Demand for Fixed Factors, Inflation and Adjustment Costs

Abstract

The purpose of this paper is to examine some of the real effects of a fully inflation. In particular, such real effects may exist if inflation is predicted only in the aggregate, while relative prices are allowed to vary randomly. Under such circumstances, firms will find it profitable to inform customers about their specific prices and, consequently, it will become costly to change these prices continuously. We adopt a micro, partial equilibrium approach, and consider a single firm which operates under inflationary expectations. The firm possesses a monopoly power which allows it to set the nominal price of its output or, alternatively, the price of one of its inputs. There are (non-convex) costs of adjustment associated with varying nominal prices. As a result, the firm will change nominal prices by discrete jumps, allowing real prices and output to vary continuously within repeated intervals of time over which the nominal price is held fixed. Clearly, the change in output need not imply a corresponding change in all inputs. Some inputs, such as the hours of work of the existing labour force, are flexible and will vary between successive price changes. Others, such as physical capital and employment, may be costly to vary continuously and will consequently be fixed over such intervals. The analysis starts with the case in which the time interval between price changes is predetermined. This assumption is intended to capture lags in the adjustment of institutional arrangements, such as the duration of labour contracts, when the rate of inflation changes (see Friedman (1977, pp. 464-468)). The main question which we address is the effect of changes in the expected rate of inflation on the demand for fixed factors. We provide a characterization of the forces which determine this relation. Two distinct effects are identified: first, the average complementarity between the fixed intputs and the initial real price during the period in which nominal price is fixed; second, the relative speed at which the marginal profitability of the fixed factor and of the initial price vary over the same interval. We present three models of costs of price adjustments: a monopoly and two types of a monopsony with respect to variable inputs. Under quite standard assumptions, namely constant elasticity demand and production functions, it is shown that the employment of fixed factors is reduced when an increase in the rate of inflation is expected. This result, however, is not necessary, as shown by another example based on linear demand functions. There is an intuitive explanation for this ambiguity. Increased inflationary expectations will induce the firm to choose a higher initial nominal and real price in each period. Due to the higher rate of inflation, real price fluctuations are amplified. It is, in general, not