New Keynesian Economics - Microfoundations of Price Stickiness

Microfoundations of Price Stickiness

'Nominal rigidities', that is, sticky prices and wages, are a central aspect of all New Keynesian models. A key question posed is "why should prices adjust slowly?" One common explanation given by New Keynesians is the presence of 'menu costs', meaning small costs that must be paid in order to adjust nominal prices. For example, the costs of making a new catalog, price list, or menu would be considered menu costs. Even though these costs seem small, New Keynesians explain how they could amplify short-run fluctuations. Not only do the firms have to pay to change the price, but also, according to N. Gregory Mankiw, there are externalities that go along with changing prices. As Mankiw describes, a firm that lowers its prices because of a decrease in the money supply will be raising the real income of the customers of that product. This will allow the buyers to purchase more, which will not necessarily be from the firm that lowered their prices. As firms do not receive the full benefit from reducing their prices their incentive to adjust prices in response to macroeconomic events is reduced.

Recent studies (e.g. Golosov and Lucas) find that the size of the menu cost needed to match the micro-data of price adjustment inside an otherwise standard business cycle model is implausibily large to justify the menu-cost argument. The reason is that such models lack "real rigidity" (see Ball and Romer). This is a property that markups do not get squeezed by large adjustment in factor prices (such as wages) that could occur in response to the monetary shock. Modern New Keynesian models address this issue by assuming that the labor market is segmented, so that the expansion in employment by a given firm does not lead to lower profits for the other firms (see Woodford 2003).

Other sources of price stickiness include: