Sticky Prices and Menu Costs

Why many prices and wages adjust slowly, and why this slow adjustment gives monetary policy real effects in the short run.

If prices and wages adjusted instantly to every change in demand, recessions would be brief: prices would fall, and people would buy again. In reality, many prices and wages change only slowly. Economists call this price stickiness or nominal rigidity.

Evidence of stickiness

Studies of millions of individual prices find that many goods keep the same price for months. Wages are often set once a year. Wage cuts are especially rare: employers avoid cutting pay because it damages morale.

Why prices are sticky

Menu costs: changing prices takes effort and money, such as printing new menus, updating price tags and informing customers. The term comes from restaurants, but applies widely.
Contracts: wages and many prices are fixed by contracts for a period.
Customer relations: firms fear upsetting customers with frequent price changes.
Coordination: a firm may not want to cut prices first if competitors keep theirs.

Economists George Akerlof and Janet Yellen, and separately Gregory Mankiw, showed in the 1980s that even small menu costs can cause large economic effects, because each firm’s reluctance to adjust adds up across the economy.

Why it matters

Sticky prices explain why money is not neutral in the short run. If the central bank cuts interest rates and demand rises, firms respond at first by producing more rather than raising prices. So monetary policy affects output and jobs in the short run. Over time, as prices adjust, the effects mainly show up in prices.

This idea is central to New Keynesian economics, the framework used by most central banks, including the RBI, to model the economy.

Digital prices

Online retailers and ride-hailing apps can change prices instantly, sometimes many times a day. Some economists study whether this is making prices more flexible, though many prices, including wages and rents, remain sticky.

The restaurant menu

A restaurant's costs rise slightly. Reprinting menus and explaining new prices to regulars is a hassle, so the owner waits several months, then raises prices all at once. Across millions of businesses behaving this way, the overall price level adjusts slowly to changes in demand.

Thinking sticky prices are caused by lazy businesses

Price stickiness reflects real costs, contracts and customer relationships. It is often a rational business choice, even though it has big effects on the whole economy.

Key takeaways

Many prices and wages adjust slowly, called nominal rigidity.
Menu costs, contracts, customer relations and coordination explain stickiness.
Sticky prices mean monetary policy affects output in the short run.
The idea is central to New Keynesian models used by central banks.