Mankiw Model of Nominal Rigidities 

There are two related reasons for which  firms do not  frequently change prices. First, as we saw in the discussion on menu costs, the costs of price changes are not negligible and could exceed the private benefits that can be obtained by  the firms in the form of increased profits. More importantly, however, the benefits to be reckoned from price changes are not so much  in the private realm, but  in the social realm. Price rigidity leads to unemployment, the social costs of which are much higher than the private costs reckoned by  the firms in terms of menu costs. The microeconomics -based models by Mankiw, and Akerlof and Yellen clearly show that the private benefits of changing a price can be much  smaller than the social benefits if there is substantial monopoly power in the economy. 

We  follow Dornbusch, Fischer  and  Startz  (2004) in presenting  a  simplified version of  the  formal Mankiw model.  The model  relies  on  the  fact  that in monopolistic markets firms face  a  downward-sloping (less than infinitely elastic) demand curve and can set a price that deviates from the optimum profit- maximising price without a large swing in demand away from the firm. This is not  possible in  a  perfectly competitive market, where every firm faces  a horizontal (infinitely elastic) demand curve -  a small deviation from the optimal price can  in this situation lead to a large swing demand and profits away  from the  firm. Even  if a  competitive firm faces the  same kind  of menu costs as an imperfectly competitive firm, the loss of profits by  not changing the price can be big enough to outweigh  the menu costs. A competitive firm is not, of course, a price setter. Not  so for the  imperfectly competitive firm. Mankiw shewed that the potential profits  from  raising prices could be  very  small for  such firms especially if the elasticity of demand for firm's output is low, i.e.,  if monopoly power of the firm is  high,  and  if  the deviation of  the  actual price from the optimal profit- maximising price  is  small.  The menu  cost could  well be higher  than the potential profits in such a  case and the  firm does not  change  its price. Other firms are likely to be similar and they too leave their prices unchanged, with the result that the nominal price level remains unchanged. The Keynesian conclusion of an increase in money supply on output rather than on prices follows from this.  An  increase  in money supply,  prices remaining unchanged, leads to an increase in real money supply. This leads to an increase in aggregate output, either through  a  decrease  in the  rate  of interest  (a  la Keynes) or through a real-balance effect. You should note that there would have been  no  output  effects in  a classical  model if  prices were  free  to  vary.  An important  difference  between the  classicals  and the Keynesians  is  hereby established. 

As  Dornbusch, Fischer and  Startz  (2004, p.  566) put  it  about the papers  of Mankiw, and Akerlof and Yellen: 

This work  provides a  rigorous microeconomic justification for nominal price stickiness. Since New Classical economists  attack the rigcr of the underpinnings of Keynesian models, such  justification is a key piece of Keynesian response to rational  expectations and  real  business cycle models. Not everyone agrees on the  empirical significance of  the  formulation by  Mankiw and  by  Akerlof and Yellen,  but  the  work  is  certainly a mile  stone  in  the New  Keynesian counterrevolution.