SMALL MENU COSTS AND LARGE BUSINESS CYCLES: A MACROECONOMIC MODEL OF MONOPOLYX The conflict between modern neoclassical and traditional Keynesian theories of the business cycle centers upon the pricing

The conflict between modern neoclassical and traditional Keynesian theories of the business cycle centers upon the pricing mechanism.' In neoclassical models, prices are fully flexible. They represent the continuous optimization of economic agents and the continuous intersection of supply and demand. In Keynesian models, prices are often assumed to be sticky. They do not necessarily equilibrate all markets at all times. One of the reasons for the resurgence of the equilibrium approach to macroeconomics has been the absence of a theoretical underpinning for this Keynesian price stickiness. This note shows that sticky prices can be both privately efficient and socially inefficient. The business cycle results from the suboptimal adjustment of prices in response to a demand shock. To the extent that policy can stabilize aggregate demand, it can mitigate the social loss due to this suboptimal adjustment. In some Keynesian models, prices are simply exogenously fixed.2 In others, agents must set their prices in advance of the transaction date.3 The act of altering a posted price is certainly costly. These costs include such items as printing new catalogs and informing salesmen of the new price. Yet these "menu" costs are small and, therefore, generally perceived as providing only a weak foundation for these fixed-price models. However, this inference is flawed. Small menu costs can cause large welfare losses. The claim that price adjustment costs are small does not rebut the claim that they are central to understanding economic fluctuations.