Aggregate and Individual Price Adjustment

Abstract

Price AdjustmentCENTRAL to the Keynesian interpretation of economic fluctuations is the notion that prices and wages are rigid or "sticky," so that movements in aggregate demand, rather than being quickly reflected in price level movements, have instead long-lasting effects on output and economic activity.The word "rigidity" covers, in fact, two quite different notions.The first, which I shall refer to as real rigidity, is that real wages and markups of prices over wages respond little to shifts in demand.The second, which I shall refer to as nominal rigidity, is that nominal wages and prices respond slowly to changes in their determinants and in particular respond slowly to each other.Both real and nominal rigidities combine to lead to lasting effects of changes in aggregate demand on output.The focus of the paper is on nominal rigidities.In earlier work on the joint behavior of prices, wages, and employment, I found that, contrary to prevailing wisdom, there appeared to be as much nominal price rigidity as nominal wage rigidity.'This paper explores those findings further, looks at how interactions between individual prices lead to aggregate nominal price rigidity, and points out the macroeconomic implications of nominal price rigidity.The first equation is a price equation, giving the price level as a function of itself lagged, the nominal wage, and the level of output.The second is a wage equation, giving the nominal wage as a function of itself lagged, the price level, and the level of output.The third equation gives aggregate demand as a function of real money balances, ignoring all other factors.In this model, the parameters [t or -q embody nominal rigidities.If V is not zero, there is nominal price rigidity, and the price level does not adjust instantaneously to movements in the nominal wage.Similarly, if -q is not zero, there is nominal wage rigidity, and the nominal wage does not adjust instantaneously to movements in the price level.The parameters a and b in turn embody real rigidities.A low value of a implies that firms require a small increase in the markup to increase output; a low value of b that workers require a small increase in the real wage to supply more labor.3Both nominal and real rigidities determine the dynamic effects of aggregate demand on output.As long as either Vt or -q is not zero, movements in aggregate demand, such as a change in the nominal money supply in equation 3, are not reflected in an instantaneous adjustment of the price level and thus have a lasting effect on output.The speed with which the price level adjusts to a change in nominal money is then a function of all four parameters, those reflecting nominal rigidities, Vt and -q, and those reflecting real rigidities, a and b.Given a and b, the stronger the nominal rigidities, that is, the larger t and -q, the lower the speed of adjustment of the price level and the longer lasting the real effects of changes in the nominal money supply.Given pL and 9, in turn, the stronger the real rigidities, that is, the lower a and b, the longer lasting the real effects of nominal money.Under standard neoclassical assumptions, however, both t and 'q are equal to zero: movements in nominal variables, everything else the same, are fully and instantaneously reflected in other nominal variables.3. In this model, absent nominal rigidities, there are no dynamics in either the wage or the price equation.This would not be the case in more general models: costs of adjustment of output or employment would lead, for example, to a dynamic relation between output and real wages in equation 1, quite apart from the presence or absence of nominal rigidities.More generally, there is no reason for the dynamic responses of prices to wages and employment to be the same in equation 1, for the dynamic responses of wages to prices and employment to be the same in equation 2.Research on nominal rigidities has focused on why nominal wages and nominal prices may not adjust instantaneously to changes in their determinants-that is, on why pL and 9 may not be zero.The initial impetus was given by Stanley Fischer, who showed the effects of nominal wage presetting, and by John Taylor, who showed how nominal wage presetting together with staggering of wage decisions could lead to substantial nominal inertia.7More recently, research on both the static and dynamic effects of costs of changing prices has started providing more solid microfoundations for models like Taylor's.8I shall review relevant aspects of this research below.The next part of the paper estimates more general dynamic counterparts to equations 1 and 2.Although I give estimates of a and b as well as of p. and -q, the focus throughout is on nominal rigidities, on the distributed lag counterparts to p. and -q.The main finding is that p. and -q are roughly of the same magnitude, that nominal wages and prices adjust to changes in each other at roughly the same speed.Given this finding, the third part of the paper examines the set of disaggregated price equations that underlies the aggregate price equation, in order to establish the source of the lags.The last part of the paper, using the estimated equations corresponding to equations 1 and 2 above, shows the respective roles of estimated Vi, -q, a, and b in determining the effects of aggregate demand on output.The Aggregate Evidence The empirical investigation starts with wage and price equations at a high level of aggregation.Such an aggregate analysis corresponds to the level at which most empirical research on inflation has been conducted.pp.235-76; and by Joseph E.

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