Sticky Prices

Definition

Sticky prices refer to the tendency of prices to remain stable and not adjust immediately to changes in supply and demand. This phenomenon can lead to delays in how markets respond to economic shifts, impacting monetary policy effectiveness and the overall economy's adjustment to shocks.

5 Must Know Facts For Your Next Test

1. Sticky prices often result from costs associated with changing prices, such as reprinting menus or adjusting labels, which can deter firms from making frequent adjustments.
2. In the context of monetary policy, sticky prices can lead to slower transmission of policy changes, making it challenging for central banks to manage inflation and output effectively.
3. When demand increases, firms may not immediately raise prices due to sticky prices, leading to short-term increases in output until they adjust.
4. Sticky prices can exacerbate economic downturns because if firms are unwilling or unable to lower prices, it can prolong periods of high unemployment and low output.
5. The existence of sticky prices supports the idea of non-neutrality of money, meaning that changes in the money supply can have real effects on the economy in the short run.

Review Questions

• How do sticky prices affect the response of firms to changes in demand within an economy?
  • Sticky prices can prevent firms from quickly adjusting their pricing strategies in response to changes in demand. When demand increases, firms may hesitate to raise prices immediately due to the costs associated with changing prices. As a result, they may increase output temporarily until price adjustments occur, leading to a mismatch between supply and demand that can create inefficiencies in the market.
• Discuss how sticky prices influence the effectiveness of monetary policy during economic fluctuations.
  • Sticky prices significantly affect monetary policy's effectiveness by causing delays in how quickly markets adjust to policy changes. For instance, when a central bank lowers interest rates to stimulate the economy, firms with sticky prices may not reduce their prices promptly. This inertia can slow down consumer spending and investment, making it more difficult for monetary policy to achieve its intended outcomes like boosting economic growth or controlling inflation.
• Evaluate the implications of sticky prices on the theory of economic equilibrium and market efficiency.
  • Sticky prices challenge traditional theories of economic equilibrium that assume instant price adjustments lead markets toward balance. In reality, sticky prices can result in prolonged periods of disequilibrium, characterized by excess supply or demand. This discrepancy highlights market inefficiencies and suggests that economies may not self-correct as quickly as classical theories propose, impacting overall resource allocation and potentially leading to sustained unemployment or inflation.

Related terms

Price Rigidity: Price rigidity is the inability of prices to change rapidly in response to changes in the market, often due to long-term contracts or menu costs.

Inflation:

Inflation is the rate at which the general level of prices for goods and services rises, eroding purchasing power, which can interact with sticky prices in determining real output.

Nominal Rigidities: Nominal rigidities are situations where nominal prices and wages do not adjust immediately to changes in economic conditions, contributing to the persistence of economic fluctuations.