Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Misperceptions about the price level

This suggested reason for sticky prices is a clever one. Essentially, people confuse an increase in the nominal price of whatever they’re selling for an increase in its real price. This mistake causes them to oversupply the market with goods. Only when they realise that the real price is unchanged do they return to their earlier production.

Imagine that you’re a baker. Every day after baking your loaves of bread, you take them to the marketplace to sell. Unknown to you, aggregate demand has increased, causing the price level to increase. Therefore the price that you can sell your bread for has also increased. You respond by singing ‘Happy days are here again!’ and rushing home to bake as many loaves as you can in order to sell to market.

What you don’t realise, however, is that all prices in the economy have also increased and so the real price you’re receiving for your bread is unchanged. Only the nominal price has increased.

At the end of the week, you go to do your weekly shop and notice that the prices of all goods have risen. Only then do you understand that the real price of bread is the same as it was last week. Armed with this understanding, the following week you go back to your usual amount of bread production, muttering ‘I knew it was too good to be true’!

The same thing can happen in the labour market. An increase in AD causes the price of all things to rise. Workers notice that their nominal wage has increased, which causes them to supply more labour (that is, existing workers work more hours or previously unemployed workers start working) and allows firms to produce more output. Eventually workers realise that the real wage is unaffected and so they return to their original labour supply.


Sticky nominal wages

Here, the argument for sticky prices goes something like this: in the short run the nominal wage (w) is fixed – firms are able to hire as many workers as they like at this wage. An increase in AD raises the price level (p) but not the nominal wage, which causes a fall in the real wage (w/p). Firms take advantage of this fall in real wages by hiring more labour, which allows them to produce more output.

Over time the nominal wage adjusts, raising firms’ costs and shifting the SRAS up and to the left (see the earlier Figure 8-6). Eventually, the nominal wage adjusts fully and the real wage is the same as it was before the increase in AD.

Although some workers may be in this situation, at the aggregate level this explanation is less convincing to economists than those in the preceding two sections. Here’s why: this analysis implies that the real wage is countercyclical, that is, it should fall during booms (when output is above the natural level) and rise during recessions (when output is

below its natural level). But in fact empirically the opposite is true: the real wage is procyclical – it rises during booms and falls during recessions.


Rounding on the Russian rouble

2014 was a tough year for the Russian currency (the rouble): it lost around half its value against the US dollar. This decline earned it the unenviable title of the world’s worst-performing currency of that year. Analysts provide a number of reasons to explain the large fall, including the dramatic tumble in world oil prices (the Russian economy is heavily dependent on oil exports) and the effect of economic sanctions placed on Russia following the crisis in Ukraine.

The rouble had been steadily losing value throughout 2014, but in December something quite extraordinary happened: within 48 hours it lost around 20 per cent of its value. Equally extraordinary was that immediately after the depreciation, consumers in Russia went on a shopping spree like no other. Car showrooms and furniture stores were bulging with customers desperate to buy anything they could get their hands on.

This behaviour may seem strange for a country experiencing an economic crisis, but it was for a very simple reason: people wanted to buy before firms had a chance to raise their prices in response to the depreciation. This is a perfect example of the effect of so-called sticky prices: the fact that prices didn’t respond immediately meant that consumers bought much more than they’d have bought otherwise.

Chapter 9