Question

Define the concept of menu costs and explain its relationship with the assumption of monetary neutrality

Answer 1

ANSWER-

Menu costs refer to an economic term used to describe the cost incurred by firms in order to change their prices. How expensive it is to change prices depends on the type of firm. For example, it may be necessary to reprint menus, update price lists, contact a distribution and sales network or manually re-tag merchandise on the shelf. Even when there are few apparent menu costs, changing prices may make customers apprehensive about buying at the new price. This purchasing hesitancy can result in a subtle type of menu cost in terms of lost potential sales.

Understanding Menu Costs

The main takeaway from menu costs is that prices are sticky. That is to say, firms are hesitant to change their prices until there is a sufficient disparity between the firm's current price and the equilibrium market price. In theory, a firm should not change its price until the price change will result in enough additional revenues to cover the menu costs. In practice, however, it may be difficult to determine the equilibrium market price or to account for all menu costs, so it is hard for firms and consumers to behave precisely in this manner.

Relation

A model of endogenous price adjustment under money growth is presented. Firms follow (s, S) pricing policies and price revisions are imperfectly synchronized. In the aggregate, price stickiness disappears and money is neutral. The connection between firm price adjustment and relative price variability in the presence of monetary growth is also investigated. The results contrast with those obtained in models with exogenous fixed timing of price adjustment.

The concept of menu costs was originally introduced by Eytan Sheshinski and Yoram Weiss in 1977. The idea of applying it as a general theory of nominal price rigidity was simultaneously put forward by several New Keynesian economists from 1985 to 1986. George Akerlof and Janet Yellen, for example, put forward the idea that, due to bounded rationality, firms will not want to change their price unless the benefit is more than a small amount. This bounded rationality leads to inertia in nominal prices and wages, which can lead to output fluctuating at constant nominal prices and wages.