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88

In addition, tlie model implies that departures of output from the flexible-price level are not at all persistent, depends only on m - Elm]. And by defmition, m - E[m] cannot have any predictable component. Thus the model implies that is white noise-that is, that it displays no pattern of either positive or negative correlation over time. This does not appear to be a good description of actual economies. A monetary contraction-such as the Federal Reserves decision in 1979 to disinflate-leads to abnormally low output over an extended time, not to a single period of low output followed by an immediate return to normal.

This difficulty can be addressed by introducing some reason that the economys initial response to an unobserved monetary shock triggers dynamics lliat cause output to remain away for normal even after the shock has become known. Examples of such mechanisms include inventory dynamics (BUnder and Fischer, 1981), capital accumulation (Lucas, 1975), and one-time costs of recruiting and training new workers. Thus the prediction of white-noise output movements is an artifact of the simple form of the model we have been considering, and not a robust implication.

Difficulties

If, as suggested above, announced shifts toward disinflationary pohcies are on average followed by below-normal output growth, then the Lucas model does not provide a complete account of the effects of aggregate demand shifts. The more important question, however, is whether the Lucas model accounts for an important element of the effects of aggregate demand. Two major objections have been raised in this regard.

The first difficulty is that the employment fluctuations in the Lucas model, like those in real-business-cycle models, arise from changes in labor supply in response to changes in the perceived benefits of working. Thus to generate substantial employment fluctuations, the model requires a significant short-run elasticity of labor supply. But, as described in Section 4.10, there is no strong evidence of such a high elasticity.

The second difficulty concerns the assumption of imperfect information. In modern economies, high-quality information about changes in prices is released with only brief lags. Thus, other than in times of hyperinflation, individuals can estimate aggregate price movements with considerable accuracy at little cost. In light of this, it is difficult to see how they can be significantly confused between relative and aggregate price level movements.

These difficulties suggest that the specific mechanisms emphasized in the model may be relatively unimportant to fluctuations, at least in most settings. But we will see in Section 6.12 that there are reasons other than intertemporal substitution that small changes in real wages or relative prices may be associated with large changes in employment and output, and that there are reasons individuals may choose not to take advantage of low-cost opportunities to acquire information relevant to their pricing decisions. Thus, as we will discuss there, it may be possible to resuscitate Lucass central idea that unexpected monetary shocks may create confusion between relative and aggregate price changes, and thereby have important effects on aggregate output.



An important earlier paper is Akerlof (1969). See also Ptielps (1978) and Blanchard (1983).

Part Staggered Price Adjustment 6.5 Introduction

The next source of nominal imperfections we consider is staggered adjustment of wages or prices. In one important respect, models of staggered adjustment are a reversion to traditional Keynesian models: sluggish nominal adjustment is assumed rather than derived. But the models are nonetheless important to the microeconomic foundations of nominal price and wage rigidity. There are three reasons.

First (and least important for our purposes), the Lucas model was initially perceived as showing that rational expectations alone are enough to undo many of the central results of tradilional Keynesian theory, most notably the stabiUzing powers of aggregate demand policy. If this were right, defending the traditional Keynesian position would require demonstrating that expectations are systematically irrational. Models of staggered adjustment show that this is unnecessary: if not all prices or wages are free to change every period, aggregate demand policy can be stabilizing even under rational expectations.

Second, the models make assimiptions about imperfect adjustment at the level of individual price- or wage-setters and then aggregate individual behavior to find the implications for the macroeconomy. In that regard, the models lay the groimdwork for the models of the next section, where nominal rigidity is derived from optimizing behavior at the microeconomic level.

Finally, the models show that interactions among price-setters can either magnify or dampen the effects of barriers to price adjustment. A consistent theme of the results in this section is that macroeconomic nominal rigidity is not related in any simple way to microeconomic price rigidity. We will see cases where a small amount of microeconomic rigidity leads to a large amount of rigidity in the aggregate, and others where a large amount of microeconomic rigidity yields little or no rigidity in the aggregate.

We consider three models of staggered price adjustment: the Fischer, or Fischer-Phelps-Taylor, model (Fischer, 1977a; Phelps and Taylor, 1977); the Taylor model (Taylor, 1979, 1980); and the Caplin-Sprdber model (Caplin and Spulber, 1987). The first two, the Fischer and Taylor models, posit that wages or prices are set by multiperiod contracts or commitments. In each period, the contracts governing some fraction of wages or prices expire and must be renewed. The central result of the models is that multiperiod contracts lead to gradual adjustment of the price level to nominal distur-



All three models take the staggering of price changes as given. But at least for the Fischer and Taylor models, if the timing of price changes is made endogenous, the result is synchronized rather than staggered adjustment (see Problem 6.8). Staggering can arise en-dogenously from firms desire to acquire information by observing other firms prices before setting their own (Ball and Cecchetti, 1988), from firm-specific shocks (Ball and D. Romer, 1989; Caballero and Engel, 1991), and from strategic interactions among firms (Maskin and Tirole, 1988).

bances. As a result, aggregate demand disturbances have real effects, and policy rules can be stabilizing even under rational expectations.

The Fischer and Taylor models differ in one important respect. The Fischer model assumes that prices (or wages) are predetermined but not fixed. That is, when a multiperiod contract sets prices for several periods, it can specify a different price for each period. In the Taylor model, in contrast, prices are fixed: a contract must specify the same price each period it is in effect. This distinction proves to be important.

In both the Fischer and Taylor models, the length of time that a price is in effect is determined when the price is set. Thus price adjustment is time-dependent. The Caplin-Spulber model provides a simple example of a model of state-dependent pricing. Under state-dependent pricing, price changes are triggered not by the passage of time, but by developments within the economy. As a result, the fraction of prices that change in a given time interval is endogenous. Once again, this seemingly modest change in assumptions has important consequences.

6.6 A Model of Imperfect Competition and Price-Setting

Before turning to staggered adjustment, we first investigate a model of an economy of imperfectly competitive price-setters with complete price flexibility. There are two reasons for analyzing this model. First, as we will see, imperfect competition alone has interesting macroeconomic consequences. Second, the models in the rest of the chapter are concerned with the causes and effects of barriers to price adjustment. To address these issues, we will need a model of the determination of prices in the absence of barriers to adjustment, and of the effects of departures from those prices.

Assumptions

The model is a variant on the model described in Part A of this chapter. The economy consists of a large number of individuals. Each one sets the price of some good and is the goods sole producer. As in Part A, labor is



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