The Increasing-Returns-to-Scale/Sticky-Price Approach to Monetary Analysis

A new approach to the analysis of the effects of monetary policy on economic activity is developing. Its pioneers are Benhabib and Farmer (1992) and Beaudry and Devereux (1993, 1995). The combined assumptions of increasing returns to scale (IRS) in production and sticky prices identify this approach.1 The goal is to rationalize slow price adjustment in response to monetary shocks and, consequently, strong and persistent real effects of monetary policy in a fashion consistent with market clearing. The IRS/sticky-price theory is new, ambitious, and exciting. The traditional approach to sticky prices of the type advanced by Phelps and Taylor (1977) and Fischer (1977) assumes (with no attachment to IRS) that prices are preset for a certain period of time. Thus, when new information on economic conditions arises that was unanticipated when prices were set, those prices are necessarily inconsistent with full optimization on the part of all agents and hence with market clearing. Furthermore, the real effects of money shocks are of short duration, stemming from the short period over which prices are preset. The inconsistency with market clearing and the lack of persistence in the real effects of money are widely viewed as significant weaknesses in the traditional theory. The new theory comes to grips with both of these weaknesses. In striking contrast to the traditional theory, the IRS/sticky-price theory explains how prices are free