prices), it became evident that these alone might not fully account for the observed persistence of business cycles. R³⁶esearchers like Laurence Ball and David Romer, in their 1990 work, emphasized the need for real rigidities to amplify the effects of nominal stickiness. F³⁵or instance, a Federal Reserve Bank of San Francisco Economic Letter in 2004 highlighted how sticky prices and wages, influenced by underlying real rigidities, are crucial for understanding business cycle behavior. T³⁴hese rigidities can stem from various market imperfections, compelling firms to be less responsive in adjusting prices even when profit-maximizing conditions suggest otherwise.

³³## Key Takeaways

• Real rigidity refers to the slow adjustment of real wages and relative prices to economic shocks.
• It is a core concept in New Keynesian economics, explaining why macroeconomic fluctuations can be persistent.
• Real rigidities can arise from imperfections in the labor market (e.g., efficiency wages), product markets (e.g., countercyclical markups), and credit markets (e.g., information asymmetries).
  *³² The presence of real rigidity means that changes in monetary policy or other aggregate shocks can have significant and long-lasting effects on output and employment.
• Understanding real rigidities is crucial for policymakers aiming to stabilize economies.

Interpreting Real Rigidity

Real rigidity indicates the extent to which real variables—such as real wages or the relative price of a firm's good—fail to move to their new equilibrium levels in response to economic disturbances. In models incorporating real rigidity, a significant shock to aggregate demand, for example, might lead to large changes in output and employment rather than prompt adjustments in real prices.

A hi³¹gher degree of real rigidity implies that firms and individuals are less inclined to adjust their desired real prices or wages in response to shifts in aggregate output. This reduced responsiveness can exacerbate the impact of economic shocks, making deviations from equilibrium more persistent. For instance, if real wages are rigid, a negative shock to labor demand might not immediately lead to lower wages, resulting in higher unemployment. Econo³⁰mists often use calibration and empirical analysis within economic models to assess the degree and impact of real rigidities in real-world data.

H²⁹ypothetical Example

Consider a hypothetical economy where a sudden, unexpected decline in consumer confidence leads to a sharp drop in aggregate demand for goods and services.

In an economy with perfect real wage flexibility, firms would immediately reduce the real wages they offer, leading workers to accept lower wages to maintain employment levels. The lower production costs would then allow firms to reduce prices, stimulating demand and quickly restoring the economy to full employment with new, lower real wages and prices.

However, in an economy characterized by real rigidity in the labor market, firms might be reluctant to cut real wages due to factors like implicit contracts or efficiency wage theories, which suggest that lower wages could harm worker morale and productivity. Similarly, in the product market, firms might hesitate to lower their real prices significantly, fearing damage to their brand perception or a price war with competitors. As a result, instead of adjusting real wages and prices downward, firms respond to the drop in demand by reducing production and laying off workers. This leads to a substantial increase in unemployment and a larger decline in overall output, with the economy remaining below its potential for an extended period because the necessary real adjustments are slow to occur.

Practical Applications

Real rigidity has significant practical implications across various areas of economics and policymaking:

• Monetary Policy Effectiveness: The presence of real rigidities is crucial for understanding how monetary policy affects the real economy. If prices and wages were perfectly flexible, changes in the money supply would only lead to proportional changes in the price level, without affecting real output or employment. However, real rigidities allow nominal shocks, such as changes in interest rates engineered by a central bank, to have substantial and persistent impacts on output and employment by influencing real variables. For instance, former Federal Reserve Chair Janet Yellen has discussed how challenges remain for monetary policy, implicitly acknowledging the existence of rigidities that affect the economy's response to policy interventions.,
• ²⁸²⁷Business Cycle Dynamics: Real rigidities are considered essential mechanisms for explaining the observed persistence of business cycles and the fact that output fluctuations often last longer than can be explained by nominal rigidities alone., Fact²⁶o²⁵rs like sticky intermediate prices or real wage rigidity can amplify and prolong the effects of shocks.
• ²⁴Labor Market Analysis: In the labor market, real wage rigidities help explain the existence of persistent unemployment. Theories such as efficiency wages or insider-outsider models suggest reasons why real wages might be held above market-clearing levels, leading to an excess supply of labor. Policies aimed at reducing these rigidities, such as labor market reforms, are often debated by organizations like the OECD for their potential to impact unemployment rates.,
• ²³²²Inflation Dynamics: Real rigidities affect the slope of the Phillips curve, influencing the trade-off between inflation and unemployment. The extent to which these rigidities are present can determine how quickly inflation adjusts to changes in the output gap.,

²¹L²⁰imitations and Criticisms

While real rigidities are integral to modern economic models, particularly in New Keynesian theory, they are not without limitations and criticisms. One challenge lies in empirically identifying and measuring the quantitative importance of real rigidities in data. Direc¹⁹t data on marginal costs, which would help test these mechanisms, are often unavailable, requiring researchers to rely on calibrations or indirect empirical tests.

Some¹⁸ critiques suggest that the levels of real rigidity required in models to generate significant monetary non-neutrality (i.e., real effects of monetary policy) might imply implausible sizes for other economic factors, such as "menu costs" or idiosyncratic productivity shocks. Moreo¹⁷ver, certain types of real rigidities, such as those related to a firm's profit function concavity ("micro" real rigidities), may require large idiosyncratic shocks to explain observed price changes. In contrast, "macro" real rigidities, like sticky intermediate prices, are more consistent with observed volatility of sectoral productivity growth.

The ¹⁶debate also extends to how real rigidities interact with nominal rigidity to produce observed economic phenomena. While models that combine both types of rigidities generally fit empirical data better, there can be challenges in determining their relative importance and specific transmission mechanisms. For example, some research indicates that while wage rigidities may improve a model's fit, their direct effect on inflation dynamics might be limited when labor market frictions are considered.

R¹⁵eal Rigidity vs. Nominal Rigidity

Real rigidity and nominal rigidity are both forms of "stickiness" in an economy, but they refer to different aspects of price and wage adjustment.

Bo⁶th types of rigidities are crucial components of New Keynesian economic models, as they collectively help explain why economies experience business cycles and why monetary policy can have real effects.,

F⁵AQs

What causes real rigidity?

Real rigidity is caused by various imperfections in the product market, labor market, and credit markets. In product markets, factors like imperfect competition, strategic pricing by firms, or search costs for consumers can lead to real price rigidity. In labor markets, theories such as efficiency wages (firms paying above market-clearing wages to incentivize productivity), implicit contracts, or insider-outsider dynamics can lead to real wage rigidity.,

⁴Why is real rigidity important in macroeconomics?

Real rigidity is important because it helps explain why nominal shocks, like changes in the money supply or monetary policy, can have lasting effects on real economic variables such as output and unemployment. Without real rigidities amplifying the effects of nominal rigidity, these real effects would likely be short-lived. It helps economists understand the persistence of business cycles and how policy interventions can influence the economy.

³Can real rigidity lead to unemployment?

Yes, real rigidity can lead to persistent unemployment. If real wages are rigid and remain above the market-clearing level, there will be an excess supply of labor, meaning more people are willing to work than firms are willing to hire at that wage. This can result in structural or persistent unemployment, as the labor market does not adjust efficiently to clear the supply-demand imbalance.,

###² How do policymakers address real rigidity?

Policymakers address real rigidity primarily through structural reforms aimed at increasing market efficiency. For example, in the labor market, policies might include reforms to employment protection laws, measures to improve worker training and mobility, or initiatives to reduce search frictions. In product markets, policies promoting competition or reducing regulatory burdens could help. While monetary policy can mitigate the symptoms of real rigidities (like output fluctuations), it is generally less effective at directly addressing their underlying structural causes.¹