key term - Sticky Prices

Definition

Sticky prices refer to the phenomenon where prices in an economy are slow to adjust to changes in supply and demand, remaining relatively fixed or 'sticky' even when market conditions would suggest they should change. This concept is central to Keynesian economic theory and its analysis of aggregate demand.

5 Must Know Facts For Your Next Test

1. Sticky prices are a key assumption in Keynesian economic theory, as they help explain why aggregate demand can have a significant impact on output and employment in the short run.
2. Firms may be reluctant to change prices frequently due to the costs involved (menu costs) or a desire to maintain stable, long-term relationships with customers (implicit contracts).
3. Sticky prices can lead to a situation where the price level does not adjust quickly to clear the market, resulting in the possibility of persistent unemployment or inflation.
4. Keynesian economists argue that sticky prices and wages are a source of market imperfections that can justify government intervention, such as fiscal and monetary policies, to stabilize the economy.
5. The degree of price stickiness can vary across different industries and markets, with some prices being more flexible than others.

Review Questions

• Explain how the concept of sticky prices relates to Keynesian analysis of aggregate demand.
  • In Keynesian analysis, sticky prices are a crucial assumption that helps explain how changes in aggregate demand can have a significant impact on output and employment in the short run. If prices are slow to adjust to changes in supply and demand, then fluctuations in aggregate demand can lead to changes in real output, rather than just changes in the price level. This is because firms may be reluctant to change their prices due to factors like menu costs or implicit contracts with customers, leading to a situation where the price level does not quickly clear the market.
• Describe the role of menu costs and implicit contracts in contributing to the phenomenon of sticky prices.
  • Menu costs, which are the costs associated with changing prices, such as printing new menus or price tags, can discourage firms from frequently adjusting their prices. Additionally, implicit contracts between firms and customers, where there is an unwritten agreement that prices will remain stable, even in the face of changing market conditions, can also contribute to sticky prices. Firms may be reluctant to change prices in order to maintain goodwill and customer loyalty, even if market conditions would suggest they should adjust their prices. These factors help explain why prices in the economy may be slow to adjust to changes in supply and demand.
• Evaluate the implications of sticky prices for government intervention and economic stabilization policies, as discussed in Keynesian economic theory.
  • Keynesian economists argue that the existence of sticky prices and wages, which lead to market imperfections, can justify government intervention and the use of stabilization policies. If prices and wages are slow to adjust, then changes in aggregate demand can have a significant impact on output and employment in the short run. This provides a rationale for fiscal and monetary policies, such as government spending and interest rate adjustments, to help stabilize the economy and mitigate the negative effects of fluctuations in aggregate demand. Keynesian theory suggests that active government intervention can help smooth out economic cycles and promote full employment, in contrast with the classical view that markets will automatically adjust to clear themselves.

Related terms

Nominal Rigidity: The inability or unwillingness of prices and wages to adjust quickly to changes in economic conditions, leading to sticky prices and wages.

Menu Costs:

The costs associated with changing prices, such as printing new menus or price tags, which can discourage firms from frequently adjusting their prices.

Implicit Contracts:

Unwritten agreements between firms and customers that prices will remain stable, even in the face of changing market conditions, in order to maintain goodwill and customer loyalty.