Stiglitz’s Sticky Prices
For decades, the assumption underlying mainstream economics was that Adam Smith’s invisible hand worked its magic seamlessly, keeping markets in equilibrium during changes in supply and demand. It was Joseph Stiglitz who showed that the invisible hand “is invisible at least in part because it is not there.”
WASHINGTON, DC – For a long time, the assumption underlying much of mainstream economics was that the invisible hand worked its magic seamlessly. Prices moved smoothly up as demand outpaced supply and rushed back down when the tables were turned, keeping markets in equilibrium.
To be sure, many observers realized the truth was actually quite different – that prices, and wages and interest rates in particular, were often sticky, and that this sometimes prevented markets from clearing. In labor markets, this meant unemployed workers facing prolonged job searches. But the response by others in the field was that what their colleagues described as “unemployment” did not truly exist; it was voluntary, the result of stubborn workers refusing to accept the going wage.
Among those who recognized the reality of involuntary unemployment were John Maynard Keynes and Arthur Lewis, who incorporated it into his model of dual economies, in which urban wages do not respond to labor-supply gluts and remain above what rural workers earn. Both Keynes and Lewis used the stickiness of prices extensively in their work. But even for them, the concept was only an assumption; they never managed to explain why wages and interest rates so often resisted the pressures of supply and demand.