Adapting Prices or Quantities in the Presence of Adjustment Costs?

Abstract

A dominant explanation of price rigidity is the so-called "menu cost model" according to which small costs of changing prices may imply that firms keep nominal prices unchanged to nominal shocks which therefore have real effects. Crucial to this explanation is the assumption that price adjustment is costly while quantity adjustment is not. This paper analyzes the role of costs of adjusting both prices and quantities, and it is found that the "small cost" argument used to support menu cost models does not hold. The predictions of menu cost models only hold if price adjustment costs are larger than quantity adjustment costs. Empirical evidence clearly indicates that the costs of adjusting quantities are non-trivial. Quantity adjustment costs also open for the possibility of non-market clearing.

JEL Classification: E32