PRICE SETTING BEHAVIOUR
Although, the augmented Phillips curve is a widely used form of aggregate supply function, there are several other competing supply functions. These include inter-
cilia, the monetary misperception based model of Lucas(Jr.) (1972, 1973); the sticky-
wage theory based model of Fischer (1977); the relative price theory based models of Taylor (1979), Calvo (1983), Führer and Moore (1995); and the p-Bar model of McCallum (1994). These models are mostly directed to provide a micro foundation
to the Phillips type relationship and better understanding of the inflationary process. Some are briefly discussed below.
Lucas Flexible Price, Monetary Misperception Model
In the monetary misperception type of model, the Phillips-type correlation results from the ‘mistaken’ belief of individuals about the macroeconomic conditions due to incomplete information about the state of the economy. The individual sellers, who observe changes in the prices of their product, may not completely know whether this was due to economy wide change or to a change in the relative demand for their product. Therefore, undecided about the quantum of increasing output the individual sellers settle for an output corresponding to an intermediate price between the economy wide average expected price and the price of their product. The misperception arises because, not knowing the current economy wide price, the individual seller forms expectations based on past information. In a simplified aggregate model, this comes out to be similar to the augmented Phillips curve, which can be expressed as
p, = p,\,-,+ c W ,-Y ,P) (2.7)
Here Pt^_x is the forecast of the general price for the period t, made at the end of period t-1 and Pt is the average aggregate price level of all firms, Ytp is the aggregate potential output of all firms, and Yt is the actual aggregate output of all firms. Taking variable in log and after a little algebra the relationship can also be expressed as
=ap,|,-i+ c ()\ -
y
! ) (2-8)Output is high when actual inflation is greater than the expected value. This approach is different“6 because of the way the model is derived based on individual mistaken perceptions about the economy wide price. Therefore, the relevance of the theory is measured by the information gap. If timely data on monetary stock and prices of other goods is available, as is now the case in most economies, the relevance of the
26 The difference between the Friedman-Phelps augmented Phillips curve and the Lucas supply curves lies in the fact that the former stresses the time lag between the expectation formation and the inflation realization, while the latter stresses the discrepancy of each local and aggregate price.
theory would diminish. With no mistake in perception about the money stock and hence the shift in aggregate demand curve, the seller would set the corresponding price and the Lucas supply curve would be vertical and free of rigidity. One important implication of the Lucas supply curve is the policy ineffectiveness theorem under rational expectation shown in Sargent and Wallace (1975).
Nominal and Real Rigidities and Sticky Prices
There are several other models commonly known as ‘New Keynesian tradition’ which seek to exploit rigidities in labour and goods market to explain short run real effect of monetary policy and hence the Phillips curve phenomenon. The paradigm of the literature dealing with this tradition can be summarized in the following three groups. (1) Labour contracts (wage bargaining) are made in nominal money terms through wage setting institutions, where different firms set their wages at different points of time and renegotiate at different intervals (staggered contracts) leading to sticky nominal wages (nominal wage rigidity). Producers prefer long-term contracts because negotiating is costly. In this situation, real wage is not equal to the marginal product of labour all the time and, therefore, real wage is also considered sticky.
(2) Monopolistically competitive firms face small ‘menu costs’ when they change prices such as those required to prepare and post new price lists and costs of annoying customers (Akerlof and Yellen 1985, Mankiw 1985, Ball, et al. 1988, Blanchard 1986). Therefore, monopolistically competitive firms do not have incentive to cut their prices when demand for their goods declines, which leads to stickiness in prices (sticky prices). (3) Firms may want to pay employees wages above the market clearing wage, in order to attract and maintain a quality workforce and to ensure they work hard and remain loyal (efficiency wage) (Yellen 1984). This also means, even with persistent unemployment, firms do not reduce wages because doing so may reduce productivity resulting in stickiness in real wages and real price of firms’ output (real rigidity). This theory, though helping to explain the existence of unemployment, by itself, does not explain slow changes in the nominal wage.
However, it is argued that real rigidities such as efficiency wages when considered together with price rigidity caused by menu costs may enhance nominal wage rigidities (Ball and Römer 1990). Menu costs prevent prices from falling in response to a reduction in aggregate demand; rigidity in real wages prevents wages from falling in response to the resulting unemployment. The failure of wages to fall,
keep firms’ costs high and thus ensures they have little incentive to cut prices (Mankiw 1990). This provides a new explanation for Keynesian disequilibrium.
In practice, both nominal and real types of rigidities can be observed. Therefore, the effectiveness of monetary policy in the short run is restored. However, one of the main issues in this chapter is to review theories which help explain the inflation process. What makes wages or prices change slowly and inflation persist? The literature identifies two sources of inflation persistence. Inflation can display persistence if the money growth rate displays persistence as would be predicted by quantity theory, discussed later. Walsh (1998:215) observes that if this were the only sense in which inflation appears to exhibit persistence, it could easily be explained within the context of flexible price models. If conduct of monetary policy is such that it introduces a high degree of serial correlation in money growth, it will get reflected in the behaviour of inflation. However, there can be inflation persistence in a non monetary sense as well, as demonstrated by models based on staggered wage setting and wage contracts. Some of these models demonstrate inflation persistence, while others demonstrate price level persistence. Therefore some of the widely cited models, such as those developed by Fischer (1977), Taylor (1979), McCallum (1994) are discussed below.
Fischer’s Model
The simplified idea behind Fischer’s (1977) two-period model of staggered wage setting is that sellers are split into two groups setting nominal wages that stay in effect for two periods. Doing this brings in wage/price stickiness. However, wages for the two periods would not be the same but would be at the market clearing level. Thus, for one half of the workers, wages are set at the end of the period t-1, which will continue for period t and t+1 and for the other half wages are set at the end of period t-2, which would continue in period t-1 and t. The supply of the output is assumed to be a decreasing function of the real wage. Let yt be log of output, yt full employment output, wt the log of nominal wage, z, the log of real wage and p t the log of price in period t such that z, = w, - p t is the real wage for some group and z,
the market clearing value of z, . Then, the expected value of the market clearing nominal wage at the end of period t-1 will be z.t|M + p t|M , which will prevail for periods t and t+ 1. For the other half of the workers, the period t nominal wage would
have been set at the end of period t-2 at the level of z,|,_2 + p,|,_2, which continued in periods t-1 and t. Using these relationships, and aggregating the output supply of the two groups, Fischer postulated a log-linear aggregate supply function of the form:
y , ~ y , = a o +a,[0.5{p, - ( z ,H + p,|,_i)} + °.5{p, + p,|f_2)}] (2.9)
With a demand function of the form of simple velocity equation, and solving the model rationally, Fischer (1977) demonstrated that monetary policy is not neutral in the short-run but supports the natural rate hypothesis. However, the model is criticized for its assumption that output is negatively related to the real wage on the ground that real wages do not exhibit the counter-cyclical behaviour predicted by Keynes’ General Theory (Mankiw 2001). As discussed earlier, in Keynes model, when the central bank contracts the money supply and prices fall, real wages rise, leading to a lay off of workers and hence the theory exhibits a short-run trade-off between inflation and unemployment. However, Mankiw (2001) considered this argument patently false. In his opinion, firms lay off workers after monetary contractions not because real labour costs are high but because they cannot sell all of the output they want at the prevailing price. Prices do not clear goods market; and firms appear to have some degree of market power as discussed earlier.
Taylor’s Model
Taylor (1979, 1980) used another version of the wage bargain model, which is characterized by its forward-looking aspect. The basic model is also discussed in Hall and Taylor (1997:438-440). Recognizing that output is a function of employment, a simplified version of this type of contract is as follows. As above the wage contracts are again staggered in two (or more) periods by two (or more) groups and stay for two periods. Let xt be the log of the contract wage, in period t and the other symbols remain the same as used in discussing Fisher’s model earlier. This time the average wage is the average of the contract wage signed in the previous year for the first group, which is still outstanding, and the contract wage signed in the current year for the second group, which will also be in effect for the following year. Thus, the aggregate wage is the geometric average of the contract wage in two periods.
w, = 0 .5 0 , +*,-i) (2.10)
However, the critical part of Taylor’s approach is the way in which xt is set taking into account the expected future average wage and the expected future excess demand (or equivalent unemployment) based on the information available at the end of period t-1, which means xt = x , _ l . For that purpose, the contract wage relationship chosen is of the form:
X,= 0.5(w, +w,tlH ) + 0.5.5 [(y,|M - y ) + (y,+1|M - y ) ] (2.11)
Equations of aggregate wage (2.10) and of contract wage (2.11) together yield the supply curve as:
x, = o.5(jc,_, + Vi h ) +<5 [(y,|,-, - y ) + ( y, . i n - y ) i (2.12)
To write Taylor’s model in terms of prices assuming a constant markup q = 0 , the log price level can then be expressed as p t = wt + q = w,. With this assumption, noting that now p t = 0.5(*, + jc,_j) and expressing an expectation eiTor
77, = p t|,_2 - p t, the price equation can be written as follows:
P, = 0-5(p,_i + Pt+\\t-i) +
. _ (2.13)
0.5S [(y,lM - y ) + (yf+1|M - y ) + - y ) + (yt{t_2 - y)] + 0.5p,
In terms of inflation the equation can be expressed as follows:
ap, =ap,.i m+ <5 Ky,|.-i - > ) + ( y , « y)+(y,-i|,-2 - y) + (y+. 2 - y )] + v, (2.14)
The value of p t is influenced by expectations of the future price and also the price level of the previous period displaying inertia effect. However, there is no inertia in the rate of inflation. Instead, significantly, any policy of disinflation is costless and may be beneficial. Thus, the model can result in violation of the natural rate hypothesis. However, Führer (1994) characterized Taylor’s specification as
satisfying the first-order natural-rate hypothesis (average output is independent of the average level of inflation) but not the second-order version (average output does depend on the rate of change of inflation). The model could not generate the kind of inflation persistence as shown by the data in the Führer (1994) experiment.
Taylor (1979) used a velocity equation in wage, money and excess demand to represent the demand equation and a function of aggregate wage as a policy rule of money supply to solve the dynamic rational expectation model. The resulting price (wage) equation is obtained in terms of the realized values of the prices (wage) and supply shock demonstrating the usefulness of the model over the simple augmented Phillips curve. The forward-looking part corresponds to the demand effect on the wage. The wage persistence comes from the backward looking part of the equation and depends on how accommodative aggregate demand policy is in relation to wage contract adjustments which are “too inflationary”.