Sticky Prices

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Sticky Prices


Price stickiness, the failure of prices to adjust fully in the face of evolving equilibrium conditions, reflects a lack of responsiveness to changes in supply and demand. This phenomenon has received considerable empirical and theoretical attention. To begin with, Barro and Grossman (1980), an early New Keynesian exposition on general disequilibrium, establishes the potential macroeconomic implications of such stickiness as divergence from equilibrium in the form of price rigidity in one market spilling over to others. For instance, they demonstrate how excess demand or supply in labor or commodity markets can stimulate more general macroeconomic shifts. Approaching the question from a slightly different perspective, John Taylor (1980) adopts a rational expectations framework with staggered wage contracts (the sole source of wage rigidities in his model) to explain the persistent unemployment observed during postwar business cycles.

While Barro and Grossman (1980), Taylor (1980), and related work generally takes for granted price stickiness (typically by assuming some mechanism for it), to explore its larger macroeconomic implications, most theoretical work has been concerned with finding plausible microeconomic foundations for the emergence of price rigidities. These efforts have generated two principal veins of inquiry: one focused on price stickiness as a possible consequence of government intervention and the other on rigidities introduced by contractual commitments set by optimizing agents.

Several avenues of state intervention have received theoretical attention. First, governments frequently regulate the prices of various goods and services. To be meaningful (i.e., consequential), these restrictions must be binding in the sense that the resulting price in the market differs from what might otherwise have emerged under ordinary equilibrium circumstances. For instance, a legally mandated minimum wage (a kind of price floor) would influence prevailing wages only in sectors of the labor market where the equilibrium wage is below that mandated minimum. Such regulations undermine the full impact of many potential shifts in supply and demand, as changes in equilibrium price that would be evident in the absence of them are no longer so in their presence. Another important form of government interference with market prices comes in the form of attempts to fix (or peg) exchange rates. This has given rise to a literature (e.g., Krugman 1979, who builds on the work of Salant and Henderson 1978) focusing on the idea that such policies drive a wedge between the prevailing exchange rate (which is determined by the governments peg) and the fundamental exchange rate (that which would prevail in an unfettered foreign exchange market). If the two diverge sufficiently, the governments ability to defend the fixed rate may be overwhelmed by speculative pressure.

On balance, however, more theoretical attention has been directed toward the possibility that stickiness might arise as a result of contract setting (the consequences of which in terms of price rigidities are straightforward) and other purposeful behavior by optimizing agents. For instance, menu costs have received a great deal of attention (see, for instance, Mankiw [1985] for a thorough review of menu costs). Essentially, this approach is rooted in the idea that prices might not respond to shifts in supply and demand if the transaction costs (in a variety of senses) associated with adjusting prices are sufficiently high. At the most trivial level there is a cost associated with adjusting menus and price labels. For instance, in markets characterized by monopoly or oligopoly, shifts in demand might yield changes in the prevailing market price only if the transaction costs associated with adjusting price are less than the erosion of profits that would occur if firms simply maintained their prices. On a more subtle level, frequent adjustment in prices might undermine consumer confidence or trust (e.g., if they believe that the frequent price changes represent some effort at manipulation).

Another popular line of inquiry revolves around efficiency wages (see Akerlof and Yellen 1986), which are set above the labor market equilibrium with the intention of promoting higher worker productivity. Frequently cited justifications for paying efficiency wages include discouraging shirking (because the financial penalty associated with being fired is greater), avoiding adverse selection (since workers with higher capabilities may be more inclined to apply for jobs with a higher wage), and reducing turnover costs (as individuals may be reluctant to quit a job with a higher-than-market wage).

A large body of empirical work is concerned with price stickiness. The principal objectives of this literature are to determine whether price stickiness actually arises in practice and whether the various theoretical explanations of price stickiness are consistent with observed empirical patterns. Rotemberg (1982) is one among many reporting evidence of price stickiness. Using U.S. data, he finds that it arises because of the transaction costs that firms incur when they change prices.

Despite the extensive empirical and theoretical literature concerned with it, the concept of price stickiness has met with skepticism. Lucas and Sargent (1978) and other New Classical economists challenge the idea that prices (or wages) are slow to adjust, suggesting instead that rational agents formulate price expectations using all available information in such a fashion that prices and wages should quickly readjust to equilibrate the market.g

SEE ALSO Adverse Selection; Akerlof, George A.; Distortions; Economics, New Classical; Economics, New Keynesian; Expectations; Expectations, Rational; Lucas, Robert E., Jr.; Macroeconomics; Microeconomics; Sargent, Thomas; Transaction Cost; Wages


Akerlof, George A., and Janet Yellen, eds. 1986. Efficiency Wage Models of the Labor Market. Cambridge, U.K.: Cambridge University Press.

Barro, Robert J., and Herschel I. Grossman. 1971. A General Disequilibrium Model of Income and Employment. American Economic Review 61 (1): 8293.

Froyen, Richard T. 1993. New Classical and New Keynesian Directions. In Macroeconomics: Theories and Policies, 341362. New York: Macmillan.

Krugman, Paul. 1979. A Model of Balance of Payments Crises. Journal of Money, Credit, and Banking 11(3): 311325.

Lucas, Robert E., Jr., and Thomas Sargent. 1978. After Keynesian Macroeconomics. In After the Phillips Curve: Persistence of High Inflation and High Unemployment. Boston. Federal Reserve Bank of Boston.

Mankiw, N. Gregory. 1985. Small Menu Costs and Large Business Cycles: A Macroeconomic Model. Quarterly Journal of Economics 100 (2): 529538.

Rotemberg, Julio. 1982. Sticky Prices in the United States. Journal of Political Economy 90 (6): 11871211.

Salant, Stephen, and Dale Henderson. 1978. Market Anticipation of Government Policy and the Price of Gold. Journal of Political Economy 86: 627648.

Taylor, John B. 1980. Aggregate Dynamics and Staggered Contracts. The Journal of Political Economy 88 (1): 123.

Mai Noguchi Hubbard