costs of price adjustment, called "menu costs,"

Solution Preview

See the attached file.

PRICES THAT CLEAR MARKETS
One reason that prices do not adjust immediately to clear markets is that adjusting prices is costly. To change its prices, a firm may need to send out a new catalog to customers, distribute new price lists to its sales staff, or in the case of a restaurant, print new menus. These costs of price adjustment, called "menu costs," cause firms to adjust prices intermittently rather than continuously.
Economists disagree about whether menu costs can help explain short-run economic fluctuations. Skeptics point out that menu costs usually are very small. They argue that these small costs are unlikely to help explain recessions, which are very costly for society. Proponents reply that small does not mean inconsequential. Even though menu costs are small for the individual firm, they could have large effects on the economy as a whole.
Proponents of the menu-cost hypothesis describe the situation as follows. To understand why prices adjust slowly, one must acknowledge that changes in prices have externalities-that is, effects that go beyond the firm and its customers. For instance, a price reduction by one firm benefits other firms in the economy. When a firm lowers the price it charges, it lowers the average price level slightly and thereby raises real income. (Nominal income is determined by the money supply.) The stimulus from higher income, in turn, raises the demand for the products of all firms. This macroeconomic impact of one firm's price adjustment on the demand for all other firms' products is called an "aggregate-demand externality."
In the presence of this aggregate-demand externality, small menu costs can make prices sticky, and this stickiness can have a large cost to society. Suppose that General Motors announces its prices and then, after a fall in the money supply, must decide whether to cut prices. If it did so, car buyers would have a higher real income and would, therefore, buy more products from other companies as well. But the benefits to other companies are not what General Motors cares about. Therefore, General Motors would sometimes fail to pay the menu cost and cut its price, even though the price cut is socially desirable. This is an example in which sticky prices are undesirable for the economy as a whole, even though they may be optimal for those setting prices.
The Staggering of Prices
New Keynesian explanations of sticky prices often emphasize that not everyone in the economy sets prices at the same time. Instead, the adjustment of prices throughout the economy is staggered. Staggering complicates the setting of prices because firms care about their prices relative to those charged by other firms. Staggering can make the overall level of prices adjust slowly, even when individual prices change frequently.
Consider the following example. Suppose, first, that price setting is synchronized: every firm adjusts its price on the first of every month. If the money supply and aggregate demand rise on May 10, output will be higher from May 10 to June 1 because prices are fixed during this interval. But on June 1 all firms will raise their prices in response to the higher demand, ending the three-week boom.
Now suppose that price setting is staggered: Half the firms set prices on the first of each month and half on the fifteenth. If the money supply rises on May 10, then half the firms can raise their prices on May 15. Yet because half of the firms will not be changing their prices on the fifteenth, a price increase by any firm will raise that firm's relative price, which will cause it to lose customers. Therefore, these firms will probably not raise their prices very much. (In contrast, if all firms are synchronized, all firms can raise prices together, leaving relative prices unaffected.) If the May 15 price setters make little adjustment in their prices, then the other firms will make little adjustment when their turn comes on June 1, because they also want to avoid relative price changes. And so on. The price level rises slowly as the result of small price increases on the first and the fifteenth of each month. Hence, staggering makes the price level sluggish, because no firm wishes to be the first to post a substantial price increase.
Coordination Failure
Some new Keynesian economists suggest that recessions result from a failure of coordination. Coordination problems can arise in the setting of wages and prices because those who set them must anticipate the actions of other wage and price setters. Union leaders negotiating wages are concerned about the concessions other unions will win. Firms setting prices are mindful of the prices other firms will charge.
To see how a recession could arise as a failure of coordination, consider the following parable. The economy is made up of two firms. After a fall in the money supply, each firm must decide whether to cut its price. Each firm wants to maximize its profit, but its profit depends not only on its pricing decision but also on the decision made by the other firm.
If neither firm cuts its price, the amount of real money (the amount of money divided by the price level) is low, a recession ensues, and each firm makes a profit of only fifteen dollars.
If both firms cut their price, real money balances are high, a recession is avoided, and each firm makes a profit of thirty dollars. Although both firms prefer to avoid a recession, neither can do so by its own actions. If one firm cuts its price while the other does not, a recession follows. The firm making the price cut makes only five dollars, while the other firm makes fifteen dollars.
The essence of this parable is that each firm's decision influences the set of outcomes available to the other firm. When one firm cuts its price, it improves the opportunities available to the other firm, because the other firm can then avoid the recession by cutting its price. This positive impact of one firm's price cut on the other firm's profit opportunities might arise because of an aggregate-demand externality.
What outcome should one expect in this economy? On the one hand, if each firm expects the other to cut its price, both will cut prices, resulting in the preferred outcome in which each makes thirty dollars. On the other hand, if each firm expects the other to maintain its price, both will maintain their prices, resulting in the inferior solution, in which each makes fifteen dollars. Hence, either of these outcomes is possible: there are multiple equilibria.
The inferior outcome, in which each firm makes fifteen dollars, is an example of a coordination failure. If the two firms could coordinate, they would both cut their price and reach the preferred outcome. In the real world, unlike in this parable, coordination is often difficult because the number of firms setting prices is large. The moral of the story is that even though sticky prices are in no one's interest, prices can be sticky simply because people expect them to be.

SOLOW MODEL AND TECHNOLOGICAL ADVANCE
In order to discuss whether or not should policy makers pay more attention to the fluctuations in output or rather to the determinants of the rate of technological advance, looking back to Solow model of growth and to its main pillars seems a like a good start.
The Solow model of growth shows that, in the long run, an economy's rate of savings determines the size of its capital stock. It rules that an increase in the rate of saving will cause a period of rapid growth but that, eventually, growth will slow as the new steady state will be reached. Therefore, although a high saving rate yields a high steady state level of output, ...