This paper studies the consequences for the behaviour of aggregate output of the perception on the part of firms that changing prices is costly. The rational expectations equilibrium of an economy with many such firms is constructed. It is shown that in this economy nominal shocks have a persistent effect on aggregate output. Furthermore, the real wage is demonstrated to move procyclically in such an economy.

It has often been argued that prices are sticky in the United States. However, the empirical papers that have claimed to support this view have not reflected any formal behavioral theory. This paper presents a theory that justifies price stickiness, namely, that firms, fearing to upset their customers, attribute a cost to price changes. The rational expectations equilibrium of an economy with many such firms is presented, estimated with postwar U.S. data, and tested against alternative hypotheses. The results largely support the model. Furthermore, the hypothesis that prices are not sticky is rejected by U.S. data.

[It has often been argued that prices are sticky in the United States. However, the empirical papers that have claimed to support this view have not reflected any formal behavioral theory. This paper presents a theory that justifies price stickiness, namely, that firms, fearing to upset their customers, attribute a cost to price changes. The rational expectations equilibrium of an economy with many such firms is presented, estimated with postwar U.S. data, and tested against alternative hypotheses. The results largely support the model. Furthermore, the hypothesis that prices are not sticky is rejected by U.S. data.]