Chapter22 - Chapter 22 A New Keynesian Model of Sticky...

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© Sanjay K Chugh 271 Summer 2008 Chapter 22 A New Keynesian Model of Sticky Prices: Menu Costs and the Rotemberg Model Modern New Keynesian sticky-price models are built on a foundation of monopolistic competition. With the basic Dixit-Stiglitz-based framework of monopolistic competition now in our toolkit, we are ready to sketch one of the simplest, yet quantitatively serious, modern sticky-price macroeconomic models. Our starting point will be exactly the monopolistically-competitive model we just laid out: namely, we will continue assuming that consumers purchase a “retail good” from retail firms; retail firms transform a continuum [0,1] of differentiated wholesale products into the retail good by operating a Dixit-Stiglitz aggregation technology; and each producer of a differentiated wholesale product wields some monopoly power over its output, which renders it a price-setter instead of a price-taker. However, rather than assuming price-setting is costless, as we d id in ou r t roduc t ion to monopo l is t ic competition, we will now assume that there are some costs associated directly with the act of price-setting . In particular, when a wholesale firm in period t decides to set a (nominal) price different from the one it charged in period t -1, it must pay a cost of re- setting its price. This cost is completely independent of any costs associated with the physical production process itself. That is, this cost is completely unrelated to any wage costs or capital investment costs that a wholesale firm pays. In the language used in the field, this pure cost of price-adjustment is a menu cost. At both an empirical level and a theoretical level, the nature of these menu costs deserves some discussion. As such, we begin there; we then proceed to sketch one of the most commonly-used (and simplest) versions of a sticky-price model featuring menu costs and analyze some of its implications. Menu Costs The predominant core of any modern theory of price stickiness is that the very act of changing prices itself entails costs. Indeed, this is also the simplest of theories of price stickiness. The basic idea is most easily illustrated with an example. Suppose a restaurant is considering increasing the prices of some or all of the items on its menu. Presumably, price increases are being considered because they would be in the best interest of the restaurant – that is, the price increases would presumably increase total profit. To make the example concrete, suppose that at current demand conditions, if the restaurant could costlessly change i ts pr ices , $1000 extra total profit would be generated. However, in order to implement its price changes, the restaurant would have to print new menus. If the restaurant had to pay its printer $2000 to print new menus, it clearly is not in the interest of the firm to change its prices – indeed, changing prices would cause total profit to decrease by $1000, so the firm instead chooses to hold its
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© Sanjay K Chugh 272 Summer 2008 prices steady.
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This document was uploaded on 11/01/2011 for the course ECON 325 at Maryland.

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Chapter22 - Chapter 22 A New Keynesian Model of Sticky...

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