Sticky Prices

Definition

Sticky prices refer to the phenomenon where prices in an economy remain relatively fixed or slow to adjust, even in the face of changes in supply and demand. This concept is a key building block of Keynesian economic theory, as it helps explain why markets may not always clear and why there can be persistent disequilibrium in the economy.

5 Must Know Facts For Your Next Test

1. Sticky prices are a key assumption in Keynesian economic theory, as they help explain why aggregate demand can have a significant impact on output and employment in the short run.
2. Sticky prices can lead to market disequilibrium, where quantity supplied does not equal quantity demanded, resulting in surpluses or shortages.
3. Factors that contribute to sticky prices include long-term contracts, implicit or explicit price agreements, and the costs associated with changing prices (menu costs).
4. Sticky prices can amplify the effects of shocks to the economy, as firms are slow to adjust their prices in response to changes in demand or supply.
5. Sticky prices can also lead to inefficient resource allocation, as prices may not accurately reflect the true scarcity of goods and services.

Review Questions

• Explain how sticky prices relate to the concept of aggregate demand in Keynesian analysis.
  • In Keynesian analysis, sticky prices are a key assumption that helps explain why changes in aggregate demand can have a significant impact on output and employment in the short run. When prices are sticky, they do not adjust quickly to changes in supply and demand, leading to market disequilibrium. This means that firms may be unable to sell all the goods they produce (a surplus) or may be unable to meet the full demand for their products (a shortage). As a result, changes in aggregate demand can lead to changes in real output and employment, rather than just changes in the price level.
• Describe the role of sticky prices in the building blocks of Keynesian analysis.
  • Sticky prices are a crucial building block of Keynesian analysis, as they help explain why markets may not always clear and why there can be persistent disequilibrium in the economy. Keynesian economists argue that sticky prices and wages, along with other market imperfections, can lead to situations where the economy does not automatically return to full employment equilibrium. This, in turn, provides a justification for government intervention and active fiscal and monetary policies to stabilize the economy and promote full employment.
• Evaluate the implications of sticky prices for the effectiveness of monetary and fiscal policies in stabilizing the economy.
  • The presence of sticky prices has important implications for the effectiveness of monetary and fiscal policies in stabilizing the economy. If prices are sticky, changes in monetary policy (such as adjustments to interest rates) may have a greater impact on real output and employment, as firms are slow to adjust their prices in response to these changes. Similarly, fiscal policies (such as changes in government spending or taxes) may be more effective in influencing aggregate demand and output when prices are sticky. However, the degree of price stickiness can vary across different markets and sectors, which can affect the overall effectiveness of these policies. Policymakers must carefully consider the extent of price stickiness in the economy when designing and implementing stabilization policies.

Related terms

Nominal Rigidity: The inability or unwillingness of prices and wages to adjust quickly to changes in economic conditions, leading to sticky prices and wages.

Downward Wage Rigidity: The tendency for wages to be slow to decrease, even in the face of high unemployment or falling demand, contributing to sticky prices.

Menu Costs: The costs associated with changing prices, such as the physical costs of printing new menus or catalogs, which can lead firms to keep prices sticky.