WAGE FLEXIBILITY, MENU COSTS, AND PRICE-LEVEL STICKINESS

I consider the relation between wage determination and price level stickiness along the lines of the menu costs approach. I allow for flexible wages and a variable fraction of firms adjusting their prices in response to aggregate demand shocks. Strategic substitutability between firms arises for empirically plausible parameter values implying (1) a price elasticity of aggregate supply which is neither zero nor infinite and (2) unrealistically high menu costs. Efficiency wages as well as fixed wages imply that either all firms do or do not adjust prices. In both cases, menu costs required for fixed prices are quite small.