slide 1

The sticky-wage modelThe sticky-wage model

If it turns out that

eW Pω

P P

eP P

eP P

eP P

then

unemployment and output are at their natural ratesReal wage is less than its target, so firms hire more workers and output rises above its natural rate

Real wage exceeds its target, so firms hire fewer workers and output falls below its natural rate

slide 2

The sticky-wage modelThe sticky-wage model

Implies that the real wage should be counter-cyclical , it should move in the opposite direction as output over the course of business cycles:– In booms, when P typically rises, the

real wage should fall. – In recessions, when P typically falls,

the real wage should rise.

This prediction does not come true in the real world:

slide 3

The cyclical behavior of the real wageThe cyclical behavior of the real wage

Percentage change in realwage

Percentage change in real GDP

1982

1975

19931992

1960

1996

19991997

1998

1979

1970

1980

1991

1974

1990

19842000

1972

1965

-3 -2 -1 0 1 2 3 7 8654

4

3

2

1

0

-1

-2

-3

-4

-5

slide 4

Small menu costs and Small menu costs and aggregate-demand externalitiesaggregate-demand externalities

There are externalities to price adjustment:A price reduction by one firm causes the overall price level to fall (albeit slightly).This raises real money balances and increases aggregate demand, which benefits other firms.

Menu costs are the costs of changing prices (e.g., costs of printing new menus or mailing new catalogs)

In the presence of menu costs, sticky prices may be optimal for the firms setting them even though they are undesirable for the economy as a whole.

slide 5

Recessions as coordination failureRecessions as coordination failure

In recessions, output is low, workers are unemployed, and factories sit idle.

If all firms and workers would reduce their prices, then economy would return to full employment.

But, no individual firm or worker would be willing to cut his price without knowing that others will cut their prices. Hence, prices remain high and the recession continues.

slide 6

Recessions as coordination failureRecessions as coordination failure

 

  Firm 1

 

Firm 2

Cut price

Keep high price

Cut price Keep high price

Firm 1 makes $30Firm 2 makes $30

Firm 1 makes $5Firm 2 makes $15

Firm 1 makes $15Firm 2 makes $5

Firm 1 makes $15Firm 2 makes $15

slide 7

The staggering of wages and pricesThe staggering of wages and prices

All wages and prices do not adjust at the same time.

This staggering of wage & price adjustment causes the overall price level to move slowly in response to demand changes.

Each firm and worker knows that when it reduces its nominal price, its relative price will be low for a time. This makes them reluctant to reduce their price.

slide 8

The staggering of wages and pricesThe staggering of wages and prices

1) Synchronized Price Setting

  Every firm adjusts its price on the first day of every month

May 1 June 1

AD

“boom”

May 10

slide 9

The staggering of wages and pricesThe staggering of wages and prices

2) Staggered Price Setting

  Half the firms set prices on the first day of each month and half on the fifteenth

May 1 June 1

AD

May 10 May 15

Half the firms raise their prices(But probably raise prices not very much)

The other firms will make little adjustment when their turn comes

slide 10

The staggering of wages and pricesThe staggering of wages and prices

2) Staggered Price Setting

Price level rises slowly as the result of small price increases on the first and the fifteenth of each month (because no firm wishes to be the first to post a substantial price increase)