New Keynesian Economics/Post Keynesian Alternatives

By Roy J. Rotheim | Go to book overview

11

MENU COSTS AND THE NATURE OF MONEY

Malcolm Sawyer

INTRODUCTION

This chapter begins by outlining the New Keynesian treatment of menu costs with particular reference to the use of such costs in providing an explanation for fluctuations in economic activity in the face of nominal demand shocks. It is argued that whilst there are undoubtedly costs of price adjustment, there are also costs of output adjustment, and it is not clear that firms would always willingly incur the output adjustment costs rather than price adjustment costs. The second and major argument of this chapter is that the New Keynesian explanation of fluctuations in economic activity is based on the assumption of exogenous money, whereas in an industrialized economy money is endogenously created within the private sector, and that the explanation of fluctuations would not survive a change of assumptions from exogenous to endogenous money. Shifts in nominal demand are modelled as akin to changes in the money stock, and hence if the analysis based on changes in the money stock is invalid then so is the analysis of nominal shocks.


NOMINAL RIGIDITIES AND MENU COSTS

New Keynesian macroeconomics has two main elements of significance for this chapter. The first is the idea that there are nominal rigidities, whereby prices change only slowly, particularly in the face of changes in demand because of adjustment costs under the general heading of menu costs. These adjustment costs have been long recognized (as well as the small gains to changing price when the elasticity of demand and the average variable costs facing a firm are perceived to be approximately constant). 1 There is much evidence on the pricing side that prices are relatively insensitive to demand (whether the level of or changes in). 2 The new element has been to argue that a small effect such as menu costs can have large effects on the level of economic activity.

Thus, if failure of the classical dichotomy is important to fluctuations in aggregate activity, it must be that nominal frictions that appear small at the level of individual households and firms—like the fact that prices are posted

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