This is basically a co-sign on Nick Rowe, but in the terms I am used to.

Arnold Kling asks

If I have this right (and the main reason I am writing this post is to get feedback on whether I have this right), then this is a bit different from the Scott Sumner mechanism. In Rowe’s world, when the money supply contracts, producers are caught temporarily off guard and prices stay too high. This reduces M/P, leading to lower spending and output. In Sumner’s world, when the money supply contracts, price-setters read the situation clearly but nominal wages are sticky. Nominal GDP falls relative to nominal wages, and output contracts.

The issue with sticky wages is that they imply when prices rises real wages should fall, but they don’t they rise.

The mechanism that I am used to is that its not just that producers are caught of guard but that they face costs in changing prices. These might be literal menu costs. It might be that part of the benefit of lowering prices goes to producers of substitutes.

I tend to think that stable prices contribute to maintaining monopoly power. I am thinking of course of a monopolistic competition model. One in which there are lots of differentiated products. Consumers face a cost in deciding which product is best for them given all of the relative prices. If a producer changes his or her prices its harder for the consumer to perform this analysis. Thus consumers shy away from differentiated products which change prices a lot.

In business I think people would say that if you move your prices a lot you are “commoditizing” your product. That is, people will start judging your product more  based on its price rather than your perceived quality difference.

Since its in the benefit of each profit maximizing company to hold its prices still but doing so hurts the general equilibrium there is an externality associated with unexpected price changes. This externality is why government intervention can improve the market result.

Now to me this all seems like the basic New Keynesian story and indeed its more or less how Greg Mankiw explains it on the EconLib website.

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