08.10.

2010 Christian Groth

Introduction to short-run Macroeconomics: A brief
history of macroeconomics; the menu cost theory
This introduction to short-run macroeconomics contains a sketch of the history of
macroeconomics since Keynes and a sketch of one of the important microfoundations for
the Keynesian assumption of nominal price stickiness, the menu cost theory.
1 From Keynes to New Classicals to New Keynesians
John Maynard Keynes General Theory (1936) came out in the midst of the Great De-
pression. It was an attempt to come to grips with this economic catastrophe. And to
nd out policies for its cure and prevention in the future. On the one hand Keynes book
revolutionized the way economists thought about the economy as a whole. On the other
hand, in many respects the analytical content of the book was incomplete.
Keynes American followers, such as Paul Samuelson, Lawrence Klein, Franco Modigliani,
Robert Solow, and James Tobin, were pragmatic and policy-oriented. Apart from incor-
porating a Phillips curve (linking price changes to the level of economic activity), they
seemed satised with the basic logic of Keynes theory. They viewed it as the relevant
point of departure for the study of the short run, in particular when excess capacity
and involuntary unemployment prevail (in fact considered to be the normal state of af-
fairs). The classical (pre-Keynesian) theory, relying on market clearing through exible
prices, was conceived applicable for the study of the long run or a state with sustained
full employment. This way of reconciling Keynes and the classics became known as the
neoclassical synthesis or the neoclassical-Keynesian synthesis. We stick to the last
label, since nowadays neoclassical usually refers simply to supply-determined models
with optimizing agents and exible prices.
The monetarists, lead by Milton Friedman, attacked the policy activism of Keynesian-
ism on the grounds of time lags in policy implementation, uncertainty about the relevant
intervention, or mere government incompetence. The monetarists shared the notion that
nominal rigidities are of importance for short run mechanisms, although in their view the
short run was shorter than believed by Keynesians. Of lasting inuence was Friedmans
1
emphatic claim that while there is usually a short-run trade-o between ination and un-
employment, there is no long-run trade-o.
1
The reason is the endogeneity of ination
expectations in the long run it is impossible to fool rational people.
The New Classical counter-revolution, started by Robert Lucas, Thomas Sargent, and
Neil Wallace in the early 1970s and later joined by Robert Barro and Edward Prescott,
rejected Keynesian thinking altogether and started afresh. Or rather, they revived the
classical or Walrasian line of thinking, emphasizing the equilibrating role of exible prices
under perfect competition not only as long-run theory, but also as short-run theory. Lucas
epoch-making contribution was the systematic incorporation of uncertainty and rational
expectations into macroeconomics. When combined with the hypothesis of market clear-
ing by price adjustment, this gave rise to the policy-ineectiveness proposition claiming
that systematic monetary policy designed to stabilize the economy is doomed to failure.
Regarding the explanation of business cycle uctuations, there were two dierent strands
in this New Classical approach. Lucas monetary misperception theory (Lucas 1972 and
1975) emphasized shocks to the money supply as the primary driving force. In contrast,
the real business cycle theory of Kydland and Prescott (1982) and Prescott (1986) views
economic uctuations as primarily caused by shocks to real factors, productivity shocks.
Yet, the two strands were developed within the same type of stochastic modeling approach
with a Walrasian foundation.
Partly in response to the challenges from this New Classical Macroeconomics, partly
independently, other economists in the 1970s and the 1980s took a dierent line of attack.
Their general conception was that the Keynesian approach, when extended by some sort of
an expectations-augmented Phillips curve, performed well empirically; money neutrality
seemed a good approximation to the long-run issues, but not to short-run issues. For
these a Keynesian approach is more adequate. At the same time, however, the Keynesian
approach was considered in need of renements along several dimensions. Fortunately such
renements were now possible due to new analytical tools from microeconomic general
equilibrium theory and the rational expectations methodology.
We are here talking about a quite heterogeneous group of economists who are often
called New Keynesians. Their endeavour became known as the New Keynesian recon-
struction eort. Here we briey describe a few elements in this reconstruction.
The limitations of the old Keynesian theory addressed by the New Keynesians can be
1
Friedman (1968). Almost simultaneously the same point had been made by the more Keynesian
oriented Edmund Phelps (1967, 1968).
2
summarized in four points:
(1) The old theory did not encompass that nominal prices and wages do in fact change
somewhat over time in response to events in the economy.
(2) It was not made clear why nominal prices and wages change only sluggishly.
(3) The underlying microeconomics was not elucidated. What are the budget con-
straints faced by the economic agents? How are demand and supply determined
when some agents have market power and are price setters? If markets do not clear
by instantaneous adjustment of perfectly exible prices, how do they then clear
(reach a state of balance)? What kind of general equilibrium arises under these
circumstances, taking into account the spillovers across the dierent markets?
(4) The integration of forward-looking rational (unbiased) expectations into the theory
was only halfway. Shocks were treated in a peculiar (almost self-contradictory) way:
they could occur, but only as a complete surprise and a once-for-all event. Agents
expectations never incorporated that new shocks could arrive.
Problem (3) was in fact taken up rst, namely by the American economists Robert
Barro and Herschel Grossman (1971) and the French economists Jean-Pascal Benassy
(1975) and Edmond Malinvaud (1977). These contributions became known as macro-
economics with quantity rationing.
2
With prices and wages predetermined in the short
run by more or less monopolistic price setters, the short side of the market determines the
actual amount of transactions. This is called the minimum transaction rule. And with
price-setting rms and wage-setting workers (or trade unions) facing downward-sloping
demand curves, prices and wages are generally set above the marginal cost of production
and the marginal disutility of labor, respectively. Thus, given the prevailing prices and
wages, rms and workers are actually happy to produce and sell more than expected. In
this way aggregate output tends to be demand-determined. At the same time the con-
sumption demand by workers depends not only on wages, prices, and initial resources,
as in the Walrasian microeconomic theory, but also on how much of their labor supply
actually gets employed. In this way also quantity signals play a role and in contrast to
the Walrasian demand function we get a so-called eective demand function.
In the rst wave of macroeconomics with quantity rationing wages and prices were
treated as exogenous, which is of course not satisfactory. But a path-breaking paper
2
Barro later shifted to the new classical camp. His reasons are given in Barro (1979).
3
on general equilibrium with monopolistic competition by Blanchard and Kiyotaki (1987)
made it possible to integrate the quantity rationing framework with price setting behavior.
At about the same time Akerlof and Yellen (1985) and Mankiw (1985) developed the
menu cost theory. Sluggishness in price adjustment caused by small menu costs can
at the aggregate level have large real eects. This became an important element in the
New Keynesian theory of nominal rigidities.
2 Menu costs
The classical theory of perfectly exible wages and prices and neutrality of money seems
contradicted by overwhelming empirical evidence. At the theoretical level the theory
ignores that the dominant market form is not perfect competition. Wages and prices
are usually set by agents with market power. And there may be costs associated with
changing prices and wages. Here we consider such costs.
2.1 Two types of price adjustment costs
The literature has modelled price adjustment costs in two dierent ways. Menu costs
refer to the case where there are xed costs of changing price. Another case considered in
the literature is the case of convex adjustment costs, where the marginal price adjustment
cost is increasing in the size of the price change.
The most obvious examples of menu costs are of course costs associated with
1. remarking commodities with new price labels,
2. reprinting price lists and catalogues.
But the term menu costs should be interpreted in a much broader sense, including costs
of:
3. information-gathering,
4. recomputing optimal prices,
5. conveying the new directives to the sales force,
6. the risk of oending customers by frequent price changes,
4
7. search for new customers willing to pay a higher price,
8. renegotiating contracts.
Menu costs induce rms to change prices less often than if no such costs were present.
And some of the points mentioned in the list above, in particular point 7 and 8, may be
relevant also in the dierent labor markets.
When convex price adjustment costs are present, the situation is somewhat dierent.
Suppose, the price change cost for rm i is c
it
= c
i
(1
it
1
it1
)
2
. c
i
0. Then the rm
will want to avoid large price changes, which means that it tends to make frequent, but
small price adjustments. This theory is related to the customer market theory. Customers
search less frequently than they purchase. Alarge upward price change may be provocative
to customers and lead them to do search in the market, thereby perhaps becoming aware
of attractive oers from other stores. The implied kinked demand curve can explain
that rms are reluctant to suddenly increase their price.
3
Below we describe the role of the rst kind of price adjustment costs, menu costs, in
more detail.
2.2 The menu cost theory
The menu cost theory originated almost simultaneously in Akerlof and Yellen (1985) and
Mankiw (1985). It is one of the microfoundations provided by New Keynesians for the
presumption that nominal prices and wages are sticky in the short run. For simplicity, here
we shall talk mostly about prices and price-setting rms. To summarize the important
theoretical insight of the menu cost theory: there are menu costs associated with changing
prices. Even small menu costs can be enough to prevent rms from changing their price
in response to a change in demand. This is because the opportunity cost of not changing
price is only of second order, i.e., small; this is a reection of the envelope theorem (see
Appendix). But, owing to imperfect competition (price MC), the eect on aggregate
output, employment, and welfare of not changing prices is of rst order, i.e., large.
2.2.1 Point of departure: imperfect competition with price setters
To understand what determines prices and their sometimes slow movement over time, we
need a theory with agents that set prices and decide when to change them and by how
3
For details in a macro context, see McDonald (1990).
5
much. This brings agents with market power into the picture.
4
That is why imperfect
competition is a key ingredient in New Keynesian economics. The challenge is to explain
the behavior of price-setting suppliers on the basis of their objectives and constraints.
We assume a market structure with monopolistic competition:
1. There is a given large number, :. of rms and equally many (horizontally) dieren-
tiated consumption goods.
2. Each rm supplies its own good on which it has a monopoly and which is an im-
perfect substitute for the other goods.
3. A price change by one rm has only a negligible eect on the demand faced by any
other rm.
Another way of stating property 3 is to say that rms are small so that each good
constitutes only a small fraction of the sales in the overall market system. Each rm, facing
a downward-sloping demand curve, chooses a price which maximizes the rms prots,
and then the rm adjusts output to the demand at that price. Or equivalently, facing a
downward-sloping demand curve, each rm chooses an output level which maximizes the
rms prots and then the rm sets its price accordingly. There is no elaborate strategic
interaction between the rms. In that respect monopolistic competition is dierent from
oligopoly.
Sometimes a fourth property is included in the denition of monopolistic competition,
namely that each rm makes no prot. The interpretation is that there is a large set
of as yet unexploited possible dierentiated goods, and that there is free entry and exit.
But here we consider entry and exit as costly and time consuming. In the short run the
number of active rms is thus given.
With respect to asset markets our framework corresponds to Paul Krugmans The
Worlds Smallest Macroeconomic Model
5
in the sense that there are no bank-created
money and no other non-human assets than base money, the supply of which at the
beginning of the current period is `. Thus, changes in the money supply can not be
brought about through open market operations since there are no other nancial assets
4
Under perfect competition nobody sets prices. This is in fact a sign of a logical diculty within
perfect competition theory. To assign the price setting role to abstract market forces or an abstract
omnipotent Walrasian auctioneer is not of much help.
5
See Krugman (1999), http://web.mit.edu/krugman/www/MINIMAC.html.
6
for the central bank to buy or sell. Instead we have to imagine that a change in ` occurs
in the form of a lump-sum helicopter drop at the beginning of the period.
2.2.2 A price setting rm i
Firm i has the production function

i
= /
c
i
. 0 < c < 1.
where /
i
is labor input (physical capital is ignored). Thus, /
i
=
1c
i
. The demand,
o
i
, for
the rms output is perceived by the rm as given by

o
i
=

1
i
1

.
1
c
:


1(
1
i
1
. 1
c
). 1. (1)
where 1
i
is the price set by the rm and xed for some time, 1 is the general price level,
1
c
is the expected level of aggregate demand, and is the (absolute) price elasticity of
demand. The interpretation is that the rm faces a downward sloping demand curve the
position of which is given by the general level of demand.
Firm i chooses 1
i
with a view to the maximization of prot. The prot maximizing
quantity and price corresponds to the point where `1 = `C. i.e., where marginal revenue
equals marginal cost. Symmetry is assumed and so, if rm i chooses its price 1
i
equal to
the average price, 1. the rm expects its sales to equal the average real spending per
consumption good, 1
c
,:.
We assume there are no expectational errors and so 1
c
= 1. where 1 is the actual level
of aggregate demand. As in The Worlds Smallest Macroeconomic Model by Krugman
(1999), aggregate demand is proportional to the real money supply, i.e.,
1 = `,1.
where 0 is a parameter reecting consumers impatience. So (1) can be written

o
i
=

1
i
1

`
:1
1(
1
i
1
.
`
1
). 1. (2)
cf. Fig. 1. (Note that along the vertical axis we have the relative price, 1
i
,1. and both
`1 and `C are measured in real terms, i.e., relative to the general price level 1.)
7
i
Y
MC
MR
,
i
P M
D
P P




'
,
i
P M
D
P P




1/
i
W
Y
P

'
and given
M M
P P

1
0
i
P
P

Figure 1:
2.2.3 Even small menu costs can be operative
The nominal prot of rm i is

i
= 1
i

i
\
1c
i
= 1
i

1
i
1

`
:1
\

1
i
1

`
:1
!
1c
(1
i
. 1. \. `).
Suppose that initially, 1
i
= 1

i
. where 1

i
is the price that maximizes
i
. given 1. \. and
`. Thus, maximum prot is
(1

i
. 1. \. `)

i
.
Given the price 1
i
= 1

i
set in advance there is a shift in money supply to the new level
`
0
` through a lump-sum helicopter drop at the beginning of the period. Suppose
no other agents respond by changing price, neither price setters nor wage setters. Will
rm i in this situation have an incentive to change its price? Not necessarily. The reason
is that the menu cost may exceed the opportunity cost associated with not changing price.
The opportunity cost to rm i of not changing price tends to be small because we have
d
d`
(1

i
. 1. \. `) =
J
J1
i
(1

i
. 1. \. `)
J1
i
J`
+
J
J`
(1

i
. 1. \. `) (3)
= 0 +
J
J`
(1

i
. 1. \. `).
8

*
i

*
i
P *'
i
P
( , , , )
i
P P W M
i
P
( , , , ')
i
P P W M
i

Figure 2: The prot curve is at at the top (1 and \ are xed, ` shifts to `
0
`).
The rst term on the right-hand side of (3) vanishes at the prot maximum because
0
01

(1

i
. 1. \. `) = 0. i.e., the prot curve is at at the maximizing price 1

i
. An illus-
tration is shown in Fig. 2. Moreover, since our thought experiment is one where 1 and
\ remain unchanged, there is no indirect eect of the rise in ` via 1 or \. Thus, only
the direct eect through the fourth argument of the prot function is left.
The result reects a general principle, called the envelope principle: in an interior
optimum, the total derivative of a maximized function wrt. a parameter is equal to the
partial derivative wrt. that parameter.
6
The relevant parameter here is the aggregate
money supply, `. Hence, the eect of a change in ` on the prot is approximately
the same (to a rst order) whether or not the rm adjusts its price. Indeed, owing to
the envelope theorem, for an innitesimal change in `, the prot of rm i is the same
whether or not the rm adjusts its price in response to the change in `.
For nite changes in ` this is so only approximately. Indeed, given a nite change,
`, the opportunity cost of not changing price can, by taking a second-order Taylor
approximation, be shown to be of second order, i.e., proportional to (`,`)
2
. This
is a very small number, when |`,`| is small. Therefore, in view of the menu cost, say
c. it may be advantageous not to change price. Indeed, the net gain (= c opportunity
cost) by not changing price may be positive. Each individual rm is in the same situation
as long as the other rms have not changed price. The outcome that no rm changes its
price is thus an equilibrium. Since there is no change in the general price level in this
equilibrium, a higher output level results.
6
See Appendix.
9
2.2.4 A closer look at the labor market
The considerations above presuppose that workers do not immediately increase their wage
demands in response to the increased demand for labor. This assumption can be rational-
ized in two dierent ways. Either one can assume that also the labor market is character-
ized by monopolistic competition between craft unions, each of which supplies its specic
type of labor. If there are menu costs associated with changing the wage claim and they
are not too small, the same envelope theorem logic as above applies and so an increase in
labor demand need not have any eect on the wage claims.
There is an alternative way of rationalizing absence of no immediate upward wage
pressure which is more apt in our case. This is because we have treated labor as homo-
geneous so that there is no basis for existence of many dierent craft unions. Instead we
simply assume there is involuntary unemployment in the labor market. By denition this
means that there are people around without a job but willing to take a job at the going
wage or even a lower wage. Such a situation is in fact what several labor market theories
tell us we should expect often to be present. Both eciency wage theory, insider-outsider
theory, and collective bargaining theory imply that wages tend to be above the individual
reservation wage. Thus involuntary unemployment arises, hence employment can easily
change with negligible eect on the wage level in the short run.
2.2.5 Menu costs in action
We have thus seen that even small menu costs can be enough to prevent rms from
changing their price in response to a change in demand. This also implies that even
small menu costs can have sizeable eects on aggregate output, employment, and social
welfare. To understand this latter point, note that under monopolistic competition neither
output, employment or social welfare are maximized in the initial equilibrium. Therefore
the envelope theorem does not apply to these variables.
Let us return to Fig. 1 where this line of reasoning is illustrated. For xed `
and 1. the demand curve faced by rm i is shown as the solid downward-sloping curve
1(1
i
,1. `,1) to which corresponds the marginal revenue curve, `1. For xed 1 and
\. the marginal costs faced by the rm are shown as the upward-sloping marginal cost
curve, `C (as mentioned, `1 and `C are measured in real terms, i.e., relative to the
general price level 1). Suppose that initially all prices are set optimally in accordance
with the `1 = `C rule. Hence, `1 = `C and 1
i
,1 = 1 initially.
10
Consider a moderate shift in the money supply from ` to `
0
`. If there were no
menu costs, prices would increase and leave real money supply and output unchanged.
But when menu costs exist, it is possible that neither prices nor wages change. Then, the
higher nominal money supply translates into higher real money supply and the demand
curve is shifted to the right. As still 1
i
,1 `C. the rm willingly produces and sells
the extra output corresponding to the higher demand. The extra prot obtained this way
is marked by the hatched area in Fig. 1. In the other production lines the rms are in
the same situation and willingly increase output. As a result, aggregate output increases
which translates into higher employment. The nal outcome is higher consumption and
higher welfare.
Thus, the eects on aggregate output, employment, and social welfare of not changing
price can be substantial; they are of rst order, namely proportional to |`,`| .
In the real world, nominal aggregate demand (here proportional to money supply)
uctuates up and down around some expected level. Sometimes the welfare eects of
menu costs will be positive, sometimes negative. Hence, on average the welfare eects
would appear to cancel out to a rst order. This does not aect the basic point of the
menu cost theory, however, which is that changes in money supply can have rst-order
real eects (positively correlated with the money change) because the opportunity costs
by not adjusting prices are only of second order.
3 Appendix
ENVELOPE THEOREM Let = ,(c. r) be a continuously dierentiable function of
two variables, of which one, c, is conceived as a parameter and the other, r. as a control
variable. Let q(c) be a value of r at which
0)
0a
(c. r) = 0, i.e.,
0)
0a
(c. q(c)) = 0. Let
1(c) ,(c. q(c)). Provided 1(c) is dierentiable,
1
0
(c) =
J,
Jc
(c. q(c)).
where J,,Jc denotes the partial derivative of ,() wrt. the rst argument.
Proof 1
0
(c) =
0)
0o
(c. q(c)) +
0)
0a
(c. q(c))q
0
(c) =
0)
0o
(c. q(c)), since
0)
0a
(c. q(c)) = 0 by
denition of q(c).
That is, when calculating the total derivative of a function wrt. a parameter and
evaluating this derivative at an interior maximum wrt. a control variable, the envelope
11
theorem allows us to ignore the terms that arise from the chain rule. This is also the case
if we calculate the total derivative at an interior minimum.
7
7
For extensions and more rigorous framing of the envelope theorem, see for example Sydsaeter et al.
(2006).
12