Economics
Price Stickiness and Menu Costs in New Keynesian Models
Quick fact
The term 'menu costs' literally refers to the cost of printing new restaurant menus, but it's a metaphor for any cost a firm incurs to change prices—like updating price tags, websites, or catalogs. These tiny costs can create large economic effects, as shown by Nobel Prize-winning economist N. Gregory Mankiw.
Why this is interesting
Have you ever noticed that the price of a candy bar stays the same for years, even when the cost of ingredients goes up? Why would a firm leave money on the table by not adjusting prices immediately?
Read the full explanation
Understanding Price Stickiness and Menu Costs in New Keynesian Models
Imagine a restaurant that must decide whether to raise its prices after the cost of beef rises. Changing the menu costs time and money—perhaps $50 in printing and labor. If the restaurant expects inflation to be low, it may be more profitable to keep prices unchanged and absorb the extra cost than to pay the menu cost. This single decision is based on a small, rational calculation; but when thousands of firms make similar choices, prices across the economy become 'sticky'—they don't adjust instantly to changes in demand or costs. In New Keynesian models, this price stickiness is deliberately added to the traditional supply-and-demand framework. Instead of assuming prices are flexible (adjusting immediately, like in classical economics), these models recognize that many firms set prices for a period and only change them occasionally. This leads to a world where, when the central bank increases the money supply, some firms don't raise prices right away. As a result, consumers have more money but see unchanged prices, so they buy more goods. Firms respond by increasing production, hiring more workers, and the economy grows—at least in the short run.
A deeper explanation
At the heart of New Keynesian economics is the idea that nominal rigidities—such as sticky prices—are crucial for understanding business cycles. Menu costs are a microeconomic justification for this stickiness: they represent the real resources a firm must expend to change its price. While an individual firm's menu cost may be trivial, the aggregate effect is significant. When the optimal price deviates from the current price by only a small amount, the firm may find it unprofitable to pay the menu cost, leading to a price that remains fixed even though supply and demand conditions have shifted. This insight was formalized in the seminal 1985 paper by N. Gregory Mankiw, 'Small Menu Costs and Large Business Cycles: A Macroeconomic Model of Monopoly.' Mankiw showed that even when menu costs are small, the resulting price stickiness can have large macroeconomic consequences: a nominal shock (like a change in money supply) can cause output and employment to fluctuate in the short run. The key mechanism is that when prices are sticky, the overall price level doesn't adjust to clear markets. Instead, firms adjust quantities—producing more or less—leading to real effects. New Keynesian models incorporate this via the Calvo pricing framework, where each period a firm has a fixed probability of being able to adjust its price. This produces a staggered price-setting pattern that is both analytically convenient and empirically plausible. The Phillips curve in these models becomes a relationship between inflation and the output gap, driven by the fraction of firms that adjust prices and their expectations of future inflation. Because not all firms adjust simultaneously, the price level becomes sluggish, and monetary policy can influence real activity in the short run. Thus, menu costs provide the microfoundation for why monetary policy is 'non-neutral'—it affects real variables like output and employment—and why central banks can stabilize the economy by managing aggregate demand.