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7.7 Real Rigidities

One important criticism of the menu cost literature noted by Ball et al. (1988)

is that models with nominal frictions can in theory produce large nominal

rigidities but ‘do so for implausible parameter values’. However, Ball and

Romer (1990) demonstrated that substantial nominal rigidities can result

from a combination of real rigidities and small frictions to nominal adjustment.

Indeed, Mankiw and Romer (1991) identify the interaction between

nominal and real imperfections as ‘a distinguishing feature of the new

Keynesian economies’.

If all nominal prices in an economy were completely and instantaneously

flexible, a purely nominal shock would leave the real equilibrium of an

economy unchanged. As Ball and Romer (1990) note, ‘Real rigidity does

not imply nominal rigidity: without an independent source of nominal

stickiness prices adjust fully to nominal shocks regardless of the extent of

real rigidities.’ However, rigidity of real prices and wages will magnify the

non-neutralities which result from small nominal frictions. The importance

of this point can be seen by considering the impact of a decline in the

money supply. Suppose initially that the presence of menu costs deters

firms from reducing their prices in response to this nominal disturbance.

With the price level unchanged real output will decline. Each monopolistically

competitive firm will find that its demand curve has shifted to

the left. Because each firm is producing less output, the effective demand

for labour declines (see Abel and Bernanke, 2001). If labour supply is

relatively inelastic, the shift of labour demand implied by the decline in

output will cause a large fall in real wages; that is, the nominal wage rate

declines to bring this about (see Ball et al., 1988; Gordon, 1990; D. Romer,

1993). This decline in the real wage rate implies a decline in marginal cost,

a decline which will be strongly reinforced if the marginal product of

labour rises sharply as the labour input decreases. As is evident from Figure

7.2, an upward-sloping marginal cost curve would greatly increase the

incentive to reduce price and would ‘swamp any plausible barriers to nominal

adjustment’ unless the elasticity of demand at the existing price falls as

the firm’s demand curve shifts to the left. The greater the decline in the

elasticity of demand at the existing price as output falls, the more the

marginal revenue curve facing a firm shifts to the left and the less incentive

there is for a firm to reduce its price.

David Romer (1993) sums up the essence of this issue as follows: ‘Thus if

the classical dichotomy is to fail, it must be that marginal cost does not fall

sharply in response to a demand-driven output contraction, or that marginal

revenue does fall sharply, or some combination of the two.’ Real price rigidity

is high the greater is the cyclical sensitivity of the elasticity of demand and

the smaller is the cyclical sensitivity of marginal cost. Hence nominal shocks

have large real consequences the greater the degree of real rigidity (see D.

Romer, 2001).

The points discussed above can be more easily understood by referring to

the familiar mark-up pricing equation facing a profit-maximizing monopolistically

competitive firm (see Pindyck and Rubinfeld, 1998, p. 340). Profit

maximization requires that the firm produces that level of output where

marginal revenue (MR) equals cost (MC). Marginal revenue can be expressed

in the form shown by equation (7.5):

MR P P(1/) (7.5)

where P is the firm’s price and is the price elasticity of demand. Profit

maximization therefore requires that:

P P(1/) MC (7.6)

By rearranging equation (7.6) we get equation (7.7):

P MC

P

1/(7.7)

This equation can also be rearranged so as to express price as a mark-up on

marginal cost. The mark-up equation is given by (7.8):

The term inside the brackets represents the mark-up, the size of which varies

inversely with the elasticity of demand (remember is negative). Equation

(7.9) indicates that P will not fall when MC declines if the mark-up rises

sufficiently to offset this decline (see Stiglitz, 1984). If the elasticity of

demand does not decline, then equation (7.9) also indicates that the incentive

to change price will be small in the presence of menu costs if MPL does not

rise strongly as the labour input is reduced (see Hall, 1991). Rotemberg and

Woodford (1991) suggest that desired mark-ups over marginal cost fall during

a boom because it becomes increasingly difficult to maintain oligopolistic

collusion; that is, industries become more competitive in periods of high

economic activity. During recessions implicit collusion increases, leading to

a countercyclical mark-up that acts as a real rigidity, magnifying the impact

on nominal rigidity of relatively small menu costs (D. Romer, 2001).