Sticky Price Model



The sticky price model generates an upward sloping short run aggregate supply curve. This is because firms are rigid in changing prices in response to changes in the economy. In this article we have discussed the reasons behind such rigidity.

Reasons Behind the Sticky Price

The wages are set in long-term contracts and cannot be changed easily even if there are changes in prices in other sectors of the economy. It would be very difficult if wages kept on changing with the changing conditions of the economy.

Secondly, firms want to keep their customer base intact. If they go on changing the price of the commodities sold, they would be annoying their customers. This is the reason why they follow a sticky price.

Thirdly, the prices of firms are displayed in a written format for customers known as menu. Changes in the prices of the commodities in response to changes in the economy would entail printing costs in making a new menu. In order to do away with this menu cost firms are reluctant to change the prices of the commodit


Upward Sloping Short Run Supply Curve

In the sticky price model appositive relation between price and output exists in the short run. This is due to high-expected price level in the short run. In response to this firms also expect the input prices to be high. So they set the price of the final goods high so as to compensate for the high input costs. The high price in the final good motivates them to produce even more. This is the reason why the hot run aggregate supply curve is upward sloping in the case of the sticky price model.

There is an alternative way to explain the positive relation between price and output in the sticky price model. The high level of output attracts high demand for goods and services. In order to reap the benefits of a high demand the firms set their prices at a high level. More and more firms follow the same trend and the general price level increases. This is how; high output level is consistent with demand, which further pushes the price level high. Hence we also find that a higher expected price level would lead to a ride in the actual price level.

From the above discussion we find that the basic tenet of the sticky wage model is that higher the deviation of the output from the natural rate higher ill be the deviation of the actual price from the expected