Sticky prices and NKPC related essay plans (Macroeconomics FHS)
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Course
Macroeconomics
Institution
University Of Oxford
Structured essay plans of past exam sticky prices (BMR model) and NKPC-related essay questions. Prepared and used by a first class E&M student to revise for Section B of the Macroeconomics FHS paper.
[2022] Discuss whether small menu costs can account for sticky prices in good markets. Discuss the
possible impact of a greater degree of downward price rigidity on the volatility of output.
Refer to my collections outline and answer (question 4)
Intro: new classical with RE and new keynesian response
Negative demand shock without menu costs: no sticky prices and low output volatility
o [graph] Ball Mankiw Romer (1988) model graph
Negative demand shock with menu costs: sticky prices and output volatility.
o Discuss w.r.t. graph in previous para
Short para: will adjust, just takes longer
Factors affecting price stickiness
o Real rigidities, frequency of reviews or low λ in calvo pricing contracts, dynamic
adjustment
Menu costs may not be the best sticky price explanation
o Relatively inelastic labour supply (low real rigidities)
But counter: inelastic at individual level, elastic at aggregate level
o If menu costs is fixed, cannot explain sticky prices with large shocks
Downward price rigidity + general price rigidity increase output volatility
o Menu costs explain bidirectional price rigidity
o Extra reasons for downward price rigidity: spark price war, signal lower quality, erode
customer goodwill, nominal wage rigidity
o [example] Tesla infuriate old customers with price cut
o [graph] AS-AD negative demand shock- output volatility with price stickiness
Price rigidity may reduce output volatility near the ZLB: curse of flexibility
o See below.
o Own thoughts: convex PC from downward price rigidity
The second part of the question is intended as the discriminator.
If candidates stick closely to the context in which the BMR paper was presented in the lectures,
they might argue that in the aftermath of negative IS curve shocks a greater downward rigidity
in prices must mean that shocks are reflected in output losses so that output volatility is
increased relative to a situation of fully flexible prices (what I did)
One way to challenge this perspective might be to turn to some of the material presented in
later lectures. At the zero lower bound for nominal interest rates Krugman-style deflationary
spirals can occur in which output is stuck below equilibrium, prices fall and, due to nominal rates
at zero, declining inflation drives up real interest rates and further reduces output. In this
example there is a ‘curse of flexibility’ in that more rapidly adjusting prices and expectations will
speed up the adverse dynamics and lead to faster output collapses. Some downward rigidity of
prices avoids, or at least lessens, the curse so that output is less prone to collapse and output
volatility is reduced.
,
o Point A is unstable: at A, y < ye, ↓π (slower with sticky prices. Less with gentler PC of
sticky prices) ↓expected π ↑rmin (negative of expected inflation) ↓y
o In this deflationary spiral, the economy slides north-west along IS to ever lower levels of
output
[Tut] Menu costs are too small and contracts are too short, therefore models of sticky prices cannot
be the explanation for prolonged periods of recession. Discuss.
Intro: new classical with RE and new keynesian response
Negative demand shock without menu costs: no sticky prices and low output volatility (no
prolonged recession)
o [graph] Ball Mankiw Romer (1988) model graph
CAN CAUSE: Negative demand shock with menu costs: sticky prices and output volatility (long
recession periods) even with small menu costs due to coordination problem.
o Discuss w.r.t. graph in previous para
Short para: will adjust, just takes longer
CAN CAUSE: With short contracts, prices are less sticky but dynamic adjustment enable
stickiness despite short contracts.
o With short contract length, firms can change prices costlessly faster, reducing period of
sticky prices. Captured as high λ in calvo pricing contracts
o But: dynamic adjustment, so time taken for price adjustments is longer than the
calendar time where all firms can change price costlessly
MAY NOT CAUSE: Menu costs may not be the best sticky price explanation
o Size of private costs dependent on real rigidities . Relatively inelastic labour supply (low
real rigidities).
o Lowered menu costs with the internet...
o If menu costs is fixed, cannot explain sticky prices with large shocks, fixed with menu
costs as a percentage, not fixed
o Research still needed on micro foundations of menu costs
REBUT COUNTERS: but these issues are overcome if menu costs are flexible; if empirically
underestimate elasticity of labour (individual labour inelastic, but elastic on aggregate)
Assume sticky prices hold, explain why it can cause recession:
o [graph] AS-AD negative demand shock- output volatility with price stickiness
[2020] Discuss whether price stickiness is more likely after negative demand shocks than after positive
demand shocks.
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