This can lead to involuntary unemployment as it takes time for wages to adjust to equilibrium, a situation he thought applied to the Great Depression.
[citation needed] A price-spell is a duration during which the nominal price of a particular item remains unchanged.
One of the richest sources of information about this is the price-quote data used to construct the Consumer Price Index (CPI).
The statistical agencies in many countries collect tens of thousands of price-quotes for specific items each month in order to construct the CPI.
The following table gives nominal rigidity as reflected in the frequency of prices changing on average per month in several countries.
[9] Removing sales and temporary price cuts raises the average length of price-spells considerably: in the US it more than doubled the mean spell duration to 11 months.
The differences can be thought of as differences in a two-stage process: In time-dependent models, firms decide to change prices and then evaluate market conditions; In state-dependent models, firms evaluate market conditions and then decide how to respond.
Two commonly used time-dependent models are based on papers by John B. Taylor[13] and Guillermo Calvo.
In the Calvo staggered contracts model, there is a constant probability h that the firm can set a new price.
In the Calvo model, when a firm sets its price, it does not know how long the price-spell will last.
For example, if h = 0.25, then a quarter of firms will rest their price each period, and the expected duration for the price-spell is 4.
There is no upper limit to how long price-spells may last: although the probability becomes small over time, it is always strictly positive.
[1] Examples of state-dependent models include the one proposed by Golosov and Lucas[15] and one suggested by Dotsey, King and Wolman.
[16] In macroeconomics, nominal rigidity is necessary to explain how money (and hence monetary policy and inflation) can affect the real economy and why the classical dichotomy breaks down.
If nominal wages and prices were not sticky, or perfectly flexible, they would always adjust such that there would be equilibrium in the economy.
In a perfectly flexible economy, monetary shocks would lead to immediate changes in the level of nominal prices, leaving real quantities (e.g. output, employment) unaffected.
For money to have real effects, some degree of nominal rigidity is required so that prices and wages do not respond immediately.
Hence sticky prices play an important role in all mainstream macroeconomic theory: Monetarists, Keynesians and new Keynesians all agree that markets fail to clear because prices fail to drop to market clearing levels when there is a drop in demand.
[17] Thus price and wage stickiness in one sector can "spill over" and lead to the economy behaving in a more Keynesian way.
The key point is that at any time t, the union setting its new contract will be using the up-to-date latest information to choose its wages for the next two periods.
A sudden change in monetary policy can have real effects, because of the sector where wages have not had a chance to adjust to the new information.
[21] This added a new feature to Fischer's model: there is a fixed probability that one can replan one's wages or prices each period.
Mankiw and Reis found that the model of sticky information provided a good way of explaining inflation persistence.
Sticky information models do not have nominal rigidity: firms or unions are free to choose different prices or wages for each period.
"[25] Additionally, within the context of the short run model there is an implication that the classical dichotomy does not hold when sticky inflation is present.
As economic output decreases and unemployment rises the standard of living falls faster when sticky inflation is present.