Real Rigidities

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.