Nominal price rigidities approach works on the idea that wages and prices are sticky. Individual wages and prices respond slowly to changes in aggregate demand. This effect translates to aggregate price level where both wages and prices adjust slowly. During the process of adjustment, output if affected by the change in demand.
The big question is not proof whether nominal rigidity exists or not. The point is to understand the possible sources of nominal wage rigidity that leads to price stickiness.
Fischer (1977) and Taylor (1980) propose a model where firms and workers sign a contract wage period. Because wages are fixed within a period and cannot adjust, nominal shocks have real effects. The important message here is that temporary nominal rigidity can have a disproportionate effect on response of aggregate price level to change in aggregate demand; the effect of the shock vanishes gradually while individuals readjust wages to the new level. This approach can be characterized by an institutional framework: the source of nominal rigidity is that there exists a fix contract duration. Even thought the theoretical contributions were important, these models were severely criticized. The existence of contacts is never microfounded, as Mankiw (1990) holds: “if the nominal wage contracts are responsible for large and inefficient fluctuations in output and employment, why do workers and firms write these contracts?”
Dissatisfaction with models emphasizing the stickiness of nominal wages, the attention turned to a new source of nominal rigidity. The idea was to assume the existence of monopoly firms who face small “menu costs” when they change prices. To illustrate our point, consider Blanchard and Kiyotaki’s (1987) classical menu cost model. Here, firms incur a fixed real cost when they change nominal prices. If this fixed cost is above a certain threshold, firms have no incentive to change their prices and nominal shocks may have real effects. Hence, in the menu cost view, a firm’s price setting decision - and hence the question whether nominal shocks can have real effects – fundamentally depends on the presence of a real cost to nominal price changes. These menu costs are the resources required to post new price lists and more metaphorical: the costumer annoyance by prices changes and the effort required to think about a price change. The advantage of these types of models is that they can explain in microeconomic terms why prices do not restore to equilibrium. A typical monopoly may have not so much incentives to adjust the price because his optimization problem, given the menu cost, indicates that the optimal action is to leave prices unchanged.
The Fischer and Taylor models assume that the timing of price changes is determined by the passage of time (notice that Blanchard and Kiyotaki model is static, and this may be considered a flaw). However, many retail stores, for example, can adjust the timing of their price in response to economic environment. Caplin and Spulber (1987) present a model where the number of price setters changing their prices at any moment of time is larger when money supply is increasing rapidly. In the aggregate, because price level may respond fully to changes in money, nominal shocks may have or not real effects. This will depend, like in the other models, on the source of rigidity. However, the novelty here is that the source of nominal rigidity is endogenous determined and may be variant though out time. A price setter keeps nominal price fixed until the difference between his ideal price and actual price equals a target level. If the ideal has passed the trigger level, he resets the price.
New emerging literature in nominal rigidities has started to consider a new possible source of nominal wage rigidity based of social norms. Truman Bewley (1999) presents evidence that wage stickiness can be explained by social norms. He concludes that, even through substitute labor is available, employers are reluctant to cut wages because of the negative effects of cuts on morale (that later on affects productivity). In this context, it might be optimal for firms not to cut wages. Elsby (2009) models Bewley’s idea to show how downward nominal wage rigidity actually exists and what are the implications for the real economy.
In a similar line, Akerloff (2007) does not present a theoretical framework, but in the context of price setting he suggests the following: “Norms regarding price changes, however, give an alternative reason why these costs might be—indeed—of sufficient size to induce a significant long-run trade-off between inflation and unemployment”. It is possible to think that Akerloff is considering to translate the source of nominal wage rigidity into consumers, and this source would be based in some kind of social normal... (will continue)
By Alex de Large.