Economics 314 Coursebook, 2008 Jeffrey Parker 11 IMPERFECT COMPETITION AND REAL AND NOMINAL PRICE RIGIDITY Chapter 11 Contents A. Topics and Tools .................................................................................1 B. What’s “New” and What’s “Keynesian” about “New Keynesian” Economics .................................................................................................3 Institutions of price setting.................................................................................5 Market structure and price adjustment ..............................................................7 C. Understanding Romer’s Chapter 6, Part B .........................................8 Equilibrium with imperfect competition.............................................................8 Nominal rigidities ..........................................................................................12 Mankiw’s menu-cost model .............................................................................13 Nominal and real rigidities .............................................................................14 Coordination failures ......................................................................................15 D. Works Cited in Text..........................................................................17 A. Topics and Tools The second and third sections of Romer’s Chapter 6 examine the “new Keynesian” response to the Lucas model. The microeconomic basis of Lucas’s model was reasonable and quite appealing, but Keynesians found the conclusions unreasonable. Thus macroeconomists who maintained Keynesian beliefs had strong incentives to develop a macroeconomic model that preserved desirable features of Lucas’s model but led to opposite conclusions about macroeconomic policy. The first models to be labeled as new Keynesian began from the assumption that (for whatever reason) firms and workers set labor contracts that specify the11 — 2 nominal wage in advance for more than one period. Stanley Fischer (1977) and John Taylor (1979) were able to show that one could derive a Keynesian policy result (i.e., that countercyclical monetary policy can improve welfare) while maintaining fairly solid microeconomic foundations and the assumption of ra-tional expectations. The key assumption for Lucas’s policy-ineffectiveness result, it turned out, was the assumption of continuous market clearing via perfectly flexible wages and prices. The first wave of new Keynesian analysis was devoted to examining the im-plications of different assumptions about how wages and prices are set. Since everyone agrees that wages and prices are unlikely to be perfectly flexible (for ex-ample, no one denies the existence of labor contracts in the union sector), these models were quite popular as alternatives to the Lucas imperfect-information framework. However, as Romer noted in Chapter 5 (pages 242 and 243), these wage-contract models predict a strongly counter-cyclical real wage, which is not consistent with actual observations. Part B of Chapter 6 lays out the basic microfoundations of the new Keynes-ian approach; Part C then applies these models in a macroeconomic context un-der several different assumptions about the frequency and nature of price changes. We focus in this coursebook chapter on Part B, which is one of the most ex-citing in the course, but also one of the most challenging. On center stage are the concepts of nominal and real price rigidity. Both of these concepts have to do with resistance to price changes. As you might expect, nominal rigidity occurs when a firm exhibits reluctance to change its price in nominal (dollar) terms. Real rigidity is a situation when a firm does not want to change its price relative to some other prices, for example when a firm wants to keep its price in line with those of other firms in the market. We begin in Section 6.4 by introducing a model in which firms are imper-fectly competitive. Imperfect competition is necessary for models with price stickiness since perfectly competitive firms by assumption must always charge the market equilibrium price. Sections 6.5 and 6.6 explore the microeconomic implications of nominal and real rigidities. Romer demonstrates that nominal rigidities of sufficient magnitude to explain price stickiness in the real world are implausible. Real rigidities alone do not introduce non-neutral effects of monetary shocks, since everyone will adjust together to the new market-clearing equilibrium. Only by combining nominal and real rigidities so that the latter amplify the non-11 — 3 neutral effects of the former are new Keynesians able to achieve a realistic depic-tion of monetary effects. Section 6.7 discusses the possibility that real rigidities can lead to coordina-tion failures in the macroeconomy. This literature employs game theory to ex-amine interactions between firms. Under certain circumstances, rigidities can lead to multiple equilibria in the macroeconomy. If there are two or more points of equilibrium, it is often possible to demonstrate that one is Pareto-superior to the other(s). In such a situation, the economy can become trapped at an inferior equilibrium where a change in policy could potentially push the economy to the best equilibrium. B. What’s “New” and What’s “Keynesian” about “New Keynesian” Economics The label “new Keynesian economics” has been given to the broad class of models that we are studying in the last two sections of Romer’s Chapter 6. Two natural questions to ask before we study their details are “In what ways are these models Keynesian?” and “In what ways do these models differ from ‘old Keynes-ian’ models?” As noted in the overview above, the first new Keynesian models evolved as a reaction to the “neoclassical revolution” represented by Lucas (1972), Sargent and Wallace (1975), and Barro (1976). Whereas the earlier intellectual skir-mishes between the post-war Keynesian and monetarists had been fought on the turf of aggregate models such as IS/LM, Lucas et al. transformed the rules of play to require rigorous specification of the maximization decisions made by in-dividual agents. The natural extension of the basic microeconomic theories of utility and profit maximization in perfect competition leads to a model with a strongly clas-sical flavor, so this change of venue posed a particular challenge to Keynesians.