Nominal rigidity

If one looks at the whole economy, some prices might be very flexible and others rigid. This will lead to the aggregate price level (which we can think of as an average of the individual prices) becoming "sluggish" or "sticky" in the sense that it does not respond to macroeconomic shocks as much as it would if all prices were flexible. The same idea can apply to nominal wages. The presence of nominal rigidity is an important part of macroeconomic theory since it can explain why markets might not reach equilibrium in the short run or even possibly the long run. In his The General Theory of Employment, Interest and Money, John Maynard Keynes argued that nominal wages display downward rigidity, in the sense that workers are reluctant to accept cuts in nominal wages. This can lead to involuntary unemployment as it takes time for wages to adjust to equilibrium, a situation he thought applied to the Great Depression.

Modeling sticky prices[edit]

Economists have tried to model sticky prices in a number of ways. These models can be classified as either time-dependent, where firms change prices with the passage of time and decide to change prices independently of the economic environment, or state-dependent, where firms decide to change prices in response to changes in the economic environment. The differences can be thought of as differences in a two-stage process: In time-dependent models, firms decide to change prices and then evaluate market conditions; In state-dependent models, firms evaluate market conditions and then decide how to respond.


In time-dependent models price changes are staggered exogenously, so a fixed percentage of firms change prices at a given time. There is no selection as to which firms change prices. Two commonly used time-dependent models are based on papers by John B. Taylor^[13] and Guillermo Calvo.^[14] In Taylor (1980), firms change prices every nth period. In Calvo (1983), price changes follow a Poisson process. In both models the choice of changing prices is independent of the inflation rate.


The Taylor model is one where firms set the price knowing exactly how long the price will last (the duration of the price spell). Firms are divided into cohorts, so that each period the same proportion of firms reset their price. For example, with two-period price-spells, half of the firms reset their price each period. Thus the aggregate price level is an average of the new price set this period and the price set last period and still remaining for half of the firms. In general, if price-spells last for n periods, a proportion of 1/n firms reset their price each period and the general price is an average of the prices set now and in the preceding n − 1 periods. At any point in time, there will be a uniform distribution of ages of price-spells: (1/n) will be new prices in their first period, 1/n in their second period, and so on until 1/n will be n periods old. The average age of price-spells will be (n + 1)/2 (if the first period is counted as 1).


In the Calvo staggered contracts model, there is a constant probability h that the firm can set a new price. Thus a proportion h of firms can reset their price in any period, whilst the remaining proportion (1 − h) keep their price constant. In the Calvo model, when a firm sets its price, it does not know how long the price-spell will last. Instead, the firm faces a probability distribution over possible price-spell durations. The probability that the price will last for i periods is (1 − h)ⁱ⁻¹, and the expected duration is h⁻¹. For example, if h = 0.25, then a quarter of firms will rest their price each period, and the expected duration for the price-spell is 4. There is no upper limit to how long price-spells may last: although the probability becomes small over time, it is always strictly positive. Unlike the Taylor model where all completed price-spells have the same length, there will at any time be a distribution of completed price-spell lengths.


In state-dependent models the decision to change prices is based on changes in the market and is not related to the passage of time. Most models relate the decision to change prices to menu costs. Firms change prices when the benefit of changing a price becomes larger than the menu cost of changing a price. Price changes may be bunched or staggered over time. Prices change faster and monetary shocks are over faster under state dependent than time.^[1] Examples of state-dependent models include the one proposed by Golosov and Lucas^[15] and one suggested by Dotsey, King and Wolman.^[16]