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This chapter discusses advances in formal economic theory by examining how different positions among economists arise from their different assumptions and models. The discussion focuses on ways in which real world economies differ from the ‘competitive equilibrium’ model that has become the benchmark model. The current benchmark competitive equilibrium framework includes new classical, representative agent, and real business cycle models which assume that all markets (including the labor market) have clear, perfect information, complete markets (including perfect capital and insurance markets), perfect wage and price flexibility, perfect competition, perfect rationality, and no externalities. If these models accurately portrayed reality, the economy would be efficient and there would be no need for government intervention. The assumptions of these models, however, are unrealistic and it is difficult to reconcile the required macro-formulations with what is known about microeconomic behavior (without resorting to ad hoc assumptions about the nature of the stochastic shocks to preferences and technology). The inadequacies of these models are even greater for developing countries where information imperfections are more pervasive and more markets are missing or incomplete (e.g., insurance markets). Accordingly, economic research since the 1990s has focused on identifying the most important limitations of the standard competitive model, particularly those limitations that help to explain the nature of economic volatility.

This chapter reports the results of a survey on price setting behavior conducted in 2004 among 2,000 Belgian firms. The results clearly deviate from a situation of perfect competition and show that firms have some market power. Prices are rather sticky, the average duration between two consecutive price reviews being ten months, whereas it amounts to thirteen months between two consecutive price changes, and both time-dependent and state-dependent behavior are observed. Evidence is found in favor of both nominal (mainly implicit and explicit contracts) and real rigidities (including flat marginal costs and counter-cyclical movements in desired mark-ups). The survey results point to a non-negligible degree of non-optimal price setting.

This chapter summarizes the vast evidence on price setting based on micro consumer and producer price data obtained for euro area countries. This analysis captures features of price behavior that cannot be fully analyzed with surveys, as well as provides important complementary evidence on the frequency and size of price changes. The main findings are that prices in the euro area are stickier than in the United States, downward price rigidity is only slightly more marked than upward price rigidity, and heterogeneity and asymmetries are observed in price setting.

This chapter reports the results on price setting asymmetries of French manufacturing companies from a survey conducted by the Banque de France during winter 2003–04. Price increases are more likely (70 percent) than price decreases (30 percent) among price changes. The magnitude of positive price changes over the year 2003 (3 percent for the median increase) is lower than the one of negative price changes (−5 percent). Asymmetries are found to be different for cost shocks compared to demand shocks: prices are more rigid downward than upward for cost shocks, while the reverse is true for demand shocks (prices are more rigid upward than downward).

This chapter compares internationally the available survey evidence of firms' price setting behavior. It reports a number of remarkable similarities across countries. Firms typically operate in imperfectly competitive markets, where they have a low market share, face several competitors, and are primarily engaged in long-term relationships with their customers, mainly other firms. The modal price review and price change frequency per year is one across countries. Implicit and explicit contracts, coordination failure, and cost-based pricing are recognized as the most important reasons for price rigidity.

This chapter investigates price rigidity after cost and demand shocks in Austria. We find that the average time lag between a shock and the price adjustment is four to six months. Furthermore, firms' price reactions to cost and demand shocks are asymmetric: prices are stickier downward than upward in the face of cost shocks and the opposite is true in the case of major demand shocks. Finally, our results suggest that tight customer relationships increase price stickiness in response to demand shocks.

This chapter analyzes monopoly and duopoly pricing when consumers display loss aversion. It assumes that consumers’ reference point is determined by their expectations. First, the model is applied to capture the idea that consumers are antagonized by unexpected price increases, and the implications of this idea for price rigidity and uniformity. Second, the model is applied to capture an “attachment effect” (a variant on the endowment effect) and the implications of this idea for the use of sales.

The benchmark New Keynesian model comprises three globalization features:1. International labor mobility: both inward and outward movements of labor. The presumption is that labor flows tend to mitigate wage demands because they introduce a substitution between domestic and foreign labor. 2. International trade in goods. The presumption is that trade leads to specialization in domestic production and diversification in domestic consumption. Therefore, trade tends to weaken the link between domestic production and domestic consumption. As a result, the effect of the fluctuations of domestic production on inflation is also weakened by the presence of international trade in goods. 3. Financial integration with the rest of the world. International trade in financial assets allows households to smooth their consumption over time and over states of nature. Such a model may be used to simulate monetary policies during The Great Moderation from 1985 to 2007.

Chapter 3 covers traditional topics of monetary macroeconomics. To acquaint readers with the present methods, it starts with conversant material, such as superneutrality of money, the Tobin effect, and forced saving. A large section is devoted to interactions between monetary and fiscal policies. This passage simulates the macroeconomic consequences of sovereign insolvencies and contains a comparison of Ricardian and non-Ricardian economies, a distinction that is crucial for policy analysis. Two closing sections pertain to price and wage rigidities. They emphasize that monetary policies have real effects in the presence of nominal frictions. According to the view sponsored here, models with sticky wages and prices do not compete with flexible price settings but rather complement them in that they shift attention to the short run.

Greece's trade deficit declined by 10 percent of gross domestic product (GDP) between 2007 and 2012, removing one of the great economic imbalances of the pre-crisis years. However, this reduction was achieved exclusively through import compression while exports fell over that period, thereby worsening the economic crisis. This chapter studies Greece's export underperformance in comparison to Ireland, Portugal and Spain as well as Greece's own pre-crisis experience. The main findings are that (1) given past performance, Greece's exports should have increased by 25 percent, rather than drop by 5 percent between 2007 and 2012; (2) labor markets have adjusted to the new economic environment; (3) product markets did not adjust, hindering the recovery of competitiveness; (4) export underperformance is responsible for a third of the decline in GDP since 2007. The chapter concludes that the business environment and firm size distribution in Greece are also hindering the necessary adjustment.