Evidence
There is now a considerable amount of evidence about how long price-spells last, and it suggests that there is a considerable degree of nominal price rigidity in the "complete sense" of prices remaining unchanged. A price-spell is a duration during which the nominal price of a particular item remains unchanged. For some items, such as gasoline or tomatoes, prices are observed to vary frequently resulting in many short price spells. For other items, such as the cost of a bottle of champagne or the cost of a meal in a restaurant, the price might remain fixed for an extended period of time (many months or even years). One of the richest sources of information about this is the price-quote data used to construct theModeling sticky prices
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 and Guillermo Calvo. In Taylor (1980), firms change prices every ''n''th 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 you count the first period 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. Examples of state-dependent models include the one proposed by Golosov and Lucas and one suggested by Dotsey, King and Wolman.Significance in macroeconomics
In macroeconomics, nominal rigidity is necessary to explain how money (and hence monetary policy and inflation) can affect the real economy and why the classical dichotomy breaks down. If nominal wages and prices were not sticky, or ''perfectly flexible'', they would always adjust such that there would be equilibrium in the economy. In a perfectly flexible economy, monetary shocks would lead to immediate changes in the level of nominal prices, leaving real quantities (e.g. output, employment) unaffected. This is sometimes called monetary neutrality or "the neutrality of money". For money to have real effects, some degree of nominal rigidity is required so that prices and wages do not respond immediately. Hence sticky prices play an important role in all mainstream macroeconomic theory: Monetarists, Keynesians and new Keynesians all agree that markets fail to clear because prices fail to drop to market clearing levels when there is a drop in demand. Such models are used to explain unemployment. Neoclassical models, common inMathematical example: a little price stickiness can go a long way
To see how a small sector with a fixed price can affect the way rest of the flexible prices behave, suppose that there are two sectors in the economy: a proportion a with flexible prices Pf and a proportion 1-a that are affected by menu costs with sticky prices Pm. Suppose that the flexible price sector price Pf has the market clearing condition of the following form: : where is the aggregate price index (which would result if consumers had Cobb-Douglas preferences over the two goods). The equilibrium condition says that the real flexible price equals some constant (for example could be real marginal cost). Now we have a remarkable result: no matter how small the menu cost sector, so long as a<1, the flexible prices get "pegged" to the fixed price. Using the aggregate price index the equilibrium condition becomes : which implies that :, so that :. What this result says is that no matter how small the sector affected by menu-costs, it will tie down the flexible price. In macroeconomic terms all nominal prices will be sticky, even those in the potentially flexible price sector, so that changes in nominal demand will feed through into changes in output in both the menu-cost sector and the flexible price sector. Now, this is of course an extreme result resulting from the real rigidity taking the form of a constant real marginal cost. For example, if we allowed for the real marginal cost to vary with aggregate output Y, then we would have : so that the flexible prices would vary with output Y. However, the presence of the fixed prices in the menu-cost sector would still act to dampen the responsiveness of the flexible prices, although this would now depend upon the size of the menu-cost sector a, the sensitivity of to Y and so on.Sticky information
In macroeconomics, sticky information is old information used by agents as a basis for their behavior—information that does not take into account recent events. The first model of sticky information was developed byEvaluation of sticky information models
Sticky information models do not have nominal rigidity: firms or unions are free to choose different prices or wages for each period. It is the information that is sticky, not the prices. Thus when a firm gets lucky and can re-plan its current and future prices, it will choose a trajectory of what it believes will be the optimal prices now and in the future. In general, this will involve setting a different price every period covered by the plan. This is at odds with the empirical evidence on prices. There are now many studies of price rigidity in different countries: the US, the Eurozone, the UK and others. These studies all show that whilst there are some sectors where prices change frequently, there are also other sectors where prices remain fixed over time. The lack of sticky prices in the sticky information model is inconsistent with the behavior of prices in most of the economy. This has led to attempts to formulate a "dual stickiness" model that combines sticky information with sticky prices.Sticky inflation assumption
The sticky inflation assumption states that "when firms set prices, for various reasons the prices respond slowly to changes in monetary policy. This leads the rate of inflation to adjust gradually over time."Charles I. Jones, Macroeconomics, 3rd edition. Text (Norton, 2013) p.309. Additionally, within the context of the short run model there is an implication that the classical dichotomy does not hold when sticky inflation is present. This is the case when monetary policy affects real variables. Sticky inflation can be caused by expected inflation (e.g. home prices prior to the recession), wage push inflation (a negotiated raise in wages), and temporary inflation caused by taxes. Sticky inflation becomes a problem when economic output decreases while inflation increases, which is also known as stagflation. As economic output decreases and unemployment rises the standard of living falls faster when sticky inflation is present. Not only will inflation not respond to monetary policy in the short run, but monetary expansion as well as contraction can both have negative effects on the standard of living.See also
* Shapiro–Stiglitz theoryReferences
Further reading
* * * * * * *Herschel I. Grossman, 1987.“monetary disequilibrium and market clearing” in '' The New Palgrave: A Dictionary of Economics'', v. 3, pp. 504–06. *'' The New Palgrave Dictionary of Economics'', 2008, 2nd Edition. Abstracts:External links
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