Asking About Prices: A New Approach to Understanding Price Stickiness

Chapter 1: Why Study Price Stickiness? Why This Way?

Chapter 1 Why Study Price Stickiness? Why This Way? Nothing astonishes men so much as common sense and plain dealing. -RALPH WALDO EMERSON The Importance of Price Stickiness In recent decades, macroeconomic theorists have devoted enormous amounts of time, thought, and energy to the search for better microtheoretic foundations for macroeconomic behavior. Nowhere has this search borne less fruit than in seeking answers to the following question: Why do nominal wages and prices react so slowly to business cycle developments? In short, why are wages and prices so "sticky"? The abject failure of the standard research methodology to make headway on this critical issue in the microfoundations of macroeconomics motivated the unorthodox approach of the present study. No one should think the question unimportant. On the contrary, sticky prices are an essential element of Keynesian economics, which is sometimes called the economics of nominal rigidities. (It is called less polite things as well.) The sobriquet is an exaggeration, to be sure, but a forgivable one, for embedding the assumption of short-run price or wage rigidity into almost any macro model will make it produce characteristically Keynesian results-such as that an injection of money raises production. The simplest illustration is the quantity theory of money with fixed velocity: MV = Py. In the absence of nominal rigidities, real output, y, is essentially fixed on the supply side of the economy, so that changes in money 4 Asking About Prices must pass directly and proportionately into prices. But if P, the price level, is sticky in the short run, the very same equation implies that part of any change in M must first show up in y. Conversely , if a vertical aggregate supply curve (attributable, say, to instantaneous market clearing) is appended to an otherwise "Keynesian " IS-LM modeL the real effects of fiscal and monetary policy disappear. When a scientific discipline knows next to nothing about a question of paramount importance, it is in some trouble. How did macroeconomics get into such a predicament? Two obvious explanations can be dismissed immediately. First, it is not because macroeconomists have just discovered that wage-price stickiness is a central issue; we have known this since Keynes's General Theory, if not before. Second, the failure does not result from lack of effort. Scores, if not hundreds, of theorists have worked on this problem, producing many interesting theoretical explanations; and new ideas keep popping up all the time.! Progress has not been hampered by lack of imagination. Nor, by the way, has it been hampered by lack of observation. Although much time and energy was wasted in the 1970s and 19805 arguing over whether or not the economy should be modeled as a giant auction hall with perfectly flexible prices, a small mountain of empirical evidence testifies to the fact that wages and prices adjust slowly to macroeconomic events. For example, the economist Robert Gordon (1990) summarizes the evidence that aggregate price indexes move sluggishly, while Yoram Weiss (1993) surveys some papers that provide similar evidence for individual prices. The tricky questions are two: How slow is slow? And what factors account for the sluggishness? This book is devoted to the second of these two questions. But a brief word on the first is in order, for it helps explain why conventional methods of economic inquiry-theory and econometrics-have yielded such meager results. Why So Little Progress So Far? When we say that wages or prices are "sticky," we generally mean that they move more slowly than would Walrasian market-clearing prices. Two curmudgeonly questions arise, each of which influ- Why Study Price Stickiness? 5 enced the design of this study: Is the statement operational? And is it something we should care about? We take these up in reverse order. Is Wage-Price Stickiness an Important Phenomenon? The question here is basically whether wage-price stickiness has allocative significance. For example, if no one ever borrowed at the credit card interest rate, which remained around 19 percent for years, then the fact that this rate was extremely sticky would hardly have mattered.2 Ever since the economist Robert Barro's (1977) ingenious paper, macroeconomists have worried that the sticky wages we see in many labor markets may in fact lack allocative significance . Specifically, firms may not equate the real wage to the marginal product of labor and workers may not equate the real wage to the the marginal utility of...