© Sanjay K Chugh
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
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
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
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
decides to set a
(nominal) price different from the one it charged in period
-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
At both an empirical level and a theoretical level, the nature of these menu costs deserves
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.
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
The basic idea is most easily illustrated with an example.
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
To make the example concrete, suppose that at current demand conditions, if the
restaurant could costlessly
extra total profit would be
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