Economist Writing Every Day

This week, I’m doing some review for a macro-related project. In economics, the concepts of real and nominal rigidities help explain why prices and wages do not always adjust quickly in response to shocks. These rigidities create frictions that affect how markets function. A well-known rigidity is downward nominal wage rigidity (I have an experimental paper on that).

“Nominal rigidities” refer to the stickiness of prices and wages in their nominal (monetary) terms. These rigidities prevent immediate adjustment of prices and wages to changes in the overall economic environment.

Examples of Nominal Rigidities

• Menu Costs: The costs associated with changing prices, such as reprinting menus or reprogramming point-of-sale systems. For instance, a restaurant might avoid changing its menu prices frequently because of the costs involved in printing new menus and the risk of confusing or losing customers.
• Nominal Wage Contracts: Many workers are employed under contracts that fix their wages for a certain period, such as a year. This means that even if the demand for labor changes, wages cannot adjust immediately. For example, a factory might have a one-year wage contract with its workers, preventing it from lowering wages even during a downturn.
• Price Stickiness Due to Psychological Factors: Prices may remain rigid because businesses fear that frequent changes might upset customers or erode their trust. A classic example is a retail store keeping prices stable to maintain a reputation for reliability, even when costs fluctuate.

Side note: Lars Christensen predicts less nominal rigidity in our future. Menu costs are getting smaller and customers could become accustomed to, for example, watching the price of milk fluctuate in real time in response to statements by the Fed. Click here for related Twitter joke.

“Real rigidities”, on the other hand, involve factors that affect the adjustment of real (inflation-adjusted) variables in the economy. These rigidities stem from structural or market characteristics.

Examples of Real Rigidities

• Labor Market Frictions: The difficulties in matching workers with jobs, such as search and training costs. For example, a high-tech company may need time to find and train highly specialized engineers.
• Capital Adjustment Costs: Firms face costs when changing their capital stock, like installing new machinery or restructuring production lines.
• Customer Relationships and Habit Formation: Businesses may avoid frequent price changes to maintain long-term customer relationships, and consumers often have habits that change slowly over time. For instance, a coffee shop might keep its prices stable to retain loyal customers.

The following older paper is a key reference for my current project: Ball and Romer’s 1991 paper suggests how coordination failures and menu costs could contribute to nominal rigidity:

1. Strategic Complementarity: The paper posits that a firm’s optimal pricing decision depends on the pricing decisions of other firms. If a firm expects others to adjust their prices, it finds it beneficial to adjust its prices as well. This interdependence is termed “strategic complementarity.”
2. Coordination Failures: Due to strategic complementarity, multiple equilibria can arise. Firms may fail to coordinate on a common price adjustment strategy, leading to nominal rigidity. Even if a nominal shock occurs (like an inflationary shock), firms may hesitate to adjust prices because they are uncertain whether their competitors will do the same.
3. Welfare Implications: The paper argues that welfare is generally higher in equilibria with less price rigidity. When firms fail to coordinate on price adjustments, the economy may settle into an equilibrium with higher nominal rigidity, resulting in lower overall welfare.

A more recent paper on price dynamics: Harding, Lindé, and Trabandt (2023) introduces a macroeconomic model that incorporates a nonlinear Phillips curve, providing a new perspective on inflation dynamics:

1. Nonlinear Phillips Curve: The model features a Phillips curve with a flat slope when inflationary pressures are low and a steep slope when pressures are high. This quasi-kinked demand schedule reflects firms’ pricing behavior, where the sensitivity of prices to economic conditions varies depending on the inflation rate.
2. Explaining Inflation Patterns: The model accounts for the modest decline in inflation during the Great Recession and the surge in inflation during the post-COVID period. The nonlinear nature of the Phillips curve implies stronger transmission of economic shocks when inflation is high, leading to more significant inflation surges from cost-push and demand shocks.
3. Policy Implications: The model suggests that the central bank faces a more severe trade-off between inflation and output stabilization when inflation is elevated.

Although both papers discuss conditions under which price adjustments may become more likely when other firms also adjust, they fundamentally differ in their primary mechanisms and contexts. One difference is the nature of interdependence. In Ball and Romer, the interdependence is due to strategic complementarities and coordination failures among firms. In contrast, Harding, Lindé, and Trabandt emphasize the nonlinearity in the Phillips curve, where the degree of price adjustment is contingent on the level of inflation. The nonlinear response of the Phillips curve suggests that under low inflation, firms might collectively delay price adjustments, which can be seen as an implicit form of coordination failure. In the Harding, Lindé, and Trabandt model, the trigger is the inflation rate itself, which modifies the sensitivity of prices to economic conditions. For Ball and Romer, the trigger for adjustment is firms’ expectations and menu costs.