Winner of the New Statesman SPERI Prize in Political Economy 2016

Sunday, 11 May 2014

Sticky prices: how we confuse students, and sometimes ourselves

For teachers and students of macroeconomics.

I’m about to teach a small number of first year undergraduate students Keynesian macroeconomics, and my aim will be not to tell them that this is the macroeconomics of sticky prices. Yet I realise I’ve already gone wrong. In week one I talked about time periods in macro, and how the ‘short run’ was the length of time ‘it takes prices to fully adjust’. I must have been saying this for years. But it is at best highly misleading.

In both the New Keynesian closed economy model, and the IS/LM model, the short run is the length of time it takes the central bank to stabilise inflation (output goes to its natural rate), or less precisely to achieve full employment. For students we could equally say it is the period it takes monetary policy to achieve the real rate of interest implied by the RBC, or Classical, model.  Calling this the time period it takes prices to fully adjust only makes sense when monetary policy involves some kind of nominal anchor, like a fixed money target in IS/LM. It makes no sense when monetary policy involves a central bank trying to choose the best nominal interest rate. The impact of an unexpected but subsequently known preference/demand shock, for example, would be very short lived when such a central bank knew what it was doing. (See this excellent post from Nick Rowe.)  

The big danger in equating Keynesian economics with sticky prices is that students forget about the crucial role monetary policy is playing. Too many think that after an increase in aggregate demand, if contracts and menu costs were absent, higher prices would in themselves choke off the increase in aggregate demand.  As they have just learnt micro, it is a natural mistake to make. They then get very confused when price flexibility does (at best) nothing at the zero lower bound.

Yet the linking of the short run with sticky prices is ubiquitous. In the edition of Mankiw I have to hand it says
“In the long run, prices are flexible and can respond to changes in supply or demand. In the short run, many prices are sticky at some predetermined level. Because prices behave differently in the short run than the long run, economic policies have different effects over different time horizons.”
This kind of statement makes sense in a fixed money supply world, but it makes much less sense in the real world. (Mankiw uses the term ‘long run’ where others would use ‘medium run’, but let us not worry about that.) Compare it with this alternative statement:
“In the long run, monetary policy adjusts to achieve steady inflation, which means output goes to its ‘natural’ or Classical level. In the short run, monetary policy fails to achieve this, so we need to look at movements in aggregate demand to explain output.”
This works for any sensible monetary policy.

In my second year lectures, I ask my students to think about a monetary policy that involved moving real interest rates in response to the output gap, but not to excess inflation.  If that policy stabilised a closed economy, then what impact would the speed of price adjustment have on anything except inflation? Inflation aside, a world where price adjustment was quick would look much like a world where prices were much stickier. The ‘short run’ would have the same length, irrespective of how quickly prices adjusted.

All this is about how Keynesian economics is taught, rather than about how it is done. Yet how it is taught can also influence how it is eventually understood. One of the problems some people have with understanding that we are still in a situation of deficient demand is that it is five years after the recession ‘and surely prices should have adjusted by now’. There is also a rather more profound point. Many anti-Keynesians use this misunderstanding about price adjustment to dismiss Keynesian economics. When they say ‘I ignore Keynesian economics, because I think prices adjust rapidly’ they are really saying ‘I ignore Keynesian economics because I think monetary policy is very successful’. And in the real world, monetary policy can only be very successful by understanding Keynesian economics! 


  1. If prices are sticky wouldn't prices not move at all in the short term? I mean wouldn't prices inflate at about 0% instead of 1 or 2?

  2. If ALL prices are perfectly flexible -- wages, too -- then there is no Keynesian short run, shocks to nominal demand cannot cause recessions (through Keynesian mechanisms), etc.

    Is that not true?

    For me, understanding things that way was quite important in sorting out how to think of the several models studied in core classes. Walrasian General Equilibrium predicts quantities assuming prices adjust instantaneously. IS-LM and friends are built on the opposite assumption -- quantities adjust faster than prices. So the first whole-economy models understandable with rigor are polar cases in this particular dimension, with the real world (and more advanced models) expected to be in some sense in between, varying over nations and time in a way that has to do with the duration of contracts and whatever else determines price flexibility.

    I found that valuable through much later study of business cycle theory and history -- unless I was wrong!

    I do see why the language you cite can be misleading, but the objective in your first sentence seems an overreaction. Keynesian as the macroeconomics of sticky prices is a deep statement about the kind of economy to which the models apply, and the kind where monetary policy has real effects. It seems to me we should emphasize that point of interpretation and eschew statements that appear to be about the whole of the "real world", as the Mankiw quote and your preferred alternative both do.

    After all, the real world is not just nations with competent and credible inflation targeting central banks. It has Spain, stuck with (lopsided) targeting of Eurozone inflation; nations after currency collapse with money supplies that consist of paper dollars and euros. And Bitcoin.

    I am about to teach intro macro for the first time post-crisis -- so please let me know if I am wrong!

    1. If you think about an economy where prices are completely flexible as a kind of barter economy where Says Law holds then fine. But if you think about a flexible price economy as one where prices are very flexible then the point I make still applies. You say 'Keynesian as the macroeconomics of sticky prices is a deep statement about the kind of economy to which the models apply', which implies that there could be a real world economy which was not Keynesian. I'd like to know where they are.

      My post was about closed economy analysis, but it also applies to open economy analysis. In this case a fixed exchange rate/currency union is a nominal anchor, so here statements about speed of price adjustment are less misleading (as with money targets for closed economies).

      You just have to think about the zero lower bound to see how framing everything in terms of price stickiness is so misleading.

    2. I would prefer to think of the zero lower bound as another price getting sticky -- one which, in some models, can be the last hope for full-employment equilibrium.

    3. OK, as long as your students understand that your definition of prices includes the interest rate, and that one of the price setters includes the central bank.

    4. "If ALL prices are perfectly flexible -- wages, too -- then there is no Keynesian short run, shocks to nominal demand cannot cause recessions (through Keynesian mechanisms), etc."

      You need to include debt principle balances in your list of flexible "prices" so if I buy a house in 2006 for $1,000,000 in debt, 3% down, but real estate crashes and you lose your job and your income drops to 35% of what it was selling cash out mortgage refis, then the mortgage balance (and the money market funds where you have your savings) need to be reduced to say $400,000.

      After all, if you had savings in cash, you were part of the crash because you should have spent it paying workers and dried up credit so he was not able to get high bonuses doing cash out refis cutting 5% mortgages to 4%.

      Back in the pre-Reaganomics era, even Milton Friedman knew principle balances must be changed to have wage and price flexibility. Or else labor costs must always go up no matter what. And monetary policy is never enough to keep forcing up labor costs to keep incomes above what's needed to service debt. Even Friedman agreed back circa 1970 - his only issue was the means.

  3. I just wonder whether all this fuss about inflation really came out of the seventies. For some reason they put it down to monetary factors - and its stabilisation to monetary policy.

    But surely this was driven by the OPEC Cartel? It was a monopolistic market. Moreover there had been an unrealistically low price for oil for decades due to the maintenance of a price kept since colonially linked companies ran the show. (On your other thread people are asking what do we really mean by capital, here we could start asking what do we mean by inflation - is a rapid adjustment in prices to a realistic price "inflation"?). It fell once prices exceed marginal costs and other technological based means of oil and energy production and utilisation became feasible.

    Anyway, now when China entered the world economy there was another resource boom. But when it put the breaks on its economy through its monetary policy (Ask a Sinologist how this works, not a mainstream economist) commodity prices dropped and worldwide inflation did not take off. And yet we have even Yellen the other day saying that it was because central banks had earned credibility in the eighties through tight monetary policy to break inflationary expectations.

    Really we can keep expectations out and talk about supply side factors and market characteristics (the oligopolistic oil dependent seventies energy markets are not like the one today).

    This is a possible example I think of the influence of intellectual hegemonies and groupthink.

    1. An oil price spike shifts the price level (if not offset by contractionary monetary policy) but not the rate of inflation. Cost-push models also don't do a good job of explaining different inflation rates e.g. why some oil-rich states had worse inflationary spells in the 1970s than countries like Germany and Japan, or why cost-push solutions didn't work.

      Also, a technological explanation of the 1980s slowdown in inflation is implausible, because countries moved to a low inflation trend at different times (corresponding with monetary squeezes, not coincidentally) e.g. US annual inflation was never above 7% after 1981, whereas the UK and Australia both had >7% inflationary spells in the late 1980s.

      Finally, overall RGDP growth in the 1970s was only slightly different from earlier or subsequent post-war decades in most developed countries, so the actual shift in supply is insufficient to explain the magnitude of the Great Inflation.

      "This is a possible example I think of the influence of intellectual hegemonies and groupthink."

      It's rather because cost-push models sound plausible to laymen, but don't do well in sustained critical contexts.

    2. Thanks for your detailed answer.

      Nobody is suggesting that monetary contraction did not play a role in containing inflation in industrial countries, just that this might be getting more weight as an explanation than it possibly deserves.

      It is interesting how it was Germany and Japan whose macro-economic policy performed well during the 1970s. Would you put this mostly down to monetary contraction, or was it something in their labour market structures? The Japanese side had a very effective labour market system that worked through a collective arrangement among firms and firm, rather than industry, based unions?

      "Finally, overall RGDP growth in the 1970s was only slightly different from earlier or subsequent post-war decades in most developed countries, so the actual shift in supply is insufficient to explain the magnitude of the Great Inflation."

      Could you please explain that to a layman.

    3. "Finally, overall RGDP growth in the 1970s was only slightly different from earlier or subsequent post-war decades in most developed countries, so the actual shift in supply is insufficient to explain the magnitude of the Great Inflation."

      Interesting. I thought the 1950s and 1960s were the Golden Age and the 1970s was the start of the great slowdown.

    4. I set a bit of a trap there, to be honest, because I've heard the "Japanese labour market" argument before, and wanted a chance to refute it. In the FIRST half of the 1970s, Japan had a relatively rapid rate of inflation (climbing to over 23% in 1974, measured by the CPI index) and only became a relatively low-inflation economy in the late 1970s. There was no radical shift in the Japanese labour market in this period, and so there is no basis to attribute much importance to Japanese labour markets in explaining their late 1970s performance.

      Also, countries like the UK had considerable periods of success in suppressing real wages during the period using incomes policies, but the UK in particular had a dreadful performance in the 1970s in terms of inflation.

      On the 1970s RGDP vs. before or after, the magnitudes can be seen here-[]=1969&end[]=1979&begin[]=1952&end[]=1969&beginP[]=&endP[]=&US[]=REALGDP&US[]=GDPDEFLATION

      (The GDP deflator being the best way of measuring inflation in this context.)

      A 0.7% slowdown off the post-Korean War trend of RGDP growth is not enough to explain the rise in the rate of inflation in the 1970s.

    5. The increase in inflation rates in countries like Germany, the Netherlands and Belgium around the eind of the sixties *did* coincide with a decline in the growth rate of productivity (the end of post war catch up), a decline not visible in the US rates (which were lower in the fifties and sixties and about as high sbusequently). I've seen labor contracts negotiated in the sixties which promised three years of 10% nominal wage growth - which did not lead toe excessive inflation. There was a 'technology shock' in the sense that, after about 1968, productivity did not increase that fast anymore (and the investment rate went down some notches). Dating supposed 'cost push' inflation in the eighties is 15 years of the mark.

      Merijn Knibbe

  4. This excellent post is important but there is a minor irony. One of the main obsessions of those who contrast Keynesian economics and the economics of Keynes is well exactly the point you make in this post. New Keynesians (and not so new Keynesians the complaint was made in the 60s too) stress price stickiness. As you note here, the price level matters in Keynesian and New Keynesian models only through real balances.

    I think the point is that Keynes often considered an economy in the liquidity trap (I also think he wasn't clear on this point and I'm not sure it was clear in his mind). By 1960 or so, economists had decided that a liquidity trap was a remote possibility. By 1980 it was views as Giffen goods are, theoretically possible but negligible.

    I think you will notice (for example in this blog) attempts to define Keynesian economics not as economics in which employment may be below full employment because of low aggregate demand, but as macroeconomics with nominal rigidities. I think an accurate if clumsy definition would be macroeconomics with nominal rigidities or the possibility of a liquidity trap or both. Having typed that, I feel sure that the list of deviations of reality and therefore decent theory from the neoclassical model must number more than 2 (an Italian platitude is translated "there isn't twice without a third time").

    1. Oh I decided not to pollute the thread with my usual rant which is over at my blog.

    2. I was aware of the irony, but that is why I emphasised that this is about the interpretation of (New Keynesian) models, not the models themselves. Most of those who say this is not the economics of Keynes imply NK models are wrong. They may be for other reasons, but not because they model sticky prices.

      I don't like the definition in your third paragraph, because the liquidity trap is just one example of where monetary policy goes wrong. Why not just define Keynesian economics as the macroeconomics of the short run, where short run is defined as in my post?

  5. Hopefully will be a useful education tool for the masses

  6. Sticky prices imply that in response to some major shock, relative prices will be stuck away from their market clearing values. When this occurs output falls below market clearing: constrained by demand where price is too high and supply where too low. The short run extends until all relative prices adjust to market clearing. If the markets where price lies above market clearing are the slowest to adjust, then the demand constraints bind. In the interim demand management policies can work by raising demand and output in these demand constrained markets.

    1. So if everyone decides to save more money, so aggregate demand falls, which relative prices are wrong?

    2. The relative price of present consumption and future consumption, that is, the real interest rate. I thought that was the basic premise of New Keynesian models? I thought (demand driven) recession and booms were the result of the central bank failing to ensure that the real interest rate equals the real interest rate that would obtain in a RBC model, according to New Keynesian Models. I thought New Keynesian economics was all about the failure of a particular relative price to adjust, namely, the real interest rate. Of course, though, I think your point was that recessions and booms are not the result of incorrect relative prices between particular current goods?

  7. I generally agree with your post. However, I thought the reason that sticky prices matter is that monetary policy would be unable to affect the equilibrium nominal interest rate otherwise in models with demand for monetary base. If prices were perfectly flexible, changes in the monetary base would simply result in equiproportional increase in the price level, leaving real cash balances unaffected, and so, the central bank would not have leverage over the equilibrium nominal interest rate via money market equilibrium. Thus, it would be impossible for the central bank to follow a nominal interest rate rule that gave it leverage over real interest rates, allow monetary policy to have real effects.

    Is this point moot because the canonical New Keynesian Model is cashless and simply assumes that the central bank can directly influence the equilibrium nominal interest rate via the interest rate that it pays on deposits at the central bank? This seems like a more realistic since the advent of IOR, I suppose.

    1. If we really did live in a world where monetary policy involved fixing the money supply, then I probably would not have written the post. In a way the problem is that textbooks still pretend that we do. In that sense, they are internally consistent. The problem is that the emphasis on sticky prices alone makes much less sense when monetary policy involves changing interest rates.

    2. Yeah, I just meant that a prerequisite for thinking about monetary policy as a nominal interest rate response function is that monetary policy have direct leverage over nominal interest rates (liquidity effect). This, in turn, requires that prices be sticky. I think you are right that too much emphasis is put on sticky prices, which misleads students into believing that changes in the price level are the equilibrating force rather than the central bank's response to price level changes. Also, even under a fixed money supply policy, changes in prices act as an equilibrating force because such changes lead to passive changes in monetary policy.

  8. With this definition of "short run", which could last for centuries, you should retire the term "short run" and develop a better term of art. "Interest rate adjustment period"?

    There is no reason to believe that the central bank will always succeed at stabilizing inflation or even that there is a well-defined "natural rate" of output. What meaning "short run" then?

  9. What I find odd in this debate is that many articles (and blog entries) state that the way that New-Keynsian models moved beyond Real Business Cycle models was by adding sticky prices, whether by the Calvo or some other route. I'm sure that I recall Krugman making this point some time ago in one of his discussions of saltwater vs. freshwater economists. I'm pretty sure that Simon Wren-Lewis has also spoken about the importance of including price stickiness, even if not via a formal model such as Calvo (this is off -hand, since I haven't time to search all past blogs). Yet now both seem to be denying the importance of price-stickiness. I think that what they may be doing is to equate recessions with being at the zero interest rate lower bound, where price\wage flexibility per se solves nothing. Obviously this is relevant now. But for several decades Keynesians, new and old, did not limit the possibility of a lack of aggregate demand to cases where we are at the ZLB.

    1. Perhaps I can put it like this. NK models add sticky prices and monetary policy to RBC models. To understand how business cycles work in NK models, you need to understand how sticky prices and monetary policy interact. What I am arguing against is the idea that flexible prices gets you to the RBC model whatever monetary policy is doing. That is wrong, as the ZLB illustrates.

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