The New Keynesian economists rely both on nominal and real rigidities to arrive at their conclusion that nominal changes in money supply have real, and not merely nominal, effects on the economy. As we indicated in Section 15.4, an increase in money supply can lead to a rise in the aggregate output and not in the price level. The flip side of this is, of course, that a fall in the money supply can lead to a fall in output and an increase in unemployment.
There is, however, a view that introducing price-setting in imperfectly competitive markets and menu costs into an economy is however not enough to generate substantial nominal rigidity at the micro level. Further, as per this view, menu costs can have important macroeconomic effects only in the presence of real instead of nominal, rigidities. This is so because it can be shown that for realistic values of elasticity of labour supply and elasticity of output demand, price-setting finns have strong incentives to change price when aggregate demand changes even by incurring menu costs required for changing nominal prices. Thus if the elasticity of demand for a firm's output is high, say 5, and the elasticity of labour supply is low, say 0.1, then Romer (2001) shows that, for a 3 per cent fall in output, the increase in profits by changing the price is about one-fourth of the revenue. This clearly suggests that firms will be ready to bear even up to one-fourth of the revenue as menu costs needed for changing the prices, if the elasticity of output demand is high and the elasticity of labour supply is low. If these elasticity values are realistic, then the existence of menu costs for changing prices cannot be used as a rationale for nominal price rigidity tind consequent unemployment. Some other factors have to be invoked to explain the constancy of nominal prices, in the face of, e.g., changes in money supply.
The other factors that have been invoked have to do with the characteristics of the goods, labour and credit markets. These markets differ in important ways from the competitjve model. In particular, the goods and labour markets appear to be such that shifts in demand translate into a smaller variation in prices and a larger variation in quantities than would be predicted in a competitive set-up. In the goods market, for example, shifts in demand for goods, in an imperfectly competitive set-up, are not accompanied by changes in mark-ups but by changes in output. Again, in the labour market, shifts in the demand for labour lead to large changes in employment and small changes in real wages. Here we are referring the rigidity in real prices in relation to quantities. Such rigidities occumng because of specific characteristics of the goods, labour and credit markets are referred to as real rigidities. The argument in Section 15.4 was based on nominal rigidities in the price level. In this section we look at real rigidities in the goods, credit and labour markets to examine how these can translate into less than full employment output. The characteristics of the labour market that produce unemployment are eltarnined in Mher details in Unit 18.