Price Stickiness

Price stickiness means that prices do not adjust immediately when demand, costs or other economic conditions change. In New Keynesian models, this nominal rigidity prevents the price level from instantly clearing markets, so changes in aggregate demand can temporarily alter real output and employment.

Why prices adjust slowly

New Keynesian models commonly assume monopolistic competition: firms sell differentiated products and have some discretion over their prices. A firm weighs the benefit of resetting its price against the costs and constraints involved.

• Menu costs include the resources required to review prices, update catalogues or computer systems, and communicate changes to customers.
• When the gain from resetting a price is smaller than the adjustment cost, keeping the existing price can be privately optimal.
• Small adjustment costs can have substantial aggregate effects because each firm does not fully account for how its pricing decision affects economy-wide demand.

Contracts, staggering and coordination

Firms do not all have the same opportunity or incentive to revise prices simultaneously, so the aggregate price level adjusts gradually.

• Nominal contracts can fix prices for an agreed period, preventing immediate adjustment after an unexpected shock.
• Staggered price setting means that different firms reset prices at different times, so some prices remain outdated.
• Strategic complementarities reinforce persistence because a firm may prefer to keep its price near competitors' prices rather than move first.
• Wage contracts can generate wage stickiness, delaying changes in labour costs, although wage rigidity and price rigidity are distinct mechanisms.

How stickiness creates output gaps

An output gap is the difference between actual output and the level consistent with flexible prices, often called natural or potential output. Because firms meet part of a demand change by altering production rather than immediately changing prices, nominal disturbances have short-run real effects.

• After a fall in aggregate demand, firms unable or unwilling to cut prices immediately face lower sales and reduce production and employment, creating a negative output gap.
• After an expansion in demand, production and employment can temporarily rise above their flexible-price levels, creating a positive output gap.
• Under fully flexible prices, price adjustment would absorb more of a nominal demand shock and return output more quickly towards its natural level.
• As firms successively reset prices, inflation and relative prices adjust; absent further shocks, the output gap tends to narrow.
• Expected future inflation affects current price-setting, linking present inflation to expectations and the degree of economic slack.

Implications for monetary policy

Price stickiness gives monetary policy short-run influence over real activity. By changing the nominal interest rate, the central bank can affect the real interest rate, aggregate demand and therefore the output gap while prices adjust slowly.

• Demand stabilisation can reduce fluctuations in output and employment, but policy operates with lags and imperfect information.
• Cost or supply shocks may create a trade-off because stabilising inflation and closing the output gap can require different policy responses.