New Keynesian School

Nominal Rigidities

Nominal Rigidities

• Some Keynesian models rely on the failure of nominal wages and prices to adjust to their new market clearing levels following an aggregate demand disturbance.

• These models typically concentrate on the labor market and nominal wage stickiness to explain the tendency of market economies to depart from full employment equilibrium.

Saved by the Bell…..

• 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.

• This means that the acceptance of rational expectations did not mean the end of Keynesian economics.

Nominal Rigidities: Long Term Wage Contracts

• In developed markets, wages are not determined in spot markets.

• Rather, wages tend to be set for an agreed period in the form of an explicit (or implicit) contract.

• The existence of these contracts can generate sufficient nominal wage rigidity for monetary policy to be effective.

Long Term Contracts

• These models assume 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.

• Monetary policy, therefore, can have real effects in the short run, but will be neutral in the long run.

Long Term Contracts

0 Y1 YN Y

AD1

AD0

P

P1

P0

SAS(W1)

SAS(W0)

A

BC

LAS

The initial equilibrium occurs at point A.

An unexpected nominal demand shocksuch as a drop in velocity causesaggregate demand to shift from AD0 toAD1.

If prices are flexible but nominal wagesequal W0 and are set by contract inthe previous period, the economy movesto point B.

Output falls from YN to Y1.

If nominal wages were flexible, SAS(W0)would shift to SAS(W1) to re-establishthe natural rate of output at point C.

Long Term Contracts

• Summary:– The existence of long term contracts prevents the

rapid establishment of equilibrium at point C and provides the monetary authority 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.

– If the central bank is free to act while workers are not, there is room for demand management, because the fixed nominal wage gives the central bank influence over the real wage and hence employment and output.

Long Term Contracts

• Why are long term contracts formed if they increase macroeconomic instability?

• There are private advantages to both firms and workers:– Wage negotiations are costly in time for both

workers and firms. – The potential for wage negotiations to break down

always exists, increasing the risk of a strike.– Decreasing wages following a negative shock may

reduce the firm’s wage relative to other firms and increase labor turnover.

Long Term Contracts: Criticisms

• The existence of such contracts is not explained from solid microeconomic principles.

• The models predict that monetary expansion increases employment by lowering the real wage, but real wages do not appear to be counter-cyclical in the real world.

• Research switched to explaining business cycles by rigidities in the goods market.

Nominal Rigidities: Real Goods Market

• When firms face a downward sloping demand curve, price reductions increase sales but also result in less revenue per unit sold.

• However, if the drop in profits is not substantive compared to the cost of changing prices, the presence of even small costs to price adjustment can generate considerable aggregate nominal price rigidity.

• The presence of frictions or barriers to price adjustment are known as menu costs. – Examples of menu costs include the physical costs of

resetting prices and expensive management time used in the supervision and renegotiation of purchase and sales contracts with suppliers and customers.

Menu Costs

• The key insight of this model is that the private cost of nominal rigidities to the individual firm is much smaller than the macroeconomic consequences of such rigidities.

Background: Definitions

• Profit maximization rule:– Produce where marginal cost equals marginal

revenue.• Marginal revenue is the revenue received from

producing the next unit of output.

• Marginal cost is the cost associated with producing the next unit of output.

Background: MR = MC

• When a firm produces at the point where marginal revenue equals marginal cost, every unit of output that contributes to profit has been produced.

• When a firm produces at a point where marginal revenue exceeds marginal cost, units of output that contribute to profit are not produced.

• When a firm produces at a point where marginal revenue is less that marginal cost, units of output that decrease profit are produced.

Background: Profit Maximization

DMR

MC

0 Q

P

Q1 Q2 Q3

At Q1, MR > MC, the firm should produce more.

At Q3, MR< MC, the firm should produce less.

At Q2, MR = MC, profits are maximized. .

Background: TR, TC, Profits

DMR

Q0

MC

P

S

T V

W

TR = ?TC = ?

Profits = ?

Q

Menu Costs

• In imperfectly competitive markets, a firm’s demand curve depends on:– The relative price of its good – Aggregate demand

• The firm decides how much to produce by setting marginal cost equal to marginal revenue unless menu costs are significant.

Menu Costs

0 Q* Q1 Q0 Q

P0

P1

S

D0

MR1D1MR0

MC

P

Y

W

J

T V X

Given the demand curve D0, the firm maximizes profits by setting price equal to P0 and selling Q0.

A drop in aggregate demand causes the demand curve facing the firm to shift to the left to D1.

Given the demand curve D1, the firm maximizes profitsby setting price equal to P1 and selling Q1.

If the firm chooses to continue to charge P1 when itsdemand curve is D1, it sells the amount Q* and no longermaximizes profits.

Menu Costs

0 Q* Q1 Q0 Q

P0

P1

S

D0

MR1D1MR0

MC

P

Y

W

J

T V X

Profits equal total revenues minus total costs.

On demand curve D0, before the decline in aggregate demand, the firm’s total revenue equals the area 0P0YQ0 and the firms total costs equal 0SXQ0.

Its profits equal the area SP0YX.

Menu Costs

0 Q* Q1 Q0 Q

P0

P1

S

D0

MR1D1MR0

MC

P

Y

W

J

T V X

Profits equal total revenues minus total costs.

After the decline in aggregate demand, on demand curve D1, the firm’s total revenue equals the area 0P1WQ1 and the firms total costs equal 0SVQ1.

Its profits equal the area SP1WV.

Menu Costs

0 Q* Q1 Q0 Q

P0

P1

S

D0

MR1D1MR0

MC

P

Y

W

J

T V X

Profits equal total revenues minus total costs.

After the decline in aggregate demand, if the firm does not decrease price from P0, the firm’s total revenue equals the area 0P0JQ* and the firms total costs equal 0STQ*.

Its profits equal the area SP0JT.

Menu Costs

• The firm must decide whether or not to reduce price to the new profit maximizing point, W on the new demand curve, D1.

– With no adjustment costs, the firm makes a profit equal to SP1WV and would reduce output to Q1.

– But, if the firm faces non-trivial menu costs of z, the firm may decide to leave the price at P0, thereby moving from point Y to point J.

Menu Costs

MC

Q* Q1 Q0 Q0

D1

P0

P1

S

P

A C

B

J

W

T V

By reducing price from P0 to P1, the firm wouldincrease its profits by B – A, but there is no incentivefor the firm to reduce price if z > B – A.

If z > B – A, the firm would to charge P0 and sell Q*.

The loss to society of producing Q* rather than Q1 is the amount B + C, which equals the loss of totalsurplus.

If B + C > z >B – A, then the firmwill not cut its price even thoughdoing so would be sociallyoptimal

Summary: Menu Costs

• If the presence of menu costs causes nominal price rigidity, shocks to nominal aggregate demand will cause fluctuations in output and welfare.

• Such fluctuations are inefficient, indicating the need for stabilization policy.

• In addition if nominal wages are rigid because of contracts, the marginal cost curve will be sticky, thus reinforcing the impact of menu costs in producing price rigidities.