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7.5 Nominal Rigidities

Both orthodox and new Keynesian approaches assume that prices adjust slowly

following a disturbance. But, unlike the Keynesian cross or IS–LM approaches,

which arbitrarily assume fixed nominal wages and prices, the new Keynesian

approach seeks to provide a microeconomic underpinning for the slow adjustment

of both wages and prices. In line with the choice-theoretical framework of

new classical analysis, the new Keynesian approach assumes that workers and

firms are rational utility and profit maximizers, respectively.

As we have seen, new classicists adopt the flexible price auction model and

apply this to the analysis of transactions conducted in all markets, including

the labour market. In contrast, new Keynesians argue that it is important to

utilize the Hicksian (1974) distinction between markets which are essentially

fix-price, predominantly the labour market and a large section of the goods

market, and markets which are flex-price, predominantly financial and commodity

markets. In fix-price markets price setting is the norm, with price and

wage inertia a reality. In order to generate monetary non-neutrality (real

effects) Keynesian models rely on the failure of nominal wages and prices to

adjust promptly to their new market-clearing levels following an aggregate

demand disturbance. Keynesians have traditionally concentrated their attention

on the labour market and nominal wage stickiness in order to explain the

tendency of market economies to depart from full employment equilibrium.

However, it is important to note that for any given path of nominal aggregate

demand it is price, not wage, stickiness which is necessary to generate fluctuations

in real output. Providing profits are sufficiently flexible, nominal

prices could adjust to exactly mimic changes in nominal aggregate demand,

leaving real output unaffected (see Gordon, 1990).

Nevertheless the first wave of new Keynesian reaction to the new classical

critique concentrated on nominal wage rigidity.

7.5.1 Nominal wage rigidity

In traditional Keynesian models the price level is prevented from falling to

restore equilibrium by the failure of money wages (costs) to adjust (see

Figure 2.6). In the new classical models developed by Lucas, Sargent, Wallace

and Barro during the 1970s, any anticipated monetary disturbance will cause

an immediate jump of nominal wages and prices to their new equilibrium

values, so preserving output and employment. In such a world, systematic

monetary policy is ineffective. Initially it was widely believed that this new

classical policy ineffective proposition was a direct implication of incorpoThe

new Keynesian school 367

rating the rational expectations hypothesis into macroeconomic models. Fischer

(1977) and Phelps and Taylor (1977) showed that nominal disturbances were

capable of producing real effects in models incorporating rational expectations,

providing the assumption of continuously clearing markets was dropped

(see also Buiter, 1980). Following these contributions it became clear to

everyone that the rational expectations hypothesis did not imply the end of

Keynesian economics. The crucial feature of new classical models was shown

to be the assumption of continuous market clearing, that is, perfect and

instantaneous wage and price flexibility. But, as Phelps (1985) reminds us, it

is often through the rejection of a theoretically interesting model that a

science progresses and ‘even if dead wrong, the new classical macroeconomics

is still important because it demands Keynesians to fortify their theoretical

structure or reconstruct it’.

The early Keynesian attempts to fortify their theoretical structure concentrated

on nominal wage rigidities and the models developed by Fischer (1977)

and Taylor (1980) introduced nominal inertia in the form of long-term wage

contracts. In developed economies wages are not determined in spot markets

but tend to be set for an agreed period in the form of an explicit (or implicit)

contract. The existence of these long-term contracts can generate sufficient

nominal wage rigidity for monetary policy to regain its effectiveness. It

should be noted, however, that neither Fischer nor Phelps and Taylor pretend

to have a rigorous microfoundation for their price- and wage-setting assumptions.

Instead they take it for granted that there is a ‘revealed preference’ for

long-term wage contracts reflecting the perceived disadvantages that accompany

too frequent adjustments to wages and prices (for an innovative attempt

to explain nominal wage inflexibility, see Laing, 1993).

Fischer’s analysis has the following main features and involves the construction

of a model similar to the Lucas–Sargent–Wallace policy ineffectiveness

models discussed in Chapter 5. The output supply equation is the standard

rational expectations Lucas ‘surprise’ function (7.1), where ˙Pt and ˙Pt

e are the

actual and expected rates of inflation respectively:

Y Y P P t N t t


t ( ˙ −˙ ), 0 (7.1)

Fischer assumes that inflation expectations are formed rationally, P˙t E(P˙


t |

t–1), so we can write (7.1) as (7.2):

Yt YNt Pt E Pt t [ ˙ −( ˙ |−1)] (7.2)

Fischer’s model abstracts from growth, so wage negotiators are assumed to

aim for constancy of the real wage by setting nominal wage increases equal

to expected inflation. This is given by (7.3):

W˙ E(P˙ | ) t t t−1 (7.3)

Substituting (7.3) into (7.2) yields equation (7.4), which shows that aggregate

supply is a decreasing function of the real wage (note this implies a

countercyclical real wage).

Yt YNt Pt Wt [ ˙ −˙ ], and 0 (7.4)

For the multi-period contract nominal wage increases are fixed at W˙t W˙t* .

Fischer (1977) makes the ‘empirically reasonable’ assumption that economic

agents negotiate contracts in nominal terms for ‘periods longer than the time

it takes the monetary authority to react to changing economic circumstances’.

Because the monetary authorities can change the money supply (and hence

inflation) more frequently than overlapping labour contracts are renegotiated,

monetary policy can have real effects in the short run although it will remain

neutral in the long run.

The argument presented by Fischer can be understood with reference to

Figure 7.1. The economy is initially operating at point A. Suppose in the

current period an unexpected nominal demand shock occurs (such as a fall in

velocity) which shifts the aggregate demand curve from AD0 to AD1. If prices

Figure 7.1 Nominal wage contracts, rational expectations and monetary


are flexible but nominal wages are temporarily rigid (and set = W0) as the

result of contracts negotiated in the previous period and which extend beyond

the current period, the economy will move to point B, with real output falling

from YN to Y1. With flexible wages and prices the short-run aggregate supply

curve would shift down to the right from SRAS (W0) to SRAS (W1), to reestablish

the natural rate level of output at point C. However, the existence of

long-term nominal wage contracts prevents this and provides the monetary

authorities with an opportunity to expand the money supply which, even if

anticipated, shifts the AD curve to the right and re-establishes equilibrium at

point A. Providing the authorities are free to react to exogenous shocks at

every time period, while workers are not, there is scope for demand management

to stabilize the economy even if agents have rational expectations. In

effect, if the monetary authorities can react to nominal demand shocks more

quickly than the private sector can renegotiate nominal wages, there is scope

for discretionary intervention. The fixed nominal wage gives the monetary

authorities a handle on the real wage rate and hence employment and output.

The non-neutrality of money in the Fischer model is not due to an unanticipated

monetary surprise. Anticipated monetary policy has real effects because

it is based on information that only becomes available after the contract has

been made.

Wage contracts are an important feature in all major industrial market

economies. However, there are significant differences between countries with

respect to both contract duration and the timing of contract renegotiations.

For example, in Japan nominal wage contracts typically last for one year and

expire simultaneously. The synchronized renegotiation of contracts (the shunto

system) in Japan is consistent with greater macroeconomic stability than is

the case in the US economy, which has a system of non-synchronized overlapping

(staggered) contracts, many of which last for three years (see Gordon,

1982b; Hall and Taylor, 1997). In the UK contracts are overlapping but are

typically shorter than in the USA, usually lasting for one year. When contracts

are staggered, nominal wages will exhibit more inertia in the face of

shocks than would be the case if existing contracts were renegotiated in a

synchronized way so as to accommodate new information. Taylor (1980)

demonstrated that if workers are concerned with their nominal wage relative

to others, then staggered contracting will allow the impact of monetary policy

on real variables to persist well beyond the length of the contracting period.

Taylor (1992b) has shown that the responsiveness of wages to supply and

demand conditions is much greater in Japan than in the USA, Canada and

other major European countries, and this accounts for the more stable macroeconomic

performance in Japan during the 1970s and early 1980s.

An immediate question arises from the above discussion. Why are longterm

wage agreements formed if they increase macroeconomic instability?

According to Phelps (1985, 1990) there are private advantages to both firms

and workers from entering into long-term wage contracts:

1. Wage negotiations are costly in time for both workers and firms. Research

must be carried out with respect to the structure of wage relativities

both within and outside the negotiating organization. In addition, forecasts

are required with respect to the likely future paths of key variables

such as productivity, inflation, demand, profits and prices. The longer the

period of the contract, the less frequently are such transaction costs

incurred and in any case management will always tend to prefer a pre-set

schedule for dealing with the complex issues associated with pay negotiations.

2. There always exists the potential for such negotiations to break down,

with workers feeling that they may need to resort to strike action in order

to strengthen their bargaining position. Such disruption is costly to both

firms and workers.

3. It will not be an optimal strategy for a firm to ‘jump’ its wage rates to the

new ‘ultimate’ equilibrium following a negative demand stock because if

other firms do not do likewise the firm will have reduced its relative

wage, which would be likely to increase labour turnover, which is costly

to the firm.

Thus the responsiveness of wage rates during a recession does not follow the

new classical ‘precision drill process’; rather we observe a ‘ragged, disorderly

retreat’ as new information becomes available (Phelps, 1985, p. 564).

Another important question raised by this discussion relates to the absence

of indexing. Why are labour contracts not indexed to the rate of inflation?

Full cost of living agreements (COLAs) are simply too risky for firms (see

Gordon, 2003). The danger for firms is that not all shocks are nominal

demand shocks. If a firm agreed to index its wage rates to the rate of inflation,

then supply shocks, such as occurred in the 1970s, would drive up the price

level and with it a firm’s wage costs, so preventing the necessary fall in real

wages implied by the energy shock.

Finally, we should also note that the staggering of wage contracts does

have some microeconomic purpose even if it causes macroeconomic problems.

In a world where firms have imperfect knowledge of the current economic

situation, they can gain vital information by observing the prices and wages

set by other firms. According to Hall and Taylor (1997), staggered wage

setting provides useful information to both firms and workers about the

changing structure of wages and prices. In a decentralized system without

staggering, ‘tremendous variability’ would be introduced into the system.

Ball and Cecchetti (1988) show how imperfect information can make stagThe

new Keynesian school 371

gered price and wage setting socially optimal by helping firms set prices

closer to full information levels, leading to efficiency gains which outweigh

the costs of price level inertia. Thus staggered price adjustment can arise

from rational economic behaviour. In contrast, the case of wage setting in a

synchronized system would seem to require some degree of active participation

from the government.

7.5.2 Nominal price rigidity

Keynesian models based on nominal wage contracting soon came in for

considerable criticism (see Barro, 1977b). Critics pointed out that the existence

of such contracts is not explained from solid microeconomic principles.

A further problem relates to the countercyclical path of the real wage in

models with nominal wage contracts. In Fischer’s model, a monetary expansion

increases employment by lowering the real wage. Yet, as we have seen,

the stylized facts of the business cycle do not provide strong support for this

implication since real wages appear to be mildly procyclical (see Mankiw,

1990). Indeed, it was this issue that persuaded Mankiw (1991) that sticky

nominal wage models made little sense. A combination of price-taking firms,

neoclassical production technology and sticky nominal wages implies that

aggregate demand contractions will be associated with a rise in the real wage,

that is, real wages move countercyclically. As Mankiw notes, if this were the

case then recessions would be ‘quite popular’. While many people will be

laid off, most people who remain employed will enjoy a higher real wage! ‘If

high real wages accompanied low employment as the General Theory and my

Professors has taught me, then most households would welcome economic

downturns’. So ‘it was thinking about the real wage puzzle that originally got

me interested in thinking about imperfections in goods markets, and eventually,

about monopolistically competitive firms facing menu costs’ (Mankiw,

1991, pp. 129–30).

As a result of these and other criticisms, some economists sympathetic to

the Keynesian view that business cycles can be caused by fluctuations of

aggregate demand switched their attention to nominal rigidities in the goods

market, rather than continue with research into nominal wage inertia (Andersen,

1994). Indeed, the term ‘new Keynesian’ emerged in the mid-1980s as a

description of those new theories that attempted to provide more solid

microfoundations for the phenomenon of nominal price rigidity (see

Rotemberg, 1987). From this standpoint, the ‘fundamental new idea behind

new Keynesian models is that of imperfect competition’ (Ibid.). This is the

crucial innovation which differentiates new Keynesians from Keynes, orthodox

Keynesians, monetarists and new classicals.

If the process of changing prices were a costless exercise and if the failure to

adjust prices involved substantial changes in a firm’s profitability we would

certainly expect to observe a high degree of nominal price flexibility. A firm

operating under conditions of perfect competition is a price taker, and prices

change automatically to clear markets as demand and supply conditions change.

Since each firm can sell as much output as it likes at the going market price, a

perfectly competitive firm which attempted to charge a price above the marketclearing

level would have zero sales. There is also no profit incentive to reduce

price independently, given that the firm’s demand curve is perfectly elastic at

the prevailing market price. Thus in this world of perfect price flexibility it

makes no sense to talk of the individual firm having a pricing decision.

When firms operate in imperfectly competitive markets a firm’s profits will

vary differentially with changes in its own price because its sales will not fall

to zero if it marginally increases price. Price reductions by such a firm will

increase sales but also result in less revenue per unit sold. In such circumstances

any divergence of price from the optimum will only produce

‘second-order’ reductions of profits. Hence the presence of even small costs

to price adjustment can generate considerable aggregate nominal price rigidity.

This observation, due to Akerlof and Yellen (1985a), Mankiw (1985) and

Parkin (1986), is referred to by Rotemberg (1987) as the ‘PAYM insight’.

The PAYM insight makes a simple but powerful point. The private cost of

nominal rigidities to the individual firm is much smaller than the macroeconomic

consequences of such rigidities. A key ingredient of the PAYM insight

is the presence of frictions or barriers to price adjustment known as ‘menu

costs’. These menu costs include the physical costs of resetting prices, such

as the printing of new price lists and catalogues, as well as expensive management

time used up in the supervision and renegotiation of purchase and

sales contracts with suppliers and customers. To illustrate how small menu

costs can produce large macroeconomic fluctuations, we will review the

arguments made by Mankiw and by Akerlof and Yellen.

In imperfectly competitive markets a firm’s demand will depend on (i) its

relative price and (ii) aggregate demand. Suppose following a decline in

aggregate demand the demand curve facing an imperfectly competitive firm

shifts to the left. A shift of the demand curve to the left can significantly

reduce a firm’s profits. However, faced with this new demand curve, the firm

may gain little by changing its price. The firm would prefer that the demand

curve had not shifted but, given the new situation, it can only choose some

point on the new demand curve. This decline in demand is illustrated in

Figure 7.2 by the shift of demand from D0 to D1. Before the decline in

demand the profit-maximizing price and output are P0 and Q0, since marginal

revenue (MR0) is equal to marginal cost (MC0) at point X. For convenience

we assume that marginal cost does not vary with output over the range

shown. Following the decline in demand, the firm suffers a significant reduction

in its profits. Before the reduction in demand, profits are indicated in

Figure 7.2 Price adjustment under monopolistic competition

Figure 7.2 by the area SP0YX. If the firm does not initially reduce its price

following the decline in demand, profits fall to the area indicated by SP0JT.

Because this firm is a ‘price maker’ it must decide whether or not to reduce

price to the new profit-maximizing point indicated by W on the new demand

curve D1. The new profit-maximizing level of output is determined where

MR1 = MC0. With a level of output of Q1, the firm would make profits of SP1

WV. If there were no adjustment costs associated with changing price, a

profit-maximizing firm would reduce its price from P0 to P1. However, if a

firm faces non-trivial ‘menu costs’ of z, the firm may decide to leave price at

P0; that is, the firm moves from point Y to point J in Figure 7.2.

Figure 7.3 indicates the consequences of the firm’s decision. By reducing

price from P0 to P1 the firm would increase its profits by B – A. There is no

incentive for a profit-maximizing firm to reduce price if z > B – A. The loss to

society of producing an output of Q* rather than Q1 is indicated by B + C,

which represents the loss of total surplus. If following a reduction of demand

B + C > z > B – A, then the firm will not cut its price even though doing so

would be socially optimal. The flatter the MC schedule, the smaller are the

menu costs necessary to validate a firm’s decision to leave the price unchanged.

Readers should confirm for themselves that the incentive to lower

prices is therefore greater the more marginal cost falls when output declines

(see Gordon, 1990; D. Romer, 2001).

Figure 7.3 Menu costs v. price adjustment

In the Akerlof and Yellen (1985a, 1985b) model, inertial wage-price behaviour

by firms ‘may be near rational’. Firms that behave sub-optimally in

their price-setting behaviour may suffer losses but they are likely to be

second order (small). The idea of near rationality is illustrated in Figure 7.4.

As before, the profit-maximizing price following a decline in demand is

indicated by P1. The reduction in profits (1 – *) that results from failure to

reduce price from P0 to P1 is small (second order) even without taking into

account menu costs (that is, in Figure 7.3, B – A is small). Akerlof and Yellen

(1985a) also demonstrate that, when imperfect competition in the product

market is combined with efficiency wages in the labour market, aggregate

demand disturbances will lead to cyclical fluctuations (see Akerlof, 2002).

Although the firm may optimally choose to maintain price at P0, the impact

of their decision, if repeated by all firms, can have significant macroeconomic

effects. Blanchard and Kiyotaki (1987), in their interpretation of the PAYM

insight, show that the macroeconomic effects of nominal price rigidity differ

from the private costs because price rigidity generates an aggregate demand

externality. Society would be considerably better off if all firms cut their

prices, but the private incentives to do so are absent. As before, assume that a

firm’s demand curve has shifted left as a result of a decline in aggregate

demand. If firms did not face menu costs, then profit-maximizing behaviour

would dictate that all firms lowered their prices; that is, in terms of Figures

Figure 7.4 Near rationality

7.2 and 7.3, each firm would move from Y to W. Because all firms are

lowering their prices, each firm will find the cost of its inputs are falling,

including money wages. Hence each firm will find that its marginal cost

curve begins to shift down. This allows firms to reduce prices further. In

Figure 7.3, as MC0 shifts down, output will expand. Since all firms are

engaged in further price reductions, input prices will fall again, producing

another reduction of MC. Since this process of price deflation will increase

real money balances, thereby lowering interest rates, aggregate demand will

increase. This will shift the demand curves facing each firm to the right, so

that output will return to Q0.

If the presence of menu costs and/or near rational behaviour causes nominal

price rigidity, shocks to nominal aggregate demand will cause large

fluctuations in output and welfare. Since such fluctuations are inefficient, this

indicates that stabilization policy is desirable. Obviously if money wages are

rigid (because of contracts) the marginal cost curve will be sticky, thus

reinforcing the impact of menu costs in producing price rigidities.

We noted earlier that there are several private advantages to be gained by

both firms and workers from entering into long-term wage contracts. Many of

these advantages also apply to long-term agreements between firms with

respect to product prices. Pre-set prices not only reduce uncertainty but also

economize on the use of scarce resources. Gordon (1981) argues that ‘persua376

sive heterogeneity’ in the types and quality of products available in a market

economy would create ‘overwhelming transaction costs’ if it were decided

that every price was to be decided in an auction. Auction markets are efficient

where buyers and sellers do not need to come into physical contact (as with

financial assets) or the product is homogeneous (as with wheat). The essential

feature of an auction market is that buyers and sellers need to be present

simultaneously. Because time and space are scarce resources it would not

make any sense for the vast majority of goods to be sold in this way. Instead

numerous items are made available at suitable locations where consumers

can choose to conduct transactions at their own convenience. The use of

‘price tags’ (goods available on fixed terms) is a rational response to the

problem of heterogeneity. Typically when prices are pre-set the procedure

used is a ‘mark-up pricing’ approach (see Okun, 1981).

As is evident from the above discussion, the theory of imperfect competition

forms one of the main building-blocks in new Keynesian economics.

Therefore, before moving on to consider real rigidities, it is interesting to

note one of the great puzzles in the history of economic thought. Why did

Keynes show so little interest in the imperfect competition revolution taking

place on his own doorstep in Cambridge in the early 1930s? Richard Kahn,

author of the famous 1931 multiplier article and colleague of Keynes, was

fully conversant with the theory of imperfect competition well before Joan

Robinson’s famous book was published on the subject in 1933. Given that

Keynes, Kahn and Robinson shared the same Cambridge academic environment

during the period when the General Theory was being written, it is

remarkable that Keynes adopted the classical/neoclassical assumption of a

perfectly competitive product market which Kahn (1929) had already argued

was unsound for short-period analysis (see Marris, 1991)! As Dixon (1997)

notes, ‘had Kahn and Keynes been able to work together, or Keynes and

Robinson, the General Theory might have been very different’. In contrast to

the orthodox Keynesian school, and inspired by the work of Michal Kalecki,

Post Keynesians have always stressed the importance of price-fixing firms in

their models (Arestis, 1997).