Nominal rigidities

Definition

Nominal rigidities refer to the inflexibility of prices and wages to adjust in response to changes in economic conditions. This phenomenon often results from contracts, social norms, or institutional factors that prevent immediate price adjustments, impacting how economies respond to shocks. In the context of economic theory, nominal rigidities are central to understanding how fluctuations in aggregate demand can affect output and employment.

5 Must Know Facts For Your Next Test

1. Nominal rigidities play a key role in explaining why economies can experience prolonged periods of unemployment despite falling prices.
2. In the presence of nominal rigidities, a drop in aggregate demand can lead to reductions in output rather than immediate price decreases.
3. These rigidities are often modeled as part of New Keynesian economics, which integrates microeconomic foundations with macroeconomic implications.
4. Nominal rigidities can lead to inefficiencies in the labor market, where wages do not adjust downward easily, causing involuntary unemployment.
5. Central banks may consider nominal rigidities when formulating monetary policy, recognizing that interest rate adjustments may not immediately translate into changes in inflation or employment.

Review Questions

• How do nominal rigidities influence the relationship between aggregate demand and unemployment?
  • Nominal rigidities affect the economy by preventing wages and prices from adjusting quickly to changes in aggregate demand. When demand decreases, rather than prices falling immediately, businesses may choose to reduce output instead. This leads to higher unemployment because firms are unable to lower wages sufficiently or quickly enough to retain workers, illustrating how nominal rigidities can create a disconnect between demand fluctuations and labor market outcomes.
• Discuss the implications of nominal rigidities for monetary policy decisions made by central banks.
  • Central banks must consider nominal rigidities when conducting monetary policy because these inflexibilities can hinder the effectiveness of interest rate adjustments. If prices and wages are sticky, changes in interest rates may not result in immediate shifts in inflation or economic activity. This can make it challenging for central banks to stabilize the economy during periods of shock, as conventional tools may take longer to yield desired effects on output and employment due to these rigidities.
• Evaluate the role of nominal rigidities in distinguishing New Keynesian economics from New Classical economics.
  • Nominal rigidities are a defining feature that distinguishes New Keynesian economics from New Classical economics. While New Classical economists assert that markets clear quickly due to flexible prices and wages, leading to full employment equilibrium, New Keynesians emphasize the importance of nominal rigidities as reasons why prices and wages do not adjust instantly. This divergence allows New Keynesian models to explain phenomena such as involuntary unemployment and persistent output gaps during economic downturns, highlighting the critical role these rigidities play in macroeconomic theory.

Related terms

Sticky Prices: Sticky prices are prices that do not adjust immediately to changes in supply and demand, leading to temporary imbalances in the market.

Keynesian Economics: Keynesian economics is a school of thought that emphasizes the role of government intervention and aggregate demand in influencing economic output and employment.

Real Rigidities: Real rigidities refer to inflexible factors, such as technology or production methods, that prevent adjustments in real wages or output levels in response to economic changes.