Sticky Prices

Sticky prices are prices that do not adjust immediately to changes in demand, costs or the money supply, but stay fixed for a period and change only occasionally. The related idea of sticky wages describes pay that is slow to move, especially downward. Price stickiness, also called nominal rigidity, explains why changes in monetary policy and in spending can affect output and employment in the short run instead of passing straight into inflation.

Stickiness is a foundation of Keynesian economics and of the New Keynesian models used by most central banks today. In theories where all prices adjust instantly, as in much of classical economics, money is neutral and a fall in demand would simply lower prices without causing unemployment. Stickiness breaks that neutrality and gives a role to stabilisation policy.

Think of a café with a menu painted on the wall. When coffee beans get more expensive, the owner does not repaint the wall the next morning. Repainting costs money and time, regular customers might be annoyed, and the bean price might fall back next month. So the price on the wall stays put for a while, and the owner absorbs the change or waits until several reasons to change have piled up.

Across a whole economy, millions of prices behave like that café menu. Because they move slowly, a sudden drop in spending first shows up as fewer customers and shorter shifts rather than lower prices. That is why a slump can cost jobs even though, in theory, cheaper prices could have kept everything selling.

• Menu costs. Changing prices has direct costs: reprinting lists, updating systems and informing customers. Even small costs can deter frequent changes.
• Contracts. Many prices and wages are fixed by contracts that run for a year or more, such as supply agreements, leases and collective pay deals.
• Customer relationships and fairness. Firms fear antagonising customers with frequent increases; surveys led by Alan Blinder in the 1990s found that firms' top reasons for not changing prices included implicit contracts and coordination worries.
• Coordination failure. No firm wants to be the first to raise or cut prices if competitors do not follow.
• Information frictions. Firms may update their information and plans only periodically, an idea called "sticky information".
• Downward wage rigidity. Employers rarely cut nominal pay because it damages morale and productivity; this is linked to money illusion and loss aversion.

Large studies of the data behind consumer price indexes measure stickiness directly. Research by Mark Bils and Peter Klenow (2004), and by Emi Nakamura and Jón Steinsson (2008) using US Bureau of Labor Statistics microdata, found that the median consumer price excluding temporary sales changes roughly every eight to eleven months, with wide variation by product. Petrol and fresh food prices change often; services such as haircuts, rents and medical fees change rarely. Studies by the Eurosystem's Inflation Persistence Network found that prices in the euro area change even less often than in the United States. During the high inflation of 2021–2023, firms changed prices more frequently, showing that stickiness itself depends on the inflation rate.

Modern models represent stickiness in two main ways. In the Calvo model (1983), each firm has a fixed chance $1 - \theta$ of being able to reset its price in any period, so the average price lasts about:

• $\theta$ is the probability that a firm keeps its price unchanged in a given period.
• $1 - \theta$ is the probability that it resets the price.

Worked example: if 75% of firms keep their prices each quarter ($\theta = 0.75$), the average price lasts $1 \div 0.25 = 4$ quarters, or one year. In the Taylor model (1980), contracts are staggered and last a fixed number of periods. Both approaches produce the New Keynesian Phillips curve, in which inflation depends on expected future inflation and on the output gap. These equations sit inside the dynamic models that central banks use for forecasting, a type of economic model.

Because prices are sticky, a cut in the policy rate lowers real interest rates for a time and stimulates spending; a rise does the reverse. This is why monetary policy has real effects, why it works with lags, and why central banks practising inflation targeting look ahead rather than reacting only to current inflation. Downward wage rigidity is one argument for a positive inflation target: modest inflation lets real wages adjust without nominal cuts. Stickiness also explains why sudden demand shocks can produce recessions and why deflation can raise real labour costs.

Critics in the new classical tradition, building on rational expectations, argued in the 1970s and 1980s that models should explain why prices are sticky from optimising behaviour rather than assume it; menu-cost and information theories were partly a response. Some economists also note that many prices are "sticky" in list form but flexible through discounts, sales and quality changes, making effective prices more flexible than they appear. Stickiness in one direction can also allow a wage-price spiral to keep momentum once inflation is high.

• European Central Bank: Inflation Persistence Network
• U.S. Bureau of Labor Statistics: Consumer Price Index