Nominal price rigidities—including explicit contracts, menu costs, information constraints, and coordination frictions—prevent prices from adjusting instantly to changes in demand or costs. When prices are sticky, monetary shocks cannot be fully offset by proportional price increases, allowing money to have real short-run effects on output and employment. Understanding the sources, magnitude, and duration of price adjustment frictions is central to New Keynesian models and monetary policy analysis.
From your study of monopolistic competition, you know that firms set their own prices rather than taking a market price as given. Each firm faces a downward-sloping demand curve and chooses the price that maximizes its profit, balancing higher margins against lower sales volume. This market structure is the prerequisite for understanding sticky prices because it explains why firms have pricing discretion in the first place—and therefore why the decision of when and how to change prices becomes economically meaningful.
In a perfectly competitive market, prices adjust automatically to clear supply and demand; no individual firm makes a pricing decision. But monopolistically competitive firms must actively decide to change their prices, and this decision involves costs. Menu costs are the most concrete example: the literal expense of printing new catalogs, updating websites, reprogramming registers, and renegotiating contracts. These costs are typically small for any individual price change—perhaps a few hundred dollars for a restaurant reprinting its menu. The puzzle is how such small costs can have large macroeconomic consequences. The answer lies in a key insight from Mankiw (1985) and Akerlof and Yellen (1985): near the profit-maximizing price, the firm's profit function is very flat. A small deviation from the optimal price costs the firm almost nothing in lost profit (second-order loss), so even a tiny menu cost can make it rational to leave the price unchanged. But the macroeconomic consequences of unchanged prices are first-order—when many firms fail to adjust prices after a monetary shock, aggregate demand changes translate into output changes rather than being absorbed by price movements.
Beyond menu costs, several other mechanisms generate nominal rigidity. Contracts fix prices for specified periods—wages are typically renegotiated annually, rental agreements lock in rates for years, and supply contracts specify prices for months. Information frictions mean firms may not immediately observe changes in demand or costs, and even when they do, they face uncertainty about whether changes are temporary or permanent. Coordination failures arise because each firm's optimal price depends on what other firms charge; if a firm expects competitors to hold prices steady, it may rationally do the same, creating a self-reinforcing equilibrium of price stickiness. These mechanisms interact and amplify one another: a firm facing menu costs, contractual obligations, and uncertainty about competitor behavior has strong reasons to delay price adjustment.
The macroeconomic consequence of sticky prices is that monetary policy has real effects in the short run. If the central bank increases the money supply and prices were perfectly flexible, all prices would rise proportionally and nothing real would change—monetary neutrality would hold. But with sticky prices, many firms leave their prices unchanged in the short run. The increase in nominal spending translates into higher real demand at prevailing prices, firms respond by producing more, and output and employment rise. This is the core mechanism of New Keynesian economics: nominal rigidities provide the friction that allows monetary policy to affect real economic activity. The duration and magnitude of these real effects depend on how quickly and how completely prices eventually adjust—questions that the Calvo pricing model and its alternatives formalize by specifying the stochastic process governing price changes.