New Keynesian Menu Cost Models

Abstract

During the stagflation of ‘70s, the Keynesian System fell from favor in the academic circles while Monetarism and, in particular, New Classical Economics became widely spread. The years ‘80s witnessed implementation of economic policies in line with Monetarism and the New Classical School, but unemployment, far from being removed automatically, increased and recession deepened. Hence during this decade these two schools fell from favor in the academic circles and in the US academic circles a new school, New Keynesian economics began to take hold. The new Classicals had criticized the Keynesian System severely because its macro analysis had no micro foundations and its result, i.e. unemployment due to lack of demand was inconsistent with the result of full employment reached in the traditional microeconomics which was based on perfect competition. To meet this criticism of methodology, the New Keynesians went into microeconomics foundations of Keynesian macro analysis, but they rejected the relevance of traditional microeconomics and instead accepted imperfectly competitive markets and lack of coordination between markets. These conditions would lead to Keynesian unemployment in the short run, if not in the long run. This would be cured by the implementation of Keynesian monetary and fiscal policies. In their analysis and models, New Keynesians also accepted the Rational Expectations Hypothesis of the New Classicals, which meant that all decision makers, including workers, could estimate future price increases and other future conditions correctly.New Keynesians came up with many models explaining how Keynesian unemployment could arise under conditions of imperfect competition and also lack of coordination between markets. One such well-known model is the “Menu Costs Model” which was first advanced by Mankiw and also Akerlof and Yellen, and later developed by several other New Keynesian economists. The Menu Costs Model works with firms under imperfect market conditions facing a negative demand curve. Supposing a fall in demand occurs that would lead firms to cut down prices. But in order to decrease prices, the firm has to incur fixed costs called “menu costs” such as preparing new price lists, reaching this new price information to customers, etc. Hence if decreasing the price and thus increasing profits under new demand conditions does not meet these costs, the firm will choose to keep the price fixed and instead will decrease production and employment. This is demonstrated in our article both with the aid of partial analysis and geometry and also with the aid of general equilibrium analysis and mathematics. In conclusion, an evaluation and criticism of Menu Cost Model is offered. It is noted that the model neglects the fact that menu costs are incurred for once while profit loss due to keeping prices rigid continues over time. Hence, though the “Menu Costs Model” may be valid under certain conditions, its validity is limited. Therefore, we cannot explain prolonged recessions and depressions with the aid of only the “Menu Costs Model”.Keywords: New Keynesian Economics, New Keynesian Models, Menu Cost Models, Inflation