Wage and Price Rigidity or Stickiness - Essay Example

It does not affect the real flow of output but rather, surprises and stabilizes the economy. It implies that in a place where the population has rational expectations, government policies which are made to influence the economy into a level of production will never be effective. Rational expectations first became a big factor in the policy activism debate in the early 1970s when Thomas Sargent and Neil Wallace wrote their famous policy ineffectiveness paper. They showed-using an elementary macroeconomic example based on Robert Lucas's then new model of the Phillips curve-that an active monetary policy could not be effective in stabilizing fluctuations in output and employment. (Taylor) Implicit wage contracts is when workers are risk averse and employers are not, an implicit contract may be made with an understanding over "compromise" basic pay and hours.

This may or may not generate nominal wage rigidity. Contracts like this may be non-implementable if there is asymmetric information. Nominal price rigidity () tests for downward nominal price rigidity. Intuition: deflationary shock, some prices not cut as there is a zero price floor; across sectors "we would expect to observe a negative correlation between mean inflation rates and the skewness of inflation". (2005) Once the place and manner of nominal wage rigidities in the economy have been specified, the model must explain why rational workers and firms enter into arrangements which may impose a macroeconomic externality and allow the economy to deviate from the natural level of output. (pg 7) Because it is advantageous for firms to enter into long-term agreements on the price of their purchased input factors, there is also price rigidity in the input factors markets.

Moreover, the commonly used procedure of firms to adjust their output price in constant proportion to changes in the price of input materials and labour costs - the notion of markup pricing - will result in rigid output prices as well. (pg 9)According to Piere Siklos, policy ineffectiveness proposition predicts the absence of an exploitable output-aggregate demand trade-off by policymakers. Therefore, when individuals are assumed to form expectations rationally (that is, they process all relevant information at their disposal), only unanticipated policies can influence output. (249)Dennis W.

Carlton and Jeffrey M. Perloff (2000) quoted Stigler (1947) that prices are relatively rigid in an industry in which there is a dominant firm that exercises price leadership. That is, there are relatively few changes in prices. In his classification, an industry has price leadership if there is a relatively large firm, "producing, say, 40 per cent of the output of the industry at a minimum, and more if the second largest firm is large ." (p. 228).Just before the new Keynesian model was formulated, it was believed that the formulation of government policies does not have any direct effect on wages and prices in the market unless a surprise monetary policy was released and discloses the economic status in a short wile.

It was also believed