EXPLAINING THE NOMINAL RIGIDITIES OF MACROECONOMICS
FOR THE SHORT-RUN
We noted earlier that some form of nominal rigidity typically plays an important part in the
explanation of short-run business fluctuations. As we shall demonstrate in this section, the
phenomenon of real rigidity discussed in the previous section may help us understand how
short-run nominal rigidity may be compatible with rational economic behaviour. Specifically, we
will show that when target real wages are not very responsive to changes in the level of
economic activity, even very small costs of nominal wage or price adjustment may be sufficient
to induce rational agents to abstain from adjusting nominal wages or price adjustment may be
sufficient to induce response to fluctuations in economic activity.
It is not unreasonable to assume that there are some small costs of adjusting nominal
wage rates. For example, union leaders may have to spend some time sitting down at the
bargaining table with the employer to write a new wage contract. Moreover, when the demand
for labour changes, wage setters may have to spend some resources estimating the exact
magnitude of the change if they want to be sure that they set the optimal wage rate. Similarly,
firms may incur small costs in resetting their nominal prices. For instance, they may have to
print new catalogues or spend other resources communicating the new prices to the market.
The costs of adjusting nominal or wages are often referred to as ‘menu costs’, like the
costs to a restaurant of having to print a new menu card. In most cases such costs are likely to
be quite small, and hence they are usually neglected in economic models. But if we can show
that even very small menu costs may be sufficient to induce economic agents not to adjust
nominal wages or prices in response to even considerable shocks, we have a potential
explanation for the nominal rigidities which seem to exist in the real world.
We start by considering the circumstances in which nominal wage rigidity may be the
outcome of optimizing economic behaviour. Our strategy is to measure the loss incurred by
individual wage setters if they do not adjust their nominal wage rate in reaction to a change in
the unemployment rate of a realistic magnitude. If this loss is very small, then the privately
optimal behaviour may be to leave the wage rate unchanged to avoid the cost of wage
adjustment.
We base our analysis on the simple model of wage formation developed in the previous
section, adding to this a shock and small menu costs. For convenience, we now assume that
the system of unemployment insurance offers a fixed compensation relative to the average
wage level, b = cw, where the replacement rate c < 1 is a constant. Recalling w = W/P, the
outside option may then be written as a function of the unemployment rate:
V = v(u) = [1 – (1 – c)u] w
