Download Mankiw 5/e Chapter 5: The Open Economy

The sticky-wage model
W
Pe
ω
P
P
If it turns out that
P P
e
P Pe
P P
e
then
unemployment and output are
at their natural rates
Real wage is less than its target,
so firms hire more workers and
output rises above its natural rate
Real wage exceeds its target, so
firms hire fewer workers and
output falls below its natural rate
slide 0
The sticky-wage model
 Implies that the real wage should be countercyclical , it should move in the opposite
direction as output over the course of business
cycles:
– In booms, when P typically rises, the real
wage should fall.
– In recessions, when P typically falls, the real
wage should rise.
 This prediction does not come true in the real
world:
slide 1
The cyclical behavior of the real wage
Percentage
change in real4
wage
3
1972
1998
2
1960
1997
1999
1
1996
1970
0
2000
1984
1993
1992
1982
1991
-1
1965
1990
-2
1975
-3
1979
1974
-4
-5
1980
-3
-2
-1
0
1
2
3
4
5
6
7
8
Percentage change in real GDP
slide 2
Small menu costs and
aggregate-demand externalities
 There are externalities to price adjustment:
A price reduction by one firm causes the overall
price level to fall (albeit slightly).
This raises real money balances and increases
aggregate demand, which benefits other firms.
 Menu costs are the costs of changing prices
(e.g., costs of printing new menus or mailing new
catalogs)
 In the presence of menu costs, sticky prices may
be optimal for the firms setting them even though
they are undesirable for the economy as a whole.
slide 3
Recessions as coordination failure
 In recessions, output is low, workers are
unemployed, and factories sit idle.
 If all firms and workers would reduce their
prices, then economy would return to full
employment.
 But, no individual firm or worker would be
willing to cut his price without knowing that
others will cut their prices. Hence, prices
remain high and the recession continues.
slide 4
Recessions as coordination failure
Firm 2
Cut price
Keep high price
Cut price
Firm 1 makes $30
Firm 2 makes $30
Firm 1 makes $5
Firm 2 makes $15
Keep high
price
Firm 1 makes $15
Firm 2 makes $5
Firm 1 makes $15
Firm 2 makes $15
Firm 1
slide 5
The staggering of wages and prices
 All wages and prices do not adjust at the
same time.
 This staggering of wage & price adjustment
causes the overall price level to move slowly
in response to demand changes.
 Each firm and worker knows that when it
reduces its nominal price, its relative price
will be low for a time. This makes them
reluctant to reduce their price.
slide 6
The staggering of wages and prices
1) Synchronized Price Setting
 Every firm adjusts its price on the first day
of every month
May 10
May 1
June 1
“boom”
AD
slide 7
The staggering of wages and prices
2) Staggered Price Setting
 Half the firms set prices on the first day of each
month and half on the fifteenth
May 10
May 15
May 1
June 1
AD
Half the firms raise their prices
(But probably raise prices not very much)
The other firms will make little adjustment when their turn
comes
slide 8
The staggering of wages and prices
2) Staggered Price Setting
 Price level rises slowly as the result of small
price increases on the first and the fifteenth
of each month (because no firm wishes to
be the first to post a substantial price
increase)
slide 9