1989 Articles

Toward a Theory of Rigidities

Stiglitz, Joseph E.; Greenwald, Bruce C.

The phenomena of dramatic variation in quantities and slight variation in prices has been a noted characteristics of business cycles. Applied to the labor market, this observation, that employment is far more variable over the cycle than wages, is one cornerstone of Keynesian theory. At the same time, real business cycle theorists accept it as a key business cycle fact to be explained. Yet attempts to provide a theoretical justification of these price rigidities have largely been unsuccessful. The article provides an explanation of this paradox based on three hypotheses; that firms act in a risk-averse manner; they are uncertain about consequences of their actions; and there is often greater uncertainty associated with pricing and wage decisions than with output and employment decisions. The first of these hypotheses is supported by ample empirical evidence; and the second, that firms are uncertain about consequences of their actions, seems uncontroversial. The third hypothesis is, however, the critical one and has been discussed in detail in the article.