SummaryInflation and unemployment can be very harmful to the economy. However, knowing how a problem originates is always helpful when trying to fix it. This is the reason why economists have created an incredible amount of economic models that try to explain how inflation and unemployment behave. In this LP we take a look at a few economic models that explain, at least to some extent or in some given context, inflation and unemployment.
Menu costs are costs that result from price changes. An easy way to understand menu costs is by means of a typical example: restaurants. When a restaurant manager wants to change prices, the cost of changing the menus (in order to show the new prices) must be taken into consideration. Therefore, the manager will need to assess whether the increase in prices will cover for the cost of printing new menus.
As Gregory Makiw demonstrates in his article “Small Menu Costs and Large Business Cycles: A Macroeconomic Model of Monopoly”, 1985, this menu costs may lead to a non-socially optimal situation. Indeed, Mankiw’s menu costs model shows how higher menu costs may lead to a situation where prices remain unchanged, thus provoking so called price stickiness.
Contrary to what economists from the New Classical Macroeconomics think, which is that business cycles are originated by shifts in supply (which originate mainly from technological shocks), New Keynesian economists believe that business cycles are originated by price stickiness. This price stickiness might be explained by menu costs, since the slow adjustment of the economy may explain business cycles.
There is a great debate over the following question: are these menu costs really large enough to cause business cycles? An article from Daniel Levy et al., “The Magnitude of Menu Costs: Direct Evidence from Large U.S. Supermarket Chains”, 1997, demonstrates, using empirical evidence, that these menu costs are indeed large enough to cause business cycles. The authors use store-level data from five multistore supermarket chains to directly measure menu costs. They find that the menu costs per store at those chains average more than 35% of net profit margins, which may be forming a barrier to price changes. When applying these findings to theoretical models of menu costs, the authors conclude that these menu costs are large enough to be capable of having macroeconomic significance. Furthermore, they believe that these menu costs may cause considerable nominal rigidity in other industries or markets, thus amplifying the effects on business cycles. These menu costs, they say, vary largely due to local and regional legislation, which may require, for instance, a separate price tag on each item, thus increasing menu costs.