Believe those who are seeking the truth. Doubt those who find it. Andre Gide

Saturday, July 3, 2010

The Sticky Price Hypothesis: A Critique

In my younger days I worked as a drywall finisher (we called ourselves "tapers"). I worked on commercial sites and residential sites, union and non-union jobs, by wage rate and by piece rate. Yep, I did it all (and no, I am not available to do your basement).

When the recession hit the Vancouver construction sector in 1981, I could no longer find work and, after a brief spell of unemployment, I went back to school. Well, looking back now, I'd say that there was plenty of work available, but none that would have compensated me enough to forego my next best opportunity. And looking back, I am struck at how I never believed, even as a kid, that my transition from employment to unemployment to out of the labor force had anything to do with a sticky nominal wage.

And I believe that Keynes would have agreed with my assessment. That is, a careful reading of the General Theory reveals that Keynes never assumed sticky prices, except briefly, as an expositional device, and in the form of a fixed nominal wage. Indeed, later on in the GT, he explains why the economy might function much better if wages were in fact sticky. Evidently, the mechanism he had in mind has little, if anything, to do with the one emphasized in a standard New Keynesian (NK) model.

A defining characteristic of the NK paradigm is the existence of price-setting agents who find it too costly to adjust (product or labor) prices at high-frequency, and who are somehow behaviorally committed to deliver goods (products or labor) in a market at historically outdated terms of trade. What is it that motivates this modeling device?

Well, the evidence, for one thing. Clearly, at least some and perhaps most nominal prices/wages are "sticky" in the sense that they appear insensitive to high-frequency changes in macroeconomic conditions. Beginning with the pioneering work of Mark Bils and Peter Klenow, we now know a lot more about the nature of this stickiness at the microeconomic level. In their 2002 study, for example, Bils and Klenow find that the median consumer item changes price every 4.3 months. Service prices exhibit more stickiness than goods prices; the former change every 7.8 months, while the latter change every 3.2 months. Another important distinction appears to be with respect to raw versus processed goods. The former change price every 1.6 months, while the latter change price every 5.7 months. (See here for a summary of their results.)

Alright then, the data show sticky prices and the NK model has sticky prices. So what is there to argue? In fact, something very important: Do not confuse measurement with theory. The sticky price hypothesis is a theory; i.e., a proposed mechanism designed to interpret the data. And while the theory arguably has some empirical support, it is not as strong as one is generally led to believe. Sticky price models calibrated to match the observed average duration of price changes (just over one quarter) imply relatively benign consequences. Things get uglier when trying to match model predictions to microdata; see Klenow 2003. These considerations have led some economist to explore other avenues of "stickiness;" e.g., the "sticky information" models posited by Mankiw and Reis (QJE 2002).

There may be more than one way to interpret the available evidence. Figuring out which interpretation is best (most accurate) is important because different mechanisms frequently lead to very different policy conclusions. I have my own favored hypothesis that I'll share with you shortly. But before I do so, I want to describe the way I think many people organize their thoughts on this matter.

I imagine that many begin by conjuring up, in their mind's eye, a pair of Marshallian scissors (supply and demand). If markets work well, then prices should be determined by a market clearing condition (scissor intersection). Because the economy is constantly changing (subject to shocks), one would expect nominal prices to change at high frequency too. But they do not. Ergo, it must be the case that (at least some) markets do not clear. Because the market mechanism is now revealed to generate mismatches in supply and demand, there is a clear role for government intervention.

This latter conclusion is taken to be obvious vis-a-vis the market for labor, where the very existence of unemployed workers is taken as prima facie evidence that markets do not clear. The economy, evidently, has a "potential" or "natural" level of GDP or employment, and deviations away from this "long-run" level (output "gaps") are the product of "shocks" together with the inability of the markets to clear in the short-run. Please enter, the stabilizers (monetary and fiscal policy).

Well, that's one way to think about it. Certainly, some variant of this line of reasoning is taught to most econ undergrads. The educated layperson is regularly exposed to this view in blog posts of pop economists. Many, if not most, Fed economists (not here in St. Louis) take this view too. A majority opinion, however, does not make it correct or, more precisely, the best interpretation possible. Let me explain.

Walras' auction and Marshall's scissors have justifiably had a large influence in the way generations of economists have organized their thinking about price-quantity determination. I am not sure, however, that the underlying assumptions are always well understood. A defining characteristic of these theoretical market mechanisms is the assumption of anonymous participants in centralized exchange settings. In a competitive setting, trades are intermediated by a fictitious auctioneer (a metaphor for unmodeled "market forces" that equate supplies and demands). In monopolistically competitive settings, agents set prices (assumed to be linear, and so, inefficient).

I want you dwell on this for a moment: anonymous people trading in centralized exchanges. It is an abstraction adopted in neoclassical and NK theory. The abstraction may be innocuous in some applications, but not for others. What does the abstraction rule out and why might this be important for interpreting price data?

To begin, anonymity rules out the existence of personal trading relationships. Every morning, you wake up and dispose of your goods or labor in some central location to some anonymous group of purchasers (wham bam - thank you ma'am, so to speak). Because trading relationships are absent, the terms of trade are "static" in the sense of being determined on the spot among transients. And because this is so, the spot price has--by assumption--an enormous role to play in determining how resources are allocated in spot exchanges. In particular, if the spot price is for some reason sticky, spot allocations will generally be inefficient (spot markets will not clear).

The theoretical construct of an anonymous spot market is probably not a bad approximation for how some goods are transacted in reality. The market for commodities like wheat and oil come immediately to mind. Goods more so than services, and raw goods more so than processed goods. (Precisely the set of goods that appear to have the most flexible prices in the Bils and Klenow data set.)

It strikes me as self-evident that most labor, as well as many goods and securities, are not transacted in the manner of (say) wheat or equity shares in General Motors. Many markets more closely resemble the marriage market, where durable (or semi-durable) relationships are formed (and terminated) in decentralized exchanges. In bilateral (or multilateral) relationships, your identity and history matter--you are not anonymous. The same is true of many goods and securities markets. Retail and wholesale outlets expend great effort to cultivate relationships with their customers. The same is true in over-the-counter securities markets. Understanding this fact turns out to have, I think, a profound implication for the way in which one interprets price data. Why is this? Let me explain.

When a pair of traders meet bilaterally, there may be gains to trade (a surplus) by forming a relationship and trading over time (until match separation). The gains to trade refer to the capitalized value of the surplus; that is, the present value of a sequence of "spot" surpluses (let me call this the match surplus). In such a relationship, there is no sense in which a Walrasian or Marshallian market "clears" in every spot exchange that occurs throughout the relationship at every point in time. Instead, the match surplus is divided by way of a bargaining process that prescribes (either implicitly or explicitly) an entire sequence of prices (or wages) over the life of the relationship.

Now here's the rub. It is not immediately clear whether anything uniquely pins down a negotiated wage/price path over the life of a relationship. In fact, in many theoretical bargaining games, the "equilibrium" price path is largely indeterminate. Evidently, there are many different ways to slice a pie (match surplus). You can pay me a lot today, and a little tomorrow--or the other way around. In many cases, it really doesn't matter. Either way, both parties presumably allocate their combined resources in a manner to maximize match surplus, independently of the time path of the terms of trade.

Now, if nominal price changes are even a tiny bit costly, one such time path may entail a nominal price that adjusts infrequently over the course of the relationship. Such apparent "stickiness" has, however, little if any allocative consequences over the life of the match (as far as I can tell, this point was originally made by Robert Barro, although I am presently unable to locate the source). [Here it is: Barro 1977 ...thanks to Nick Rowe]

In decentralized relationship markets, the notion of "market clearing" needs to be modified. The simple fact that nominal prices are sticky does not constitute evidence that the relevant market is not clearing in an appropriate sense. Note that this does not imply that there is no role for government intervention. In particular, it is possible that while resources within a match are allocated efficiently, resources economy-wide are not (this may happen, for example, if there are externalities in the search market).

According to this interpretation, unemployment (workers without a job, but who are looking for jobs) is entirely unrelated to the phenomenon of observed nominal wage stickiness. Unemployment is instead an equilibrium phenomenon--the byproduct of search and matching frictions and shocks that alter the value of match formation and job retention. No amount of price flexibility, whether real or nominal, will ever eliminate unemployment in a growing and dynamic economy. (It is possible, of course, for unemployment to be too high or too low, or to vary too much, or not enough).

What accounts for the enduring popularity of sticky price models? I'm not sure, but here are some possibilities. First, they do the least violence to the comfort of Walras and Marshall. Second, they imply that money is non-neutral; something that central bankers are particularly fond of believing in. And third, they appear to rationalize (legitimize) interest rate policies like the Taylor rule.

I'm not sure that these are particularly compelling reasons (although, there may be others -- feel free to share). First, perhaps we should do violence to Walras and Marshall (search and bargaining theory is one way to go). Second, it is easy to generate money non-neutrality in models with full price flexibility (and heterogeneous consumers). Third, modeling financial (instead of price-setting) frictions would turn attention away from simple Taylor rules, diverting it to other (arguably more important) aspects of central banking (payments system, lender-of-last-resort, etc.).

In conclusion, I have a hard time taking the sticky price hypothesis seriously. The theory literally implies that if prices were fully flexible, many of the worst properties of recessions would be avoided. There would be no liquidity traps, no financial crises, and no lost decades. Conversely, if prices are sticky (in the theoretical sense), simple government policies, like raising the long-run inflation rate or expanding government spending, can evidently restore something close to economic nirvana when the economy is in a liquidity trap. More than one prominent econblogger appears wedded to this view. I remain skeptical of such easy fixes.

Update: December 27, 2012
From Arthur Robson, a restaurant in Vancouver, B.C.


  1. Wow, that's a big 'un.

    Specific to the labor market, there was an NBER paper recently (end of last year, maybe?) showing geography as the main force separating people from work. What was especially interesting was why people don't follow the work when the work leaves: family ties. I don't have the paper on hand, but I'm sure I can find it if you are interested but haven't read it.

  2. Nicely worded for a lay audience, but what about Hall and Shimer having documented the failure of MP and similar models to account for the stylized facts of the labor market?

  3. The Barro source? I'm pretty sure this is it:

  4. And yes, as far as I know too, Barro was the first person to make that point, in 1977. My guess is that this paper marks the watershed between Barro the disequilibrium Keynesian and Barro as we know him today. Glad to see you too think this is a very important paper.

    This is a very good post. It's stuff that needed explaining to people. This is what the blogosphere is supposed to be doing. I will be back soon to try to tear it apart!

  5. "Second, it is easy to generate money non-neutrality in models with full price flexibility (and heterogeneous consumers)."

    Care to expand, on which particular sort of theory you had in mind here?

    And, on second thoughts, I'm going to have to do a post on this, if I'm going to try to say why I disagree. It's going to be far too long for a comment. Plus, this stuff matters.

  6. Agentcontinuum: My post was long enough, don't you think, without me having mentioned Hall and Shimer! I am a step behind that literature, but last I heard, the search models did reasonably well assuming sufficient *real* wage rigidity (a possible equilibrium bargaining outcome).

    Nick: Thanks for the Barro reference; I can't believe that I forgot it! A lump-sum injection of cash to all agents in a simple OLG model delivers money non-neutrality, for example. I look forward to your post trashing mine!

  7. maybe i am missing something, but does not your explanation suffer from the same pitfall that you use to critique the nk hypothesis of sticky prices? you argue that the nk models cannot calibrate to the known micro evidence concerning sticky prices -- but yet i see no evidence presented for your hypothesis of match/search frictions, much less any mention of how such frictions -- as actually observed and measured at the micro level -- might feed a macro model which fits and forecasts better. once again, i am sure if you had more time you would have made a more detailed case, but from the looks of it, you seem to attack the nk model from an empirical, evidence-based stance, but at the same time you simply assert your alternative hypothesis.

  8. ds:

    I should clarify something. I did not mean to argue that NK cannot match micro data; I meant to say that current formulations do not appear to do so.

    The main point of my post was to alert the reader that there are other ways of interpreting sticky prices and that, therefore, one should remain circumspect in making strong policy conclusions based solely on a sticky price model (I think you know who I am speaking to here).

    But you are right to question the empirical support for search theoretic models. There is still a lot of work to be done and I am not wedded to any given hypothesis.

  9. David: "A lump-sum injection of cash to all agents in a simple OLG model delivers money non-neutrality, for example."

    Yep. Money is only neutral if a monetary injection doubles *each individual's* cash, not just aggregate cash, otherwise we get distribution effects. Archibald/Lipsey, and Patinkin, went through that in the 1960's, and we rejected it as too quantitatively insignificant to matter. Much bigger changes in the distribution of wealth are happening all the time.

    I would love to come fishing with you in those freshwater lakes, but you have to show me a bigger fish than that!

  10. Nick,

    A minor quibble: it is not necessary to change *each individual's* cash. It is sufficient to change only for a subset (the young, in the OLG model -- a transfer to the old is neutral).

    The quantitative significance of changes in the wealth distribution from cash injections (or withdrawals) is questionable. I wouldn't rule it out entirely though. The wealth distribution is highly skewed, and many people have close to zero financial wealth (and high propensity to consume). A lump-sum cash transfer to the "poor" might have a measurable macro effect.

    Ah, freshwater. So refreshing. When you get thirsty enough (and tired of fishing) which well are you going to drink from? :)

  11. David: well, I finally got my post up:

    I didn't "trash" you post, as I said I would. Sorry! It's too good, plus I agree with too much of it.

    See what you think.

  12. What about wage stickiness related to a worker's idea that he may actually make less in aggregate by taking a career detour in what he views is hopefully a business cycle effect that will eventually reverse?

    Additionally, there is just his marginal cost to work: driving to work, incidental expenses that come up related to working (increased stress requires increased expense). Another barrier - the market rate of labor is below his opportunity cost of leisure.

    Back to the original point: If I'm unemployed, I have all the incentive in the world to hold out if taking an irrelevant job will 'de-train' me, making me a less attractive hire in the long run. It may be a gamble worth taking that the NPV of taking a temporary poor job + hopefully getting back on track with a better job/wage in the long run is smaller than enjoying leisure and unemployment checks now and taking the next possible opportunity as the economy recovers, avoiding a 'job reputation/career path' damage.

    So perhaps, the worker is guessing the net present value of taking a career detour is actually below that of just waiting and enjoying his time. Who knows, the worker is just hoping that this is a cyclical recession and not a structural change in the economy. Often, that's a good bet to take.

    Additionally, if a firm's production function is at a point where adding an additional employee won't necessarily add enough marginal revenue to make it a marginally profitable decision, (especially as demand is uncertain or nonexistent) the firm (buyer of labor) then will have a willingness to pay of zero or even negative (as even an unpaid intern may be dead weight with substantial training and babysitting costs).

    So we are left with a firm with a labor demand curve hitting 0 and below, while a worker's supply point is at positive.

    So both sides benefit from holding their ground.

    What about a market of a nonstorable commodity in surplus as an analog. Lets the say I am a strawberry producer, and the fridge has not been invented yet. There is a surplus crop this year. I sell as much as I can to clear my inventory, but the grocers are telling me they have no room to take the surplus. In fact, lets say my strawberries aren't universally popular(a disliked variety?). The grocer only wants a certain amount, no matter how low the price. He is telling me he only wants 1/2 of my crop. (since the demand curve for strawberries only means he'll sell 1/2 of my crop even if they were set to the most desireable price) Since it costs him to take the other half (he'll have pay employees to put it on display, then dispose of it as it spoils), he refuses at any price. In fact, he says he'll only buy the surplus if I pay him (his disposal costs).

    Then for me to sell it, I have to hire pickers, truck it. My marginal cost (and supply curve) is above 0, and the buyer's demand curve is below 0.

    Best let the strawberries rot and trade zero quantity. Just the same, best to wait for a cyclical recovery.

  13. Also more food for thought, while aggregate factors (population) affect individual labor markets, it is worth remembering that each job (not just locality) has its own labor market. Depending on the position and composition of the labor pool, the markets range from perfect competition to many forms of imperfect.

    Perhaps it is a good idea to attach the empirical stickiness 'rating' to different types of labor markets. Nonspecialized work-by-the-hour trades, with job markets that are more perfectly competitive, with low barriers to entry (ditch digging amongst a large blue collar population) have much less stickiness (discounting the impact of price floors like minimum wage) than economists at the Fed or engineers who lead their field.

    An engineer who leads his field (assuming it is a field in-demand), even in the worst of economies, often has a bit of pricing power. And in fact, his wage is likely to be stickier on the way down, and probably exhibits less day to day (or month to month) volatility.

    Then there's the issue of the cost of indexing wages to more volatile external variables. In the long run, assuming price levels in an economy are generally stable and labor market trends are slow to change and reverse, creating discontent by changing a wage (especially in a cyclical downturn) to a volatile market hourly rate may injure morale and productivity. Additionally, the firm may have to pay a lot more for employee labor in upturns than otherwise. While we most notice wages tend to be sticky downward, they absolutely are sticky upward.

  14. "see Klenow 2003"

    Can ya give us the full ref for this or a working link?


  15. Well, it can either be (my best bet) or the less referenced

  16. Excellent post and very clear. However, if you have time, could you elaborate on this:

    In particular, it is possible that while resources within a match are allocated efficiently, resources economy-wide are not (this may happen, for example, if there are externalities in the search market).

    What kinds of externalities are you referring to?

  17. Pani Pani,

    I was referring to what search theorists call "thin market" or "congestion" externalities.

    So, for example, when I choose to enter a night club, I do not take into account the fact that it lowers the probability of all other males from making contact with the fairer sex. This is why there are too many men at nightclubs. ;)

  18. Bild and Klenow is not the end of that story.

    "The goal of this paper is to show empirically that once we distinguish between macroeconomic
    and sector-specific fluctuations, the fact that prices change frequently at the disaggregate level does not imply that prices are flexible in the face of macroeconomic shocks. In fact, we argue that the flexibility of disaggregated prices is perfectly compatible with stickiness of aggregate
    price indices."


  19. Pontus: Thanks for the link...the paper looks interesting.

  20. I was always a big fan of Dennis Carlton's 1986 paper "The Rigidity of Prices". He looked mainly at manufacturing data, so I don't know how well it generalizes to services. But he pointed out that the facts about price rigidities weren't well explained by any simple models and that they changed with markets and with relationships. In many markets, he argued, lots of other margins (time to delivery, warranties, etc) were used to balance demand and supply long before prices changed. But he also showed that the link between price rigidity and relationships was pretty complicated. For example, he argued that long-term relationships were less likely in markets where prices changed frequently. On the other hand, where a relationship did exist between buyer and seller, there was a tendency for prices to change more frequently (but for smaller amounts) when the parties had been in a longer relationship.

  21. Thanks for providing examples of the search externalities. This is all beginning to make sense.

    And already you've posted two more articles with excellent comments... hmmm....

  22. Everytime i go to whole foods which is the natural foods grocery store, their prices seem to go up and up. So they don't have price stickiness i guess.

  23. Hey, your site is great. I need your expertise..what is the best filler for a hole in my drywall. You are the expert. I went to home depot and they gave me this really bad pink stuff. It didn't my wife wanted to kick my butt after she found the hole i tried to cover up in the wall. Now i have to fix it.

  24. I'm really worried about the Fed's money printing and the extension of Operation Twist. This is really going to have an effect on prices. If they keep printing money they will really create inflation. The price stickiness should start becoming un-sticky. As i see a rise in prices in a more rapid fashion then in the past due to the problem with the dollar devaluation.