What is the role of menu costs in New Keynesian models? Is the importance placed on menu costs in these models justified by the empirical evidence?

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EC201 Assessment One

Question: What is the role of menu costs in New Keynesian models? Is the importance placed on menu costs in these models justified by the empirical evidence?

Most economists believe that short-run fluctuations in output and employment represent deviations from the economy’s natural rate. They think these deviations occur because nominal wages and prices are slow to adjust to changing economic conditions. This stickiness makes the short-run aggregate supply curve upward sloping rather than vertical. For decades, many New Keynesians worked on possible reasons and relevant evidence for the price stickiness by putting the traditional theories of short-run fluctuations on a firmer theoretical foundation, examining the microeconomics behind. Among these well-known economic theories, menu cost is the one I will talk about here. The aim of this essay is to demonstrate the role of menu costs in New Keynesian economic models and find out whether it was justified by the empirical evidence.

Before talking about the role of menu costs, I have to point out that the fundamental ‘new’ idea behind New Keynesian models is that of imperfect competition. All the major innovations of the New Keynesian school are made possible or worthwhile only because of imperfect competition. By this I mean that all the firms set their own profit-maximizing prices rather than take from the market.

So what are exactly menu costs? Menu costs are costs of changing nominal price. The classic example of menu costs is the costs that a restaurant faces when it has to reprint its menu to show changes in the prices of its offerings. More general examples of menu costs include costs of remarking merchandise, reprinting price lists and catalogues, and informing potential customers. The New Keynesian approach assumes that small menu costs will deter imperfectly competitive firms from constantly changing their prices.

After the definition let us turn to find out the role of menu costs. Suppose there is an increase in aggregate demand (See figure 1 in appendix). This increase will lead to an increase in demand at firm level from D0 to D1; the new profit-maximizing price is P1 at output level Y1. Assume that the nominal wages are sticky so the marginal cost schedule is unchanged. Firm will incur menu cost z if it increases price to P1. The gain from changing price must be larger than the gain from not changing price, as P1 is the new profit-maximizing price. So the change in profit from not adjusting price must be negative because area A is greater than area B. That is Δπ= B-A < 0. It is obvious that the firm will not adjust its price if and only if menu cost incurred is larger than the profit gain from adjusting price, i.e. z > -(B-A) = A-B. On the other hand, the change in social welfare from firm not adjusting price equals the change in consumer surplus plus the change in firm’s profit. The change in consumer surplus is area A+C so that ΔSW = ΔCS +Δπ= (A+C)+(B-A)=C+B.│C+B│>│B-A│so the gain in social welfare is larger than the firm’s profit loss. The firm has a private incentive to increase price if A-B>z but it is socially desirable that the firm does not adjust its price if C+B>z. This is an example of the Keynesian notion of macroeconomic externality: a cost incurred by society as a result of a decision by an individual economic agent. If the change in demand is small, the profit loss from not adjusting price is likely to be smaller than menu costs so the firm will not change price. Even quite small menu costs can lead to significant price rigidity. However, whilst the menu costs might be quite small, the welfare benefits of an increase in demand can be large. If the increase in demand is due to a tax cut or an increase in the nominal money supply, then when there are menu costs, this sort of policy can lead to ‘Keynesian’ multiplier effects and also ‘Keynesian’ welfare effects, since there is a Pareto improvement – consumers and the owners of firms are both made better off.

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The case of a fall in aggregate demand could be analysed in the similar way (See figure 2 in appendix). The firm ignores the macroeconomic externality when making its decision, so it may decide not to pay the menu cost and cut its price even though the price cut is socially desirable. The resulting profit gain for the firm from not to adjust price will be small in comparison to the large welfare loss for society. Hence, sticky prices may be optimal for those setting prices, even though they are undesirable for the economy as a whole.

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