7 - Price flexibility, inventory behavior, and production responses

Summary

Introduction

Two paradigms based on different assumptions about the response of economic agents to disturbances in markets have characterized the debate in macroeconomics of the past decade. In one paradigm, originating in the work by Patinkin (1965), Clower (1965), and Leijonhufvud (1968), the main conceptual framework of Keynesian theory has been substantially reconsidered. In view of sluggish price movements in most Western economies, a number of short-run macroeconomic models have been developed that assume that prices adjust only after quantities have fully adjusted. Malinvaud (1977, 1980) argues that such sluggish adjustment is more than a purely institutional fact and that, due to uncertainty and to information and transactions costs, the first reaction of firms to changes in demand is more often a revision of quantities than a revision of prices. This new disequilibrium macroeconomics, therefore, posits fixed prices (and price expectations) for the short run; movement in prices between two periods is treated as autonomous and “it is not significantly influenced… by the formation of demands and supplies” (Malinvaud 1977, p. 12).

A second paradigm has been evolved by supporters of the new classical equilibrium economics, especially in the context of rational expectations. Here it is assumed that universal auction markets allow economic agents to adjust instantly to perceived nominal demand changes and that only imperfect information prevents economic agents from selecting the quantity that would maintain an aggregate equilibrium. [For a discussion, see Gordon (1981).]