Menu costs : an overview and a study within a strategic interaction setting

Abstract

Chapter 1 presents the background to the development of macroeconomic models with "menu costs", i.e., the costs of adjusting nominal prices. The debate on microeconomic foundations of macroeconomics is introduced in Section 1. The theoretical basis of the "classical dichotomy" between real and nominal variables and the role of nominal imperfection for the failure of such dichotomy are briefly surveyed in Section 2 and 3, respectively. The "monetary illusion" assumption and its limits are presented in Section 4. An account of some potential sources of nominal imperfections concludes the chapter. Chapter 2 deals with the New Keynesian microeconomic foundations of nominal rigidity. Section 1 introduces the key elements of New Keynesian microfoundations. In Section 2, the seminal 1985 paper by Mankiw is examined in some detail. It will be shown that small menu costs can cause "monetary" business cycles to have large welfare effects. The role of real rigidities in explaining nominal price stickiness is addressed in Section 3. The remaining part of the chapter focuses on dynamic models of menu costs. Chapter 3 gives a quick overview of microeconomic studies on costly price adjustment. Section 1 outlines Barro (1972) and Sheshinski and Weiss (1977), where a monopoly optimal pricing policy is derived. In Section (2), an overview of recent game-theoretic frameworks with menu costs is given. It will be argued that these models fail to capture the theoretical essence of menu costs. The last part of the chapter deals with the issue of the empirical relevance of costly price adjustments. Chapter 4 presents a theoretical study that can contribute to shed light into menu costs within a game-theoretic setting. Section 1 introduces the issue. In Section 2, a Bertrand duopoly model with menu costs is set up in order to derive the duopolists' best response to a nominal shock. The main findings are expounded in Section 3. A duopoly nominal price adjustment rule will be derived. This turns out to be contingent to the sign of the nominal shock. Situations of multiple equilibria, both symmetric and asymmetric, can also arise.