Output and Welfare Effects of Inflation with Costly Price and Quantity Adjustments

Abstract

There exists by now a burgeoning literature concerned with the consequences of a fixed cost of price adjustment. Due to this cost, a monopolistic firm does not necessarily adjust its price even though the current price deviates from the price that would maximize the firm's current profit. As a result, the production generally differs from what it would be in the absence of a menu cost, with the effect of inflation on the average output and welfare under monopolistic competition being ambiguous and depending in a complicated way on the profit and demand functions. 1 However, one strong result holds unambiguously for all profit and demand functions: at low inflation rates, the average output and welfare are above their levels at full price stability where firms charge the static monopoly price.2 The driving force is that discounting makes a firm more concerned with its real profits earlier in a period with a constant nominal price than with its real profits later in the period. In fact, as the inflation rate approaches zero, the firm's initial real price converges to the profit-maximizing real price, while the terminal real price converges to a smaller real price. At low inflation rates, therefore, a firm's price is most of the time below the price that would maximize the current profit. Since output and welfare under monopolistic competition are inversely related to price, average output and welfare are higher than under full price stability. The inevitable conclusion is that the economy benefits from a little bit of inflation. A critical assumption underlying this result is that firms can continuously adjust their production to satisfy demand. So while the menu-cost literature explicitly assumes that there is a small fixed cost incurred at each price adjustment, it also implicitly assumes that it is costless to continuously adjust the quantity of output.3 This is, however, a questionable assumption. There is some empirical evidence indicating the existence of a cost of quantity adjustment, part of which is fixed in that it does not depend on the size of the adjustment.4 The cost of quantity adjustment stems from the need to rearrange and reorganize the factor inputs for the new level of production and includes managerial time and effort. A fixed cost of quantity adjustment rules out any continuous adjustment of the production to satisfy the increasing demand that results from a decreasing real price within a period with a constant nominal price. Under the reasonable assumption that the menu cost does not exceed the fixed cost of quantity adjustment,5 in an inflationary environment a firm chooses to adjust its nomi-