Snowdon & Vane Modern Macroeconomics

certainly expect to observe a high degree of nominal price flexibility. A firm operating under conditions of perfect competition is a price taker, and prices change automatically to clear markets as demand and supply conditions change. Since each firm can sell as much output as it likes at the going market price, a perfectly competitive firm which attempted to charge a price above the marketclearing level would have zero sales. There is also no profit incentive to reduce price independently, given that the firm’s demand curve is perfectly elastic at the prevailing market price. Thus in this world of perfect price flexibility it makes no sense to talk of the individual firm having a pricing decision.

When firms operate in imperfectly competitive markets a firm’s profits will vary differentially with changes in its own price because its sales will not fall to zero if it marginally increases price. Price reductions by such a firm will increase sales but also result in less revenue per unit sold. In such circumstances any divergence of price from the optimum will only produce ‘second-order’ reductions of profits. Hence the presence of even small costs to price adjustment can generate considerable aggregate nominal price rigidity. This observation, due to Akerlof and Yellen (1985a), Mankiw (1985) and Parkin (1986), is referred to by Rotemberg (1987) as the ‘PAYM insight’.

The PAYM insight makes a simple but powerful point. The private cost of nominal rigidities to the individual firm is much smaller than the macroeconomic consequences of such rigidities. A key ingredient of the PAYM insight is the presence of frictions or barriers to price adjustment known as ‘menu costs’. These menu costs include the physical costs of resetting prices, such as the printing of new price lists and catalogues, as well as expensive management time used up in the supervision and renegotiation of purchase and sales contracts with suppliers and customers. To illustrate how small menu costs can produce large macroeconomic fluctuations, we will review the arguments made by Mankiw and by Akerlof and Yellen.

In imperfectly competitive markets a firm’s demand will depend on (i) its relative price and (ii) aggregate demand. Suppose following a decline in aggregate demand the demand curve facing an imperfectly competitive firm shifts to the left. A shift of the demand curve to the left can significantly reduce a firm’s profits. However, faced with this new demand curve, the firm may gain little by changing its price. The firm would prefer that the demand curve had not shifted but, given the new situation, it can only choose some point on the new demand curve. This decline in demand is illustrated in Figure 7.2 by the shift of demand from D0 to D1. Before the decline in demand the profit-maximizing price and output are P0 and Q0, since marginal revenue (MR0) is equal to marginal cost (MC0) at point X. For convenience we assume that marginal cost does not vary with output over the range shown. Following the decline in demand, the firm suffers a significant reduction in its profits. Before the reduction in demand, profits are indicated in

Figure 7.2 Price adjustment under monopolistic competition

Figure 7.2 by the area SP0YX. If the firm does not initially reduce its price following the decline in demand, profits fall to the area indicated by SP0JT. Because this firm is a ‘price maker’ it must decide whether or not to reduce price to the new profit-maximizing point indicated by W on the new demand curve D1. The new profit-maximizing level of output is determined where MR1 = MC0. With a level of output of Q1, the firm would make profits of SP1 WV. If there were no adjustment costs associated with changing price, a profit-maximizing firm would reduce its price from P0 to P1. However, if a firm faces non-trivial ‘menu costs’ of z, the firm may decide to leave price at P0; that is, the firm moves from point Y to point J in Figure 7.2.

Figure 7.3 indicates the consequences of the firm’s decision. By reducing price from P0 to P1 the firm would increase its profits by B – A. There is no incentive for a profit-maximizing firm to reduce price if z > B – A. The loss to society of producing an output of Q* rather than Q1 is indicated by B + C, which represents the loss of total surplus. If following a reduction of demand B + C > z > B – A, then the firm will not cut its price even though doing so would be socially optimal. The flatter the MC schedule, the smaller are the menu costs necessary to validate a firm’s decision to leave the price unchanged. Readers should confirm for themselves that the incentive to lower prices is therefore greater the more marginal cost falls when output declines (see Gordon, 1990; D. Romer, 2001).

Figure 7.3 Menu costs v. price adjustment

In the Akerlof and Yellen (1985a, 1985b) model, inertial wage-price behaviour by firms ‘may be near rational’. Firms that behave sub-optimally in their price-setting behaviour may suffer losses but they are likely to be second order (small). The idea of near rationality is illustrated in Figure 7.4. As before, the profit-maximizing price following a decline in demand is indicated by P1. The reduction in profits (π1 – π*) that results from failure to reduce price from P0 to P1 is small (second order) even without taking into account menu costs (that is, in Figure 7.3, B – A is small). Akerlof and Yellen (1985a) also demonstrate that, when imperfect competition in the product market is combined with efficiency wages in the labour market, aggregate demand disturbances will lead to cyclical fluctuations (see Akerlof, 2002).

Although the firm may optimally choose to maintain price at P0, the impact of their decision, if repeated by all firms, can have significant macroeconomic effects. Blanchard and Kiyotaki (1987), in their interpretation of the PAYM insight, show that the macroeconomic effects of nominal price rigidity differ from the private costs because price rigidity generates an aggregate demand externality. Society would be considerably better off if all firms cut their prices, but the private incentives to do so are absent. As before, assume that a firm’s demand curve has shifted left as a result of a decline in aggregate demand. If firms did not face menu costs, then profit-maximizing behaviour would dictate that all firms lowered their prices; that is, in terms of Figures

Figure 7.4 Near rationality

7.2 and 7.3, each firm would move from Y to W. Because all firms are lowering their prices, each firm will find the cost of its inputs are falling, including money wages. Hence each firm will find that its marginal cost curve begins to shift down. This allows firms to reduce prices further. In Figure 7.3, as MC0 shifts down, output will expand. Since all firms are engaged in further price reductions, input prices will fall again, producing another reduction of MC. Since this process of price deflation will increase real money balances, thereby lowering interest rates, aggregate demand will increase. This will shift the demand curves facing each firm to the right, so that output will return to Q0.

If the presence of menu costs and/or near rational behaviour causes nominal price rigidity, shocks to nominal aggregate demand will cause large fluctuations in output and welfare. Since such fluctuations are inefficient, this indicates that stabilization policy is desirable. Obviously if money wages are rigid (because of contracts) the marginal cost curve will be sticky, thus reinforcing the impact of menu costs in producing price rigidities.

We noted earlier that there are several private advantages to be gained by both firms and workers from entering into long-term wage contracts. Many of these advantages also apply to long-term agreements between firms with respect to product prices. Pre-set prices not only reduce uncertainty but also economize on the use of scarce resources. Gordon (1981) argues that ‘persua-

sive heterogeneity’ in the types and quality of products available in a market economy would create ‘overwhelming transaction costs’ if it were decided that every price was to be decided in an auction. Auction markets are efficient where buyers and sellers do not need to come into physical contact (as with financial assets) or the product is homogeneous (as with wheat). The essential feature of an auction market is that buyers and sellers need to be present simultaneously. Because time and space are scarce resources it would not make any sense for the vast majority of goods to be sold in this way. Instead numerous items are made available at suitable locations where consumers can choose to conduct transactions at their own convenience. The use of ‘price tags’ (goods available on fixed terms) is a rational response to the problem of heterogeneity. Typically when prices are pre-set the procedure used is a ‘mark-up pricing’ approach (see Okun, 1981).

As is evident from the above discussion, the theory of imperfect competition forms one of the main building-blocks in new Keynesian economics. Therefore, before moving on to consider real rigidities, it is interesting to note one of the great puzzles in the history of economic thought. Why did Keynes show so little interest in the imperfect competition revolution taking place on his own doorstep in Cambridge in the early 1930s? Richard Kahn, author of the famous 1931 multiplier article and colleague of Keynes, was fully conversant with the theory of imperfect competition well before Joan Robinson’s famous book was published on the subject in 1933. Given that Keynes, Kahn and Robinson shared the same Cambridge academic environment during the period when the General Theory was being written, it is remarkable that Keynes adopted the classical/neoclassical assumption of a perfectly competitive product market which Kahn (1929) had already argued was unsound for short-period analysis (see Marris, 1991)! As Dixon (1997) notes, ‘had Kahn and Keynes been able to work together, or Keynes and Robinson, the General Theory might have been very different’. In contrast to the orthodox Keynesian school, and inspired by the work of Michal Kalecki, Post Keynesians have always stressed the importance of price-fixing firms in their models (Arestis, 1997).

7.6Dornbusch’s Overshooting Model

As we have already seen, the sticky-price rational expectations models put forward by Fischer (1977) and Phelps and Taylor (1977) analyse the role of monetary policy in the context of a closed economy. Before considering the importance of real rigidities in new Keynesian analysis we briefly examine Dornbusch’s (1976) sticky-price rational expectations model of a small open economy. This exchange rate ‘overshooting’ model has been described by Kenneth Rogoff (2002) ‘as one of the most influential papers written in the

field of International Economics since World War II’, a paper which Rogoff suggests ‘marks the birth of modern international macroeconomics’.

Before discussing the main predictions of Dornbusch’s model it is helpful to place the model in the context of earlier discussion of aspects of international macroeconomics. In Chapter 3, section 3.5.4 we discussed how in the fixed price (IS–LM–BP) Mundell–Fleming model of an open economy operating under a regime of flexible exchange rates monetary expansion results in an increase in income, with the effects of monetary expansion on aggregate demand and income being reinforced by exchange rate depreciation. Furthermore, in the limiting case of perfect capital mobility monetary policy becomes ‘all-powerful’. In contrast, in Chapter 4, section 4.4.3 we considered how in the monetary approach to exchange rate determination, where real income is exogenously given at its natural level, monetary expansion leads to a depreciation in the exchange rate and an increase in the domestic price level. In what follows we outline the essence of Dornbusch’s (1976) sticky-price rational expectations model in which monetary expansion causes the exchange rate to depreciate (with short-run overshooting) with no change in real output.

In his model Dornbusch made a number of assumptions, the most important of which are that:

1.goods markets are slow to adjust compared to asset markets and exchange rates; that is, goods prices are sticky;

2.movements in the exchange rate are consistent with rational expectations;

3.with perfect capital mobility, the domestic rate of interest of a small open economy must equal the world interest rate (which is given exogenously), plus the expected rate of depreciation of the domestic currency; that is, expected exchange rate changes have to be compensated by the interest rate differential between domestic and foreign assets; and

4.the demand for real money balances depends on the domestic interest rate (determined where equilibrium occurs in the domestic money market) and real income, which is fixed.

Given these assumptions, what effect will monetary expansion have on the exchange rate? In the short run with fixed prices and a given level of real income an increase in the (real) money supply results in a fall in the domestic interest rate, thereby maintaining equilibrium in the domestic money market. The fall in the domestic interest rate means that, with the foreign interest rate fixed exogenously (due to the small-country assumption), the domestic currency must be expected to appreciate. While short-run equilibrium requires an expected appreciation of the domestic currency, long-run equilibrium

requires a depreciation of the exchange rate. In other words, since long-run equilibrium requires a depreciation of the domestic currency (compared to its initial level), the exchange rate depreciates too far (that is, in the short run it overshoots), so that it can be expected to appreciate back to its long-run equilibrium level. Such short-run exchange rate overshooting is fully consistent with rational expectations because the exchange rate follows the path it is expected to follow.

A number of points are worth noting with respect to the above analysis. First, the source of exchange rate overshooting in the Dornbusch model lies in goods prices being relatively sticky in the short run. In other words, the crucial assumption made in the model is that asset markets and exchange rates adjust more quickly than do goods markets. Second, the rate at which the exchange rate adjusts back to its long-run equilibrium level depends on the speed at which the price level adjusts to the increase in the money stock. Finally, in the long run, monetary expansion results in an equi-proportionate increase in prices and depreciation in the exchange rate.

7.7Real Rigidities

One important criticism of the menu cost literature noted by Ball et al. (1988) is that models with nominal frictions can in theory produce large nominal rigidities but ‘do so for implausible parameter values’. However, Ball and Romer (1990) demonstrated that substantial nominal rigidities can result from a combination of real rigidities and small frictions to nominal adjustment. Indeed, Mankiw and Romer (1991) identify the interaction between nominal and real imperfections as ‘a distinguishing feature of the new Keynesian economies’.

If all nominal prices in an economy were completely and instantaneously flexible, a purely nominal shock would leave the real equilibrium of an economy unchanged. As Ball and Romer (1990) note, ‘Real rigidity does not imply nominal rigidity: without an independent source of nominal stickiness prices adjust fully to nominal shocks regardless of the extent of real rigidities.’ However, rigidity of real prices and wages will magnify the non-neutralities which result from small nominal frictions. The importance of this point can be seen by considering the impact of a decline in the money supply. Suppose initially that the presence of menu costs deters firms from reducing their prices in response to this nominal disturbance. With the price level unchanged real output will decline. Each monopolistically competitive firm will find that its demand curve has shifted to the left. Because each firm is producing less output, the effective demand for labour declines (see Abel and Bernanke, 2001). If labour supply is relatively inelastic, the shift of labour demand implied by the decline in

output will cause a large fall in real wages; that is, the nominal wage rate declines to bring this about (see Ball et al., 1988; Gordon, 1990; D. Romer, 1993). This decline in the real wage rate implies a decline in marginal cost, a decline which will be strongly reinforced if the marginal product of labour rises sharply as the labour input decreases. As is evident from Figure 7.2, an upward-sloping marginal cost curve would greatly increase the incentive to reduce price and would ‘swamp any plausible barriers to nominal adjustment’ unless the elasticity of demand at the existing price falls as the firm’s demand curve shifts to the left. The greater the decline in the elasticity of demand at the existing price as output falls, the more the marginal revenue curve facing a firm shifts to the left and the less incentive there is for a firm to reduce its price.

David Romer (1993) sums up the essence of this issue as follows: ‘Thus if the classical dichotomy is to fail, it must be that marginal cost does not fall sharply in response to a demand-driven output contraction, or that marginal revenue does fall sharply, or some combination of the two.’ Real price rigidity is high the greater is the cyclical sensitivity of the elasticity of demand and the smaller is the cyclical sensitivity of marginal cost. Hence nominal shocks have large real consequences the greater the degree of real rigidity (see D. Romer, 2001).

The points discussed above can be more easily understood by referring to the familiar mark-up pricing equation facing a profit-maximizing monopolistically competitive firm (see Pindyck and Rubinfeld, 1998, p. 340). Profit maximization requires that the firm produces that level of output where marginal revenue (MR) equals cost (MC). Marginal revenue can be expressed in the form shown by equation (7.5):

where P is the firm’s price and η is the price elasticity of demand. Profit maximization therefore requires that:

This equation can also be rearranged so as to express price as a mark-up on marginal cost. The mark-up equation is given by (7.8):

Since marginal cost is the nominal wage (W) divided by the marginal product of labour (MPL), we finally get equation (7.9):

The term inside the brackets represents the mark-up, the size of which varies inversely with the elasticity of demand (remember η is negative). Equation (7.9) indicates that P will not fall when MC declines if the mark-up rises sufficiently to offset this decline (see Stiglitz, 1984). If the elasticity of demand does not decline, then equation (7.9) also indicates that the incentive to change price will be small in the presence of menu costs if MPL does not rise strongly as the labour input is reduced (see Hall, 1991). Rotemberg and Woodford (1991) suggest that desired mark-ups over marginal cost fall during a boom because it becomes increasingly difficult to maintain oligopolistic collusion; that is, industries become more competitive in periods of high economic activity. During recessions implicit collusion increases, leading to a countercyclical mark-up that acts as a real rigidity, magnifying the impact on nominal rigidity of relatively small menu costs (D. Romer, 2001).

7.7.1 Other sources of real price rigidity

We have already noted that mild sensitivity of marginal cost to variations in output and procyclical elasticity of demand (implying a countercyclical markup) will contribute towards real price rigidity. The new Keynesian literature has also identified several other potential sources of real price rigidity.

Thick market externalities In the real world buyers and sellers are not brought together without incurring search costs. Consumers must spend time searching the market for the goods they desire and firms advertise in order to attract customers. Workers and employers must also spend time and resources searching the market. When markets are thick during periods of high economic activity it seems plausible that search costs will be lower than is the case in a thin market characterized by a low level of trading activity (see Diamond, 1982). It may also be the case that people are much more willing to participate in thick markets where a lot of trade is taking place and this leads to strategic complementary; that is, the optimal level of activity of one firm depends on the activity of other firms. If these thick market externalities help to shift the marginal cost curve up in recessions and down in booms, then this will contribute to real price rigidity.

Customer markets The distinction between auction and customer markets has been developed by Okun (1975, 1981). The crucial characteristic of a customer market is a low frequency of search relative to the frequency of purchase (McDonald, 1992). Most products are sold through a process of shopping and, providing the costs of searching the market are non-trivial, the buyer will always have imperfect (limited) information concerning the lowest price in the marketplace. Because of the search costs associated with the shopping process, sellers have some monopoly power even though there may be a large number of firms in the market, each selling a similar product. Since a large number of customers make repetitive purchases it is in the interests of any firm to discourage its customers from searching the market in order to find a better deal. Firms are therefore discouraged from frequently changing their prices, a practice which will provide an incentive for customers to look elsewhere. Whereas an increase in price will be noticed immediately by customers, a decrease in price will produce a much smaller initial response as it takes time for this new information to reach the buyers at other firms. This difference in the response rates of customers to price increases and decreases, and the desire of a firm to hold on to its regular customers, will tend to produce relative price stickiness (see Phelps, 1985, for an excellent discussion of customer markets).

Price rigidity and the input–output table Gordon (1981, 1990) has drawn attention to the complexity of decision making in a world where, typically, thousands of firms buy thousands of components containing thousands of ingredients from numerous other firms, many of which may reside overseas. ‘Once decentralisation and multiplicity of supplier–producer relationships are recognised, no single firm can perform an action that would eliminate the aggregate business cycle’ (Gordon, 1981, p. 525).

Because a firm is linked to thousands of other firms via a complex input– output table, it is impossible for it to know the identity of all the other agents linked together in the web of supplier–producer relationships. Because of this complexity there is no certainty that marginal revenue and marginal cost will move in tandem following an aggregate demand shock. There is no certainty for an individual firm that, following a decline in aggregate demand, its marginal cost will move in proportion to the decline in demand for its products. Many of its suppliers may be firms in other countries facing different aggregate demand conditions. To reduce price in these circumstances is more likely to produce bankruptcy for the particular firm than it is to contribute to the elimination of the business cycle because a typical firm will be subject to both local and aggregate demand shocks as well as local and aggregate cost shocks. As Gordon (1990) argues, in such a world no firm would be likely to take the risk of nominal GNP indexation that would inhibit its freedom and