Prof. Bryan Caplan

Econ 311

Fall, 1999

Week 9: Nominal Rigidities and Short-run Aggregate Supply

  1. Involuntary Unemployment Without Regulation?
    1. If the price level and the real wage are flexible, goods markets and labor markets clear. The economy is always on the production possibilities frontier, and remaining unemployment is voluntary.
    2. Price controls, minimum wages, labor market regulations, and unions have all been mentioned as factors that impede market-clearing.
    3. But: Isn't it possible that an unregulated market will fail to clear, especially over a short time horizon? There are two simple "nominal rigidity" mechanisms that have been suggested.
    4. Mechanism #1: "Menu costs." Suppose it is costly to change prices; e.g., you have to print up a new menu, retag items on your shelves, etc. In this case, if demand increases a little, you may not raise you price, and if demand decreases a little, you may not decrease your price.
      1. Evidence: Most prices change infrequently, a median of once/year.
    5. Mechanism #2: "Money illusion." Is everyone actually rational enough to constantly adjust for changes in the purchasing power of money? In particular, are workers indifferent between a 5% pay cut with 0% inflation and a 5% raise with 10% inflation?
      1. Evidence: Numerous psychological studies indicate that most people have money illusion to some degree. Even when you make the point explicit, respondents evaluate employers' "fairness" partly in nominal terms.
      2. In one study, people were asked to evaluate two firms' behavior when both are making "small" profits.
      3. Firms


        Inf=0, Raise=-7%


        Inf=12%, Raise=+5%


      4. Who cares about fairness? There is also evidence that disgruntled workers' performance worsens. "Wage cuts hurt morale." Effort is partly about incentives and partly about trust.
      5. Ask employers: How do workers respond to wage cuts versus layoffs?
      6. The UC Berkeley pay cut.
    6. Implication: If either menu costs or money illusion matter, nominal changes can have real effects. In particular, if the equilibrium real wage falls, adjustment will be more painful if nominal wages fall and less painful if the price level rises.
    7. How important and long-lasting are these mechanisms?
      1. Menu costs probably pretty minor. You could always have a "sale." Prices do decline in many cases.
      2. Money illusion, in contrast, seems to be a major force. Nominal wages hardly ever decline.
      3. People eventually catch on about inflation, but it often takes a while. (Then it takes time to make them realize that inflation has stopped!)
  2. Keynesian AS
    1. Both menu costs and money illusion change the shape of the AS curve in the short-run. Instead of vertical, it becomes upward-sloping.
    2. Why? With menu costs, this means that if demand increases, some firms will increase output, while others increase prices in spite of menu costs. When AD increases, then, both output and the price level rise.
    3. With money illusion, if the price level rises, reaching the equilibrium wage is less likely to require nominal wage cuts. In other words, fewer employers will face the tough choice between cutting nominal wages, and laying off workers to avoid hurting morale. Thus, when AD increases, both output and the price level rise.
    4. Such an upward-sloping AS curve is called a "Keynesian" AS curve, in contrast to the vertical "Classical" AS curve. If the AS curve is Keynesian, AD shifts have real effects.
    5. Keynesian AS and the PPC: If the AS is Keynesian, you may not be on the frontier, and increases in AD can move you towards the frontier.
  3. Keynesian AS as Classical AS + Price Controls in the Labor Market
    1. Begin with the Classical view of the labor market.
    2. Add a nominal minimum wage.
    3. Notice: the effect of the minimum wage depends on the price level! The higher the price level, the less damage (in terms of involuntary unemployment) the minimum wage does.
    4. Government often prevents the labor market from working, then tries to undo the damage by e.g. increasing the money supply, raising the price level, and thereby weakening the employment impact of their labor market regulations.
    5. Example: What is the real minimum wage?
    6. Now moving over to an AD-AS diagram, it can been seen that adding a nominal minimum wage to a Classical model gives the AS curve a positive slope.
    7. Here is a case where one government policy might undo the damage created by another policy. But why not take the more certain route of just getting rid of the bad policies directly?
    8. Application: Do you have money illusion?
  4. Keynesian Short-Run versus Classical Long-Run
    1. How does AS actually look? In the long-run, it's Classical. In the short run, it's Keynesian.
    2. How can the Keynesian AS be right in the short-run, but the Classical AS be right in the long-run? Draw both on an AD-AS diagram.
    3. When you are off the long-run AS diagram, the short-run curve gradually shifts back to the intersection of the long-run AS and the AD curve. Why? Eventually, all menus get changed, and money illusion fades.
      1. Note: AD never shifts back unless the money supply is reduced to its earlier level.
    4. The tough question is: How long is the long-run? Best guess: About 2-3 years.
    5. Note: Just because you might be able to increase output by increasing AD just not mean you can in any particular instance, or that you will succeed even if conditions are ripe. Policies motivated by Keynesian views of the economy often produce the results predicted by the Classical perspective.
    6. Keynesian views always appeal more to journalists and politicians because of their short-run emphasis. It is important to be able to acknowledge the role of short-run fluctuations, but remember that these are a minor problem compared to the long-run growth that the Classical model emphasizes.