Sticky Prices and Macroeconomics

Mike Smitka

We're now starting on AD/AS analysis in my intro macro class. It involves a lot of handwaving, given the simplifications imposed by using blackboard models – do we want our y-axis to be "the" price level or the rate of inflation π or (later in the term) the rate at which π is changing? At the same time the x-axis is a broad aggregate, (real) GDP, that we conceptualize as a physical aggregate. So why do they behave as supply and demand curves ought to, sloping up and down, respectively? One answer is that prices are sticky. If you want the argument, go to a textbook.

The more general issue is one that plagued the classical economists: if prices adjust freely, then why should there ever be unemployment, or other unsold goods? Why should productive capacity in an economy ever sit idle? Here the key is that prices are sticky. My wage, for example, is set but once a year, and that in accord with a salary pool based on expected tuition and other revenue sources, which likewise are updated only once a year. So if a shock hits the economy – prices rise unexpectedly (or inflation, the rate of price rises, rises unexpectedly) I will see my pay fall behind, and even if the university does set out to adjust things, it may take a couple years to get back in synch. Since labor accounts for a bit over half of all costs for producers of goods and services in the US, most attention focuses on that behavior.

Now I've never seen a breakdown of the frequency of wage changes across the economy, though I've never looked and I'm not a labor economist. But the Federal Reserve Bank of Atlanta Inflation Project does recompile the data that underly the Consumer Price Index into goods and services that are "sticky" and those that are "flexible". Over time they average out to be about the same, inflation truly is general, but in the time frame of a few years they can and often do move in opposite directions.

Their web site details which goods are sticky and which are flexible, with the weights each have in the CPI basket of goods and services. On the flexible end are things such as gasoline, electricity prices, food purchased in a supermarket, women's clothing and (yes!) new car prices – think of all those rebates and subvented [jargon for manufacturer-subidized] loans and leases that appear when sales are slow. On the sticky side are personal care services (how many years since my barber upped his price? – the sign's yellow!), fast food prices, school fees and beer prices.

For building a supply model we'd want to look at components of business costs besides labor, things like the billing rates for lawyers and accountants or xerox paper. No one to my knowledge has put together a comparable flexible/sticky producer price index. But for building theory, all we need to know is that in the real world prices are sticky.