Sticky Price Models Notes

Sticky Price Models

• Implicit assumption of price and wage flexibility so far in the IS-PC-MR model. Despite this, model has strongly Keynesian features eg. Demand shock elicits persistent disequilibrium. Demand shocks important for explaining where an economy is, relative to equilibrium, and there’s strong basis for policymaker interventions to improve output/inflation.

• Keynesian conclusions = demand shocks matter, MP should be used to stabilise

But only when we assume AE. With RE, instant adjustment, no persistent effects and no role for MP except in forming expectations – this New Classical perspective is associated with Chicago economists such as Robert Lucas. Rise of this New Classical theory was a challenge to Keynesians, as RE is intellectually persuasive (agents maximise), but macro implications deny traditional Keynesian policy prescitpions. So how do we reconcile RE with Keynesian conclusions?

• New Keynesian response: attempting to reconcile RE with persistent shocks.

  • Bringing in the assumption of sticky prices, citing frictions such as menu costs to varying prices (could be literal or broader eg. Customer goodwill).

  • Question becomes how can small menu costs cause such significant macroeconomic disequilibria?

Sticky Prices

• Ball, Mankiw and Romer: paper in which small menu costs generate price stickiness central to New Keynesian analysis

  • Assumptions:

    • Imperfect competition – only firms with some monopoly power would ever face a decision over whether to adjust prices or leave them the same and let quantities vary

    • Rational expectations

    • Periodically, firms can costlessly reset prices and this was planned anyway, so there are zero incremental costs to varying prices, since the costs to varying prices were essentially sunk. Changing price at any other time incurs the menu costs.

    • Assume a staggering of the scheduled price changes, so assume 1/12 firms can costlessly change at any time, aka a uniform distribution of the firms that can change, eg. 1 in 12 firms plan price review each 1^st Jan, 1 in 12 each 1^st Feb etc.

  • In micro terms, when every firm is achieving its equilibrium quantity, there is equilibrium at the macro level

  • Consider a negative demand shift without menu costs:

    • Agg price level drops until AD intersects vertical AS again. AR shifts to AR’ and MR to MR’

    • Absent menu costs firm i reduces p to achieve relative price (p_i/p)₂ at which MR’ = MC.

    • All other firms do the same driving down agg price level p

    • Fall in p raises demand along AD curve, so AR’ reverts to AR, MR’ to MR (since demand higher without any change to relative prices as all firms acted the same)

    • Results = original relative price restored and firm output revers to full employment level

• Consider a negative demand shift with menu costs as imagined by B, M and R:

  • 1/12 of firms could cut their costs, whilst others have to make a decision and assess whether profits from price adjustment justify paying menu costs

  • If they didn’t change price, so firm i held its price constant, the quantity/output in the market will fall to q₂, as relative price won’t change. In this case, profit losses relative to case with no menu costs are area HDBAG

  • Triangle ABC is profit i could generate through cutting own price to increase sales (lower ratio of i’s price to P), and HDCG is externally conferred profit occurring when all other firms cut prices. Firm i will only take into account ABC when assessing cost of leaving prices unchanged (the only profit increment under its control, other gains feasible but depend on actions of others

  • A social planner that could have all firms coordinate on price reductions would always choose to do so to realise gain HDBAG per firm (basis for the claim that avoiding menu costs could never explain welfare losses arising from sticky price recessions) – so with social planner all firms would cut their prices to realise that gain

• Therefore, price stickiness not derived simply by assuming there are menu costs, rather it is from the impact of menu costs when firm decision making is skewed by an externality problem (each firm ignores benefits conferred by others’ price changes and concentrates on smaller private profit gains)

• Explanations for market inefficiency of price stickiness of this kind often referred to as examples of coordination failure

• Under what conditions is price inertia most likely:

  • Key condition is menu cost exceeds ABC but not HDBAG

  • Condition most likely satisfied when MC relatively elastic (flatter MC, reduces size of private profit gain ABC relative to externally conferred gain HDCG), so less likely to change their prices

  • If MC flatter, then starting from q₂ marginal profit from raising output (distance AB – where MR above MC) is smaller the flatter MC, and the smaller profits from raising output the greater the incentive to stay at current output and price and avoid paying menu costs

  • Factors contributing to flat MC known as real rigidities, include flat WS (since then labour costs vary little with employment and output)

Note: critics of menu costs would argue this loss in profit is far bigger than any plausible menu costs.

But: B,M and R argue this isn’t the rationalisation firms would make. They only consider private effect of their price change, which is addition to profits of A-B-C (the result of all other firms cutting their prices and this shifting back the IS). This is not a private effect, it’s the aggregate demand externality. Therefore, their argument is that private profit gain could be outweighed by menu costs, leading firms rationally choosing a sticky price. It’s a coordination failure skewed by an externality problem.

The bigger the firms, the steeper the Ar and MR curves, therefore the smaller the area of ABC because the triangle is narrower for the same height. Therefore, more chance of menu costs outweighing this the more market power/fewer firms, and therefore the steeper the MR and AR curves.

• Assumption of atomistic firms: where firms...

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