Nominal rigidity

• 1. Introduction

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  Nominal rigidity shows up most simply as a contract locking a good's price at $10 per unit for a year. That price will not budge no matter what happens to supply or demand in the meantime. Economists call this complete rigidity, since the number on the price tag simply does not move. There is also a softer version, called partial rigidity. In a regulated market, a price may be allowed to change, but only within legal limits set for that year. Why would a price freeze in place while everything around it keeps moving? How long do these freezes actually last, and can economists measure them? What do economists build into their models to capture this behavior? And why does any of this matter for the wider economy?

• 2. Clocking Price Spells

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  Gasoline and tomatoes change price often, generating many short spells in a row. A bottle of champagne or a restaurant meal can hold the same price for months, sometimes years. Economists call each such stretch, however long, a price spell. National statistics agencies gather tens of thousands of price quotes every month to build the Consumer Price Index. In the early 2000s, researchers mined that CPI microdata to measure rigidity across the US and Europe. Those researchers pulled price data from the UK between 1996 and 2007, and from Germany between 1998 and 2004. Similar records covered Switzerland as recently as 2008 to 2020, plus the US, the Eurozone, Italy and France.

  In France and the UK, 19 percent of prices change in a typical month, leaving 81 percent unchanged. That pace implies an average price spell of about 5.3 months in those two countries. Across all price changes, including temporary sales, the raw average spell lasts only 3.7 months. Sales distort that number, since discounted prices soon snap back to their usual reference price. Once researchers strip out sales and temporary discounts, the average spell length more than doubles, to 11 months in the US. The underlying reference price itself stays unchanged for an average of 14.5 months in the US data. Taken together, these studies suggest fully sticky prices typically hold for around 12 months.

  Tomatoes and canned tomatoes make a subtler distortion visible. Together the two goods produce 13 price spells in a year, averaging out to roughly two months apiece when counted spell by spell. Yet averaged good by good rather than spell by spell, those same two prices last about 6.5 months on average. A 2012 study by Carlsson and Nordström Skans found that firms weigh both current and future expected costs when they do reset a price. That forward-looking habit is exactly what later economists tried to build directly into formal models of price setting.

• 3. Two Ways To Model A Frozen Price

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  John B. Taylor and Guillermo Calvo each built a model in which firms change prices simply because time has passed. Economists sort such models into two families. Time-dependent models have firms reset prices on a schedule; state-dependent models have firms reset only when conditions push them to. In a time-dependent model, a firm decides to change its price first and checks the market second; a state-dependent firm does the reverse.

  In Taylor's 1980 model, firms are split into cohorts, and each period the same fraction of firms resets its price. With two-period price spells, for instance, half the firms reset their price in any given period. If a price spell instead lasts n periods, one nth of firms reset each period. The typical spell's age then averages out to n plus 1, divided by 2.

  Guillermo Calvo's 1983 model instead gives every firm a constant probability, h, of being allowed to reset its price in any period. A firm with h set at 0.25, for example, has a one in four chance of repricing each period. That gives an expected spell length of four periods. Unlike Taylor's model, a firm under Calvo's rule never knows in advance how long its price will hold.

  State-dependent models tie the decision to menu costs, the expense of actually changing a listed price. A firm only changes its price once the benefit outweighs that cost. That threshold is why changes under this approach can bunch together rather than arrive on a steady schedule. Golosov and Lucas, along with Dotsey, King and Wolman, each built state-dependent models along these lines. Prices adjust faster, and monetary shocks fade quicker, under a state-dependent model than under a time-dependent one.

• 4. A Little Stickiness Spreads

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  Huw Dixon and Claus Hansen showed that even a small pocket of sticky prices can change how the rest of the economy behaves. In their finding, one sticky sector can "spill over" and make prices elsewhere less responsive to shifts in demand. Picture an economy split into two groups: a share, call it a, with fully flexible prices, and the rest fixed by menu costs. So long as that flexible share is less than the whole economy, its prices get pegged to the fixed ones anyway. This holds no matter how small the sticky sector is. That result holds because the two sectors share a common aggregate price index, built as if consumers split spending between them under Cobb-Douglas preferences. Once real marginal cost is allowed to vary with aggregate output instead of staying constant, the pegging effect softens. Even then, the fixed-price sector still drags on how far the flexible prices can move. That same forward-looking logic pushed later economists to ask whether it is prices that are slow to change, or the information behind them.

• 5. Old Information, New Wages

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  Stanley Fischer proposed a different explanation in a 1977 article: a price might look sticky because the information behind it is old. In his staggered contract model, two unions take turns setting wages, and each locks in pay for the next two periods. The union renewing its contract today uses the latest available information. The other union is still working off the plan it made one period earlier, based on older news. A sudden shift in monetary policy still has real effects, because the union stuck on old information cannot yet react to it.

  N. Gregory Mankiw and Ricardo Reis later extended Fischer's idea by giving every firm or union a fixed chance to replan its prices each period. Working with quarterly data, they set that chance at 25 percent. Each quarter, one in four firms updates its plan using current information, while the rest stick with an older forecast. Mankiw and Reis found this sticky-information framework explained the persistence of inflation particularly well. Solving that puzzle neatly, though, raised a new question about whether the framework matched what researchers actually saw in real prices.

• 6. The Limits Of Sticky Information

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  Sticky-information models, strictly speaking, contain no nominal rigidity at all. A firm or union remains free to set a different price every single period once its turn to replan arrives. It is the information that lags, not the price itself. That clashes with what studies in the US, the Eurozone, the UK and other countries actually find. Those studies consistently show some sectors repricing often while others hold a fixed price for a long stretch, a pattern sticky-information models alone cannot produce. That mismatch pushed some economists toward a "dual stickiness" model, blending sticky information with sticky prices in one framework. Long before any of these models existed, John Maynard Keynes had already pointed to a real-world case where wages simply refused to fall.

• 7. Why Prices Refuse To Clear

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  In The General Theory of Employment, Interest and Money, John Maynard Keynes argued that nominal wages resist falling. He said workers are reluctant to accept a pay cut. He thought that reluctance produced involuntary unemployment, since wages take time to fall to a market-clearing level. He tied that pattern directly to the Great Depression.

  If wages and prices were perfectly flexible, a monetary shock would simply shift the price level. Output and jobs would stay untouched, an idea known as monetary neutrality. Some degree of nominal rigidity is exactly what breaks that neutrality, letting changes in the money supply ripple into real output and employment. Monetarists, Keynesians and new Keynesians all accept that markets fail to clear because prices do not fall far enough when demand drops.

  Neoclassical models, more common in microeconomics, predict involuntary unemployment should not persist, since employers facing willing workers would simply cut wages until jobs opened up. Because wages cannot be cut instantly in practice, they sometimes sit too high for the market to clear, leaving willing workers without jobs. Facing that constraint, price-setters and wage-setters become forward looking, weighing what conditions will be later rather than only what they are today. That forward-looking habit also sits at the center of one more assumption economists lean on to explain why inflation itself can get stuck.

• 8. Sticky Inflation And Stagflation

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  The sticky inflation assumption holds that when firms set prices, the rate of inflation adjusts only gradually to a change in monetary policy. Economists trace that gradual adjustment to several sources. These include expected inflation, such as home prices running up before a recession; wage-push inflation from a negotiated raise; and temporary inflation caused by taxes. Sticky inflation turns into a serious problem once economic output falls while inflation keeps rising, a combination known as stagflation. As output drops and unemployment climbs, a falling standard of living compounds faster whenever sticky inflation is in play. In that setting, neither a monetary expansion nor a contraction guarantees relief. Sticky inflation lets policy moves in either direction drag the standard of living down.