Sticky Prices
Sticky prices are prices that do not adjust immediately to changes in supply and demand, so that markets may not clear in the short run. Price stickiness is a central element of New Keynesian economics and provides a microfoundation for the real effects of monetary policy.
Sources of Stickiness
Several factors make prices sticky. Menu costs, the costs of changing prices, including the costs of reprinting catalogues and informing customers, discourage frequent adjustment. Contracts, including long-term agreements with customers or suppliers, fix prices for specified periods.
Imperfect competition also contributes, since firms with market power may prefer to adjust quantities rather than prices, and may be reluctant to be the first to change prices for fear of triggering a price war. Coordination failures among firms can produce stickiness, as each waits for others to move.
Price Setting with Menu Costs
Models of price setting with menu costs analyse the optimal decision of a firm facing a cost of changing its price. The firm adjusts its price only when the benefit of adjustment exceeds the cost, leading to a range of inaction around the optimal price. The result is that prices adjust infrequently and in discrete steps.
State-dependent models, in which the timing of adjustment depends on the state of the economy, and time-dependent models, in which adjustment occurs at fixed intervals, are the two main approaches. Both generate price stickiness and real effects of nominal shocks, though their implications for the dynamics of inflation differ.
Implications for Monetary Policy
Price stickiness gives monetary policy real effects in the short run. When the money supply increases, prices do not adjust immediately, so real balances rise, interest rates fall, and demand and output expand. The effect persists until prices adjust, restoring real balances and returning output to its potential.
The degree of stickiness determines the size and duration of the real effects. Where prices are stickier, monetary policy has larger and longer-lasting effects. The analysis of stickiness informs the design of monetary policy and the assessment of its ability to stabilise the economy.
Empirical Evidence
Empirical research on price setting, drawing on micro-level data, finds that prices change relatively infrequently, with the median duration of a price spell ranging from a few months to over a year depending on the country and the product. The frequency of adjustment varies across products, with some prices changing frequently and others rarely.
The evidence supports the view that prices are sticky, though the degree of stickiness varies. The findings inform the calibration of models and the assessment of the effects of monetary policy, and they highlight the heterogeneity of price-setting behaviour across sectors.
Staggered Price Setting
Staggered price setting, as in the Calvo model, assumes that a fixed fraction of firms adjusts prices each period, with the timing of adjustment determined randomly. The resulting distribution of prices generates gradual adjustment of the aggregate price level and persistence in inflation.
The model, widely used in New Keynesian analysis, provides a tractable framework for incorporating price stickiness into dynamic models. It generates a relationship between inflation and economic activity, the New Keynesian Phillips curve, which is central to the analysis of monetary policy.
Downward versus Upward Stickiness
The degree of stickiness may differ in the upward and downward directions. Some evidence suggests that prices and especially wages are more rigid downward, reflecting the reluctance of firms to cut prices and workers to accept nominal wage cuts. This asymmetry has implications for the behaviour of inflation and for the response of the economy to shocks.
Downward rigidity contributes to the persistence of inflation and to the difficulty of achieving very low inflation. It also informs the analysis of deflation, since prices that cannot fall easily may lead to larger reductions in output and employment in response to negative shocks.
Price Stickiness and Real Effects
The real effects of nominal shocks depend on the extent of price stickiness. Where prices are sticky, an increase in the money supply raises real balances and demand, expanding output. The effect persists until prices adjust, restoring real balances.
The duration of the real effects depends on the degree of stickiness and on the response of expectations. Where prices adjust quickly, the real effects are short-lived, and the economy returns rapidly to its potential. The analysis of these dynamics informs the design of monetary policy and the assessment of its power.
Microeconomic Evidence
Micro-level studies of price data provide direct evidence on the frequency and size of price changes. These studies find substantial heterogeneity across products, with some prices changing frequently and others rarely, and with the size of changes varying.
The evidence has informed the calibration of models and has highlighted the complexity of price-setting behaviour. It shows that stickiness is not uniform and that the aggregate degree of stickiness reflects the mix of products and the behaviour of firms, with implications for the transmission of shocks and the effects of policy.