Sticky Prices?

Arguably the most difficult question in macroeconomics is: why do individuals set prices in nominal terms that do not respond to changes in the aggregate price level? Of course some must respond, or the aggregate does not change, but many prices seem sticky in the short run. In popular macro models, including those used by most policy makers, this is an assumption. We derive it as a result. We use search-based theory, where money is a genuine medium of exchange, so it is natural that prices are set in dollars, and equilibrium yields a nondegenerate price distribution, where low-price sellers earn less per unit but make it up on the volume. When the money supply increases, the real price distribution is invariant, but not all sellers need change nominal prices. If you do not change, with inflation, your real price falls but profit does not. Hence, you can change prices infrequently. The model is consistent with the following micro observations: sellers who change do not all change to the same price; some prices go down even during inflation; the frequency of price changes increases with inflation; and sellers who have not changed recently are more likely to do so. In a sense, we provide -- finally -- microfoundations for the critical assumption in Keynesian economics. But the policy implications are completely different: we show that price stickyness does not entail monetary nonneutrality. If the central bank tries to raise output by printing money, say, prices respond and the policy fails.