The neutrality of money stands as one of classical economics' most elegant propositions. Double the money supply, and prices double—leaving real quantities unchanged. Yet central bankers worldwide dedicate extraordinary resources to manipulating monetary conditions, and empirical evidence consistently shows that monetary policy affects output and employment for extended periods.

This apparent contradiction dissolves once we recognize that prices do not adjust instantaneously. Nominal rigidities—the tendency for prices and wages to remain fixed in nominal terms despite changing economic conditions—transform monetary policy from a veil over real activity into a powerful lever for macroeconomic stabilization. The New Keynesian research program has made understanding these rigidities its central theoretical project.

The stakes extend far beyond academic interest. Different micro-foundations for price stickiness yield dramatically different predictions about monetary policy's transmission mechanism, optimal policy design, and the welfare costs of inflation. Whether firms face menu costs, contractual obligations, or information frictions determines how aggressively central banks should respond to demand shocks and what inflation targets best serve economic welfare. This analysis examines the theoretical foundations and empirical evidence underlying our understanding of nominal rigidities.

The menu cost literature begins with a simple observation: adjusting prices requires resources. Firms must gather information about market conditions, calculate optimal prices, print new catalogs, update point-of-sale systems, and communicate changes to customers. These costs appear trivially small—early calibrations suggested figures around 0.7 percent of revenue annually. Yet strategic complementarity transforms negligible individual frictions into substantial aggregate rigidity.

Strategic complementarity arises when one firm's optimal price depends positively on other firms' prices. If my competitors maintain their prices, aggressive price increases risk losing market share, while aggressive cuts sacrifice margin unnecessarily. This interdependence creates a coordination problem. Each firm, facing a monetary shock, waits to see how others respond—and when everyone waits, prices remain sticky collectively despite the private incentive to adjust.

The mathematics reveals a striking amplification mechanism. Let the elasticity of individual optimal prices with respect to the money supply be denoted by θ, and the elasticity with respect to the general price level by α. When α is large (high strategic complementarity), individual firms find it optimal to move only partially toward their new equilibrium price, even absent menu costs. Adding even infinitesimal adjustment costs then generates complete nominal rigidity over relevant time horizons.

Laurence Ball and David Romer formalized this insight, demonstrating that menu costs generating merely second-order private losses produce first-order aggregate welfare effects. The externality operates through demand spillovers: when firm A maintains its price following a monetary contraction, it produces less output, reducing income available to purchase from firm B. This cascade magnifies the real effects of nominal shocks far beyond what individual optimization problems would suggest.

Real rigidities—factors that flatten firms' desired price responses to changing conditions—amplify strategic complementarity's power. Increasing marginal costs, customer relationships that penalize price variability, and nominal wage contracts all reduce the private cost of maintaining suboptimal prices while preserving the social costs of misallocated resources. The interaction between real and nominal rigidities explains why monetary shocks can affect output for years despite adjustment costs that firms could easily absorb.

Takeaway

Tiny individual costs of changing prices can generate massive aggregate effects through strategic complementarity—when optimal pricing depends on competitors' choices, coordination failures transform negligible frictions into economy-wide rigidity.

The Calvo model's elegance derives from a radical simplification: each period, a randomly selected fraction (1-θ) of firms receive the opportunity to adjust prices, regardless of how far current prices deviate from optimal levels. This time-dependent structure permits log-linearization and yields the workhorse New Keynesian Phillips Curve relating inflation to expected future inflation and the output gap.

State-dependent alternatives, including menu cost models with explicit adjustment thresholds, allow firms to choose when to adjust based on the gap between current and optimal prices. When nominal prices drift sufficiently far from targets, firms pay the menu cost and reset optimally. This Ss framework—named for the trigger bounds defining inaction regions—generates more realistic cross-sectional price behavior but complicates aggregation considerably.

The policy implications diverge substantially. Under Calvo pricing, monetary policy's real effects depend primarily on the frequency of price adjustment. A shock that moves all desired prices by 5 percent produces output effects that decay as successive cohorts of firms adjust. The response function is approximately linear in shock size, and money remains persistently non-neutral regardless of shock magnitude.

State-dependent models exhibit fundamentally different dynamics. Small monetary shocks produce persistent real effects—few prices cross adjustment thresholds, maintaining rigidity. But large shocks trigger widespread repricing, potentially restoring neutrality rapidly. This selection effect means firms adjusting prices are those with the largest gaps, amplifying the price level response to shocks. Golosov and Lucas demonstrated that calibrated state-dependent models can eliminate monetary non-neutrality entirely for shocks of relevant policy magnitude.

Recent theoretical advances have reconciled these perspectives partially. Adding strategic complementarity to menu cost models dampens the selection effect—even firms with large price gaps may delay adjustment when competitors maintain prices. Multi-product firms, which the data strongly support, exhibit smoother aggregate adjustment as products cycle through thresholds asynchronously. The choice between frameworks depends critically on the policy question: Calvo serves admirably for business cycle analysis around steady state, while state-dependent models better address regime changes and large disinflationary episodes.

Takeaway

How firms decide when to change prices—randomly over time or deliberately when gaps grow large—determines whether monetary policy loses potency during major shocks, a distinction crucial for understanding extraordinary interventions.

The empirical revolution in price-setting research began with Bils and Klenow's examination of Bureau of Labor Statistics microdata underlying the Consumer Price Index. Their finding that prices change approximately every four months initially appeared to challenge New Keynesian models requiring substantial stickiness. Median price duration seemed insufficient to generate observed monetary policy persistence.

Subsequent research complicated this picture considerably. Nakamura and Steinsson distinguished temporary promotional sales from regular price changes, finding regular price duration averaging nearly one year. The distinction matters theoretically: if sales represent anticipated price variation along known demand curves, they may not indicate flexibility in response to aggregate shocks. Regular prices, which respond to cost and demand fundamentals, exhibit far greater persistence.

The microdata also revealed enormous sectoral heterogeneity. Gasoline prices adjust weekly; services prices persist for years. This heterogeneity creates compositional effects in aggregate measures and complicates the mapping from micro frequencies to macro dynamics. Multi-sector models incorporating realistic cross-industry variation generate more persistent real effects than single-sector calibrations with equivalent average stickiness.

Perhaps most importantly, price changes exhibit both large magnitudes and negative serial correlation—patterns consistent with menu cost models but not with Calvo's purely time-dependent adjustment. Firms that adjust prices move them substantially, then maintain new prices for extended periods. The data reject models implying smooth, frequent small adjustments while supporting frameworks emphasizing discrete, infrequent large changes.

Information rigidities offer a complementary explanation. Mankiw and Reis proposed sticky information—firms update their information sets infrequently, even if price adjustment itself is costless. Mackowiak and Wiederholt developed rational inattention frameworks where limited cognitive processing capacity generates optimal incomplete responses to aggregate shocks. These theories explain why firms might not adjust prices even absent direct menu costs, and why measured price flexibility may overstate firms' responsiveness to monetary policy. The empirical program continues refining our understanding of which frictions dominate in which circumstances.

Takeaway

Microdata reveals that headline price change frequency dramatically overstates flexibility—distinguishing temporary sales from fundamental repricing and accounting for sectoral heterogeneity restores substantial nominal rigidity consistent with monetary policy effectiveness.

Price stickiness transforms monetary economics from a study of nominal quantities without real consequence into the analysis of how central banks influence output, employment, and welfare. The research program examining nominal rigidities has progressed from identifying that prices are sticky to understanding why and when they exhibit such behavior.

The theoretical frameworks—menu costs with strategic complementarity, time-dependent and state-dependent adjustment rules, information frictions—each illuminate different aspects of price-setting behavior. Their synthesis with increasingly detailed microdata enables monetary economists to move beyond calibration to empirically disciplined structural estimation.

For policy design, these foundations matter profoundly. The optimal response to demand shocks, the appropriate inflation target, and the channels through which unconventional policies operate all depend on the nature and extent of nominal rigidities. Understanding price stickiness remains not merely foundational but essential to effective monetary policy in complex economic environments.