The sticky-wage model If it turns out that then unemployment and output are at their natural rates Real 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

The 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:

The cyclical behavior of the real wage Percentage change in real 4 1972 wage 3 1998 1965 2 1960 1997 1999 1 1996 2000 1970 1984 1982 1993 1991 1992 -1 1990 -2 1975 -3 1979 1974 -4 1980 -5 -3 -2 -1 1 2 3 4 5 6 7 8 Percentage change in real GDP

Small menu costs and aggregate-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.

Recessions 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. The textbook (p.511) shows a game between two firms in which both would be better off if both cut prices, but each is unwilling to cut price first; in the equilibrium, neither cuts its price.

Recessions as coordination failure   Firm 1   Firm 2 Keep high price Cut price Cut price Firm 1 makes $30 Firm 2 makes $30 Firm 1 makes $5 Firm 2 makes $15 Keep high price Firm 1 makes $15 Firm 2 makes $5 Firm 1 makes $15 Firm 2 makes $15 The textbook (p.511) shows a game between two firms in which both would be better off if both cut prices, but each is unwilling to cut price first; in the equilibrium, neither cuts its price.

The 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. The text does not discuss contracts, but contracts may also explain price stickiness: The cost of negotiating may be sufficiently high that buyers and sellers agree to a contract that fixes the price for the duration of the contract’s life. However, we are trying to explain the stickiness of nominal prices. One wonders why contracts do not specify a real price (i.e., index the nominal price to a measure of the price level), as the elimination of inflation uncertainty would make buyer and seller better off (provided both are risk averse).

The 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 The text does not discuss contracts, but contracts may also explain price stickiness: The cost of negotiating may be sufficiently high that buyers and sellers agree to a contract that fixes the price for the duration of the contract’s life. However, we are trying to explain the stickiness of nominal prices. One wonders why contracts do not specify a real price (i.e., index the nominal price to a measure of the price level), as the elimination of inflation uncertainty would make buyer and seller better off (provided both are risk averse).

The 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 The text does not discuss contracts, but contracts may also explain price stickiness: The cost of negotiating may be sufficiently high that buyers and sellers agree to a contract that fixes the price for the duration of the contract’s life. However, we are trying to explain the stickiness of nominal prices. One wonders why contracts do not specify a real price (i.e., index the nominal price to a measure of the price level), as the elimination of inflation uncertainty would make buyer and seller better off (provided both are risk averse).

The 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) The text does not discuss contracts, but contracts may also explain price stickiness: The cost of negotiating may be sufficiently high that buyers and sellers agree to a contract that fixes the price for the duration of the contract’s life. However, we are trying to explain the stickiness of nominal prices. One wonders why contracts do not specify a real price (i.e., index the nominal price to a measure of the price level), as the elimination of inflation uncertainty would make buyer and seller better off (provided both are risk averse).