American Economic Association

Monopolistic Competition and the Effects of Aggregate Demand

Author(s): Olivier Jean Blanchard and Nobuhiro Kiyotaki
Source: The American Economic Review, Vol. 77, No. 4 (Sep., 1987), pp. 647-666
Published by: American Economic Association
Stable URL: http://www.jstor.org/stable/1814537
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 Monopolistic Competition and the Effects
of Aggregate Demand
By OLIVIERJEANBLANCHARDAND NOBUHIROKIYOTAKI*

How importantis monopolistic competitionto an understanding of the effectsof

aggregatedemandon output?Weask the questionat threelevels.Canmonopolis-
tic competition,
by itself,explainwhyaggregatedemandmovements affectoutput?
Can it, togetherwithotherimperfections, generateeffectsof aggregatedemandin
a way thatperfectcompetition cannot?If so, can it givean accurateaccountof the
responseof the economyto aggregatedemandmovements?The answersare no,
yes, andyes.

Monopolisticcompetitionprovidesa con- Section I builds a simple general equi-

venient conceptual frameworkin which to
think about price decisions,and appearsto
describemany marketsmoreaccuratelythan
perfect competition.But, how importantis
monopolisticcompetitionfor macroeconom-
ics? In particular,how importantis monopo-
listic competitionto an understandingof the
effects of aggregate demand on economic
activity?This is the questionwe analyzein
this paper.
One can ask the questionat three levels.
First, using perfect competitionas a bench-
mark, can monopolistic competition, by
itself, explain why aggregatedemandmove-
ments affectoutput?Second,can monopolis-
tic competition, together with some other
imperfection, generate effects of aggregate
demand in a way that perfect competition
cannot?Third,takingas giventhat aggregate
demand movementsaffect output, can mo-
nopolistic competitiongive a more accurate
account of the responseof the economy to
aggregatedemand shocks?The paper ana-
lyzes these three questionsin turn.
*Departmentof Economics,MIT, CambridgeMA
02139,andUniversityof Wisconsin,Madison,WI 53706,
respectively.We thank AndrewAbel, LaurenceBall,
Russell Cooper, RudigerDornbusch,StanleyFischer,
Mark Gertler, Robert Hall, Andrew John, Kenneth
Rogoff, Jeffrey Sachs, Lawrence Summers, Martin
Weitzman,and two refereesfor discussionsand sugges-
tions. We thank the NationalScienceFoundationand
the Sloan Foundationfor financialsupport.
647
libriummodel, with goods, labor, and mon-
ey, and monopolisticcompetitionin both the
goods and the labor markets.It then char-
acterizes the equilibrium.Section II char-
acterizesthe inefficiencyassociatedwith mo-
nopolistic competitionand shows that it is
associatedwith an aggregatedemandexter-
nality. It shows that this externalitycannot,
however, explain why pure aggregatede-
mand movementsaffect output. In particu-
lar, it cannot explainwhy changesin nomi-
nal money have real effects.The answerto
the first question is thereforenegative.Sec-
tion III studies the effects of "menu costs"
when combinedwith monopolisticcompeti-
tion. It shows that small(second-order)costs
of changing prices may lead to large (first-
order) changes in output and welfarein re-
sponse to changes in nominal money. It
shows the close relationbetweenthis result
and the aggregatedemandexternalityiden-
tifiedin SectionII. The answerto the second
question is therefore positive. Section IV
takes as given that prices and wages do not
adjustto movementsin nominalmoney,and
drawsthe implicationsof monopolisticcom-
petition with fixed costs for the behaviorof
output, productivity,profits, and entry by
new firms in responseto fluctuationsin ag-
gregate demand. These implicationsfit the
facts and our answerto the thirdquestionis
positive. We concludeby discussinghow the
implicationsfor entry may in turn help ex-
plain the lack of adjustmentof prices and
wages.
648 THEAMERICANECONOMICREVIEW
Our paperis closelyrelatedto threerecent
strands of research,on generalequilibrium
implications of monopolistic competition
(Oliver Hart, 1982, and Martin Weitzman,
1982, in particular),on "menu costs" or
"near rationality" (N. Gregory Mankiw,
1985, George Akerlof and Janet Yellen,
1985a, b) and on "coordinationfailures"
(Russell Cooper and AndrewJohn, 1985, in
particular).We shall point out specificrela-
tions as we proceed.Ourintent is in part to
show their relation and macroeconomicim-
plicationsin the specificcontextof monopo-
listic competition.
I. A Modelof MonopolisticCompetition
In developing a model of monopolistic
competition, we make four main choices.
Becausewe want to focus on both wage and
price decisions, we constructa model with
both households and firms, with separate
labor and goods markets.Both labor and
goods marketsare monopolisticallycompeti-
tive. The assumptionof monopolisticcom-
petition in both sets of marketsis made for
symmetryand transparenceratherthan for
realism. For some purposes, however, the
model that has both wageand pricesettersis
not the simplest, and we also occasionally
focus on a special case, that can be thought
of as an economy of household-firms,each
producinga differentiatedgood; in that case,
there is only one set of price settersand the
analysisis simplified.
The second choice follows from the need
to avoid Say's Law, or the result that the
supply of goods producedby the monopolis-
tically competitivefirms automaticallygen-
erates its own demand.To avoid this, agents
must have the choice between these goods
and somethingelse. In the standardmacro-
economic model, the choice is betweencon-
sumption and savings. In other models of
monopolistic competition,the choice is be-
tween produced goods and a nonproduced
good (Hart, for example). Here, we shall
assume that the choice is between buying
goods and holding money.This is most sim-
ply and crudely achieved by having real
money balancesin the utilityfunction.Thus,
money plays the role of the nonproduced
SEPTEMBER1987
good and providesservices.1'2 Moneyis also
the numeraire,so that firms and workers
quote prices and wages in termsof money;
this plays no role in this and the next sec-
tion, but will become importantin Section
III.
The third choice is to make assumptions
about utility and technology that lead to
demand and pricingrelations,which are as
close to traditionalones as possible,so as to
allow an easy comparisonwith standard
macroeconomicmodels. In effect,we follow
Avinash Dixit and Joseph Stiglitz(1977) in
adopting constant elasticity of substitution
specifications in utility and production.3
These specificationslead to log-linear de-
mand and pricing functions, and rule out
potentially importantnonlinearitiesas well
as a potentialsourceof multipleequilibria.4
Finally, the model is static and we leave
the potentially importantdynamicimplica-
tions of monopolisticcompetitionto future
work.'
A. TheModel
The economy is composed of m firms,
each producing a specific good that is an
imperfectsubstitutefor the othergoods, and
n consumer-workers,householdsfor short,
'A ClowerConstraintwould lead to similarresults.
Developingan explicitlyintertemporal modelto justify
why moneyis positivelyvalueddid not seemworththe
additionalcomplexityin this context.
2There are, however,differencesbetweenmoneyand
a standardnonproducedgood that arise from the fact
that real,not nominal,moneybalancesenterutility;we
shall point out these differencesas we go along.
3The main alternativeto productdiversification a la
Dixit-Stiglitz,is geographicdispersion.This is the ap-
proachfollowedby Weitzman.
4Our assumptionsimply a constantelasticityof de-
mand, and a constantmarkupof price over marginal
cost. Somerecentworkon the implicationsof imperfect
competitionfor macroeconomics has preciselyfocused
on why markupsmay not be constant,eitherbecauseof
changes in elasticityof demand,or of changesin the
degree of collusion between firms. See, for example,
Stiglitz (1984), Julio Rotembergand Garth Saloner
(1986), and MarkBils (1985).
5Kiyotaki(1985b) studies the implicationsof mo-
nopolisticcompetitionfor investmentand thelikelihood
of multipleequilibria.
VOL. 77 NO. 4 AND KIYOTAKI:
BLANCHARD COMPETITION
MONOPOLISTIC
each of them sellinga type of laborwhichis
an imperfect substitutefor the other types.
As a result, each firm and each workerhas
some monopoly power.6 We now describe
the problem faced by each firm and each
household.
Firms are indexed by i, i = 1,..., m. Each
firm i has the followingtechnology:
(1) Yi= NE N0?- l)/a3
j =1
where Yi denotes the output of firm i. Nij
denotes the quantityof laborof type j used
in the productionof output i. There are n
different types of labor, indexed j, j =
1,..., n. The productionfunction is a CES
productionfunction,with all inputsentering
symmetrically.Introducingfixedcosts would
not affect the analysisof the first three sec-
tions where we assumethe numberof firms
to be fixed; we shall, for simplicity,intro-
duce them only in the last sectionwherethey
matter.
The two parameters characterizingthe
technologyare a and a. The parametera is
the elasticity of substitutionof inputs in
production.The parametera is the inverse
of the degreeof returnsto scale; a -1 is the
elasticity of marginalcost with respect to
output, elasticity of marginalcost for short
in what follows. To guaranteethe existence
of an equilibrium,we restricta to be strictly
greaterthan unity, and a to be equal to or
greaterthan unity.
The firmmaximizesprofits.Nominalprof-
its for firm i are givenby
n
(2) Vi=pi I E WjNij,
j=1
where Pi denotes the nominal output price
6Since in equilibriumeach labor suppliersells some
of his (her)labor to all firms,it is moreappropriateto
thinkof laborsuppliersas craftunions,or syndicatesas
in Hart, ratherthan individualworkers.However,since
we want to analyze labor supply and consumption
decisions simultaneously,we shall continueto referto
laborsuppliersas "consumer-workers" or "households."
649
of firm i, and W4denotesthe nominalwage
associatedwith labor type j. The firmmaxi-
mizes (2) subjectto the productionfunction
(1). It takes as given nominalwages and the
prices of the other outputs. It also faces a
downward-slopingdemand schedule for its
product, that will be derived below as a
result of utility maximizationby households.
We assumethat the numberof firmsis large
enough that taking other prices as given is
equivalentto takingthe price level as given.
Householdsare indexed by j, j = 1, .. ., n.
Household j supplies labor of type j. It
derivesutilityfromleisure,consumption,and
real money balances. Its utility function is
given by
(3) U = ( m'A'l- )Cj)Y(Mj'1P )1 Y_ N#j
m - 1))
(OA(@
where j = f C,1)/O
1m 1A(1- )
and p= (m f pl)- A
i=1
The first term in utility is a consumption
index (basket) that gives the effect of the
consumptionof goods on utility. C,j denotes
the consumptionof good i by householdj,
and C1 is a CES function of the C,,s. All
types of consumption goods enter utility
symmetrically.The parameter6 is the elas-
ticity of substitutionbetweengoods in util-
ity. To guarantee existence of an equi-
librium, 0 is restrictedto be greater than
unity. The constant in front of C), that de-
pends on 6 and on the numberof products
m, is a convenient normalizationwith the
implication that an increasein the number
of products does not affect marginalutility
after optimization.
The second term gives the effect of real
money balances on utility. y is a parameter
between zero and one. Nominal money bal-
ances are deflatedby the nominalprice in-
dex associatedwith CJ.We shallreferto P as
the price level.
The thirdtermin utilitygivesthe disutility
from work, N) is the amountof labor sup-
plied by household j. The term ,B-1 is the
650 THE AMERICAN ECONOMIC REVIEW SEPTEMBER 1987

elasticityof marginaldisutilityof labor;/3 is and

assumed to be equal to or greater than m \1/(1 - )
unity.7'1 P-(l/m) Ep,l-0
Households maximizeutility subject to a
budget constraint. Each household takes
prices and other wages as given. Again we The demand functionsfor goods and labor
assume that n is large enough that taking are given by
other wages as given is equivalentto taking
n
the nominalwage level as given.It also faces
a downward-slopingdemandschedulefor its (7) Yi= Y. Cij = KY(PiIP)
j=1
type of labor, which will be derivedas the
result of profit maximizationby firms.The m
budget constraintis givenby
m
m m (8) Nj= E
Nij= KYa(Wj/W)
(4) QP1Cj+Mj'=WjNj+Mj+ EVj, i =1
i=l i=l

where M. denotes the initial endowmentof

money, and Vijis the shareof profitsof firm where the wage index W is given by
i going to household j.
1 n /-
B. The Equilibrium (9) W= nj=
The derivationof the equilibriumis given
in the Appendix. The equilibriumcan be The price and wage rulesare given by
characterized by a relation betweenreal mon-
ey balances and aggregate demand, a pair of (10) (Pt/P) = [(o/(0-1))Kp
demandfunctionsfor goods and laborand by
a pair of price and wage rules.
The relationbetweenreal money balances X (W/P) Y ]Af/+e(Gl))
and real aggregate consumption expendi-
i=l,..., m
tures, which we shall call aggregatedemand
for short,is given by
(11) ( Wj/W) =[(a(a-1))K
(5) Y=K(M/P)
X (Pl/W) ya(,8-1)] 1(+ 0(#- 1))
where
j= l,...,n
/n m
v =
(6) Ev Dr
PI /D The letters K, Kc, Kn Kp, and Kw are
constants that dependon the parametersof
the technology and the utility function as
well as the numberof firmsand households.
7The assumptionthat utilityis homogeneousof de- We interprettheseequations,startingwith
gree one in consumptionand real money balances,as the relation between real money balances
well as additivelyseparablein consumptionand real
money balanceson the one hand, and leisure,on the and aggregate demand. First-ordercondi-
other,eliminatesincomeeffectson laborsupply.Under tions for householdsimply that desiredreal
these assumptions,competitivelaborsupplywouldjust money balances are proportionalto con-
be a function of the real wage, using the price index sumption expenditures. Aggregating over
definedin the text. It alsoimpliesthatutilityis linearin
income and this facilitateswelfareevaluations. households and using the fact that, in equi-
8For reasonsthat will be clearbelow,we excludethe librium, desired money is equal to actual
case whereboth a and f areequalto unity. money gives equation(5).
VOL. 77 NO. 4 AND KIYOTAKI:
BLANCHARD
MONOPOLISTIC
The demandfor each type of good relative
to aggregate demand is a function of the
ratio of its nominal price to the nominal
price index, the price level, with elasticity
(- 0). The demand for labor by firms is a
deriveddemandfor labor;it dependson the
demand for goods. The demand for each
type of labor is a functionof the ratio of its
nominal wage to the nominal wage index,
with elasticity (- a).
We now consider the price rule. Given the
price level, each firm is a monopolist and
decidesaboutits real(or relative)priceP1/P.
An increase in the real wage (W/P) shifts
the marginalcost curve upward,leading to
an increasein the relativeprice.An increase
in aggregatedemandshiftsthe demandcurve
for each product upward;if the firm oper-
ates under decreasingreturns,the marginal
cost curveis upwardslopingand the relative
price increases.Under constantreturns,the
shift in demandhas no effecton the relative
price.
We finally consider the wage rule, equa-
tion (11). We can think of households as
solving theirutility-maximization problemin
two steps. They first solve for the allocation
of their wealth, includinglabor income,be-
tween consumptionof the differentproducts
and real money balances.Afterthis step, the
assumption that utility is linearly homoge-
neous in consumptionand real money bal-
ances implies that utility is linearin wealth,
thus linear in labor income.The next step is
to solve for the level of laborsupplyand the
nominal wage. Given that utility is linearin
labor income, we can thinkof householdsas
monopolists maximizingthe surplus from
supplying labor. Formally,if ILdenotes the
constant marginal utility of real wealth,
householdssolve in the secondstep:
max ,u(Wj/P)ANj- NJ
Nj = K,Y( W/W)
The real wage relevant for worker j is
Wj/P, which we can write as the product
(Wj/W)(W/P). The demand for labor of
type j is a function of the relative wage
(Wj/W) as well as of aggregatedemand.
COMPETITION
651
An increase in the aggregatereal wage
(W/P) leads household j to increase its
labor supply, thus to decrease its relative
wage (W//W). An increasein aggregatede-
mand leads, if ,B is strictly greater than
unity, to an increasein the relativewage. If
,B is equal to unity, if the marginaldisutility
of labor is constant, workerssupply more
labor at the same relativewage, in response
to an increasein aggregatedemand.
C. SymmetricEquilibrium
Equilibriumand symmetry,both across
firms and acrosshouseholds,impliesthat all
relativeprices and all relativewagesmustbe
equal to unity. Thus, using Pi = P for all i
and W4/=W for all j, and substitutingin
equations(10) and (11) gives
(12) (P7W) = (0/(O-1))KPYa-l;
(13) (W1/P) = (a1/(a-1))KWYa(fl-1).
Equation(12), obtainedfrom the individ-
ual price rules and the requirementthat all
prices be the same,givesthe pricewageratio
(P7W) as a function of output. If firms
operateunderstrictlydecreasingreturns,the
price wage ratio is an increasingfunctionof
the level of output. Equivalently,the real
wage (W/P) consistentwith firms'behavior
is a decreasingfunctionof output.We shall
refer to equation(12) as the "aggregateprice
rule."
Equation(13), obtainedfrom the individ-
ual wage rules and the requirementthat all
wagesbe the same,givesthe realwage(W/P)
as a functionof output.If /3is strictlygreater
than unity, that is, if workershaveincreasing
marginal disutility of work, an increasein
output, that leads to an increase in the
derived demand for labor, requiresan in-
crease in the real wage. The real wage con-
sistent with households'behavioris an in-
creasingfunctionof output.We shallreferto
equation(13) as the "aggregatewage rule."
Equations(12) and (13) give (W/P) and
Y. The value of (M/P) follows from (5).
The equilibriumis characterizedgraphically
in Figure 1. As (12) and (13) are log-linear,
we measure log(W/P) on the vertical axis
652 THEAMERICANECONOMICREVIEW
wage rule
- pA sope,aB -)
slope -(a- I)
price rule
log Y (log (M/P)+constant)
COMPETITIVE
FIGURE1. THEMONOPOLISTICALLY
EQUILIBRIUM
and log(Y) (or log(M/P) as the two are
linearly related)on the horizontalaxis. If a
and /3 are both strictlygreaterthan unity,
the aggregatewage rule is upwardsloping,
while the aggregateprice rule is downward
sloping. The equilibriumdeterminesthe real
wage and output. Given output, we obtain
the equilibriumlevel of real moneybalances
and given nominal money,we finallyobtain
the pricelevel.
of
Figure 1 looks like the characterization
equilibriumunder perfectcompetition,with
an upward-slopinglabor supplycurveand a
downward-slopinglabor demand. What is,
therefore,the effectof monopolisticcompeti-
tion? Before turningto that issue, we briefly
considera specialcase of the modelthat will
be convenientlater.
SpecialCase
D. A Convenient
In the special case of the modelwherethe
marginalutility of leisureis constantso that
3 = 1, the characterizationof the equilibrium
is much simpler. The relationbetween real
money balanceand aggregatedemandis still
given by equation (5). But, from equation
(11) and symmetry,the real wage is con-
stant, so that the price rules are now given
by
(14) Pji/P =k(M/P)(a-1)A1+(-1))
where k is an unimportant constant. Equa-
tions (5) and (14) characterizethe equi-
librium.The symmetricequilibriumis identi-
SEPTEMBER1987
cal to that in Figure 1, except for the fact
that the aggregatewagerule is horizontal.
This specialcase is convenientas it allows
to concentrateon the interactionsbetween
price setters ratherthan betweenboth price
and wage setters. The assumptionof con-
stant marginalutility of leisureis unattrac-
tive, but equations (5) and (14) admit an
alternativeinterpretation:they can also be
derived as the equationscharacterizingthe
equilibrium of an economy with many
household-firms,eachproducinga differenti-
ated good with a constant returnstechnol-
ogy and increasing marginal disutility of
work,and derivingutilityfromthe consump-
tion of all goods and moneyservices.9Under
that interpretation,(a-1)) stands for the
elasticityof marginalutilityof leisure.
II. InefficiencyandExternalities
A. ComparingMonopolisticCompetition
and Perfect Competition
To characterizethe inefficiencyassociated
with monopolisticcompetition,we firstcom-
pare the equilibriumto the competitiveequi-
librium. The competitive equilibrium is
derived under the same assumptionsabout
tastes, technology,and the numberof firms
and households,but assumingthat eachfirm
(each household) takes its price (wage) as
given when decidingaboutits output(labor).
The competitiveequilibriumis very simi-
lar to the monopolisticallycompetitiveone.
The demand functionsfor goods and labor
are still given by equations(7) and (8). The
price and wage rules are identical to equa-
tions (10) and (11), exceptfor the absenceof
O/(O-1) in the price rules and the absence
of a/(a -1) in the wage rules (the K's are
the samein both equilibria).The explanation
is simple.The termO/(O-1) is the excessof
price over marginalcost, reflectingthe de-
gree of monopoly power of firms in the
goods market; if firms act competitively,
price is instead equal to marginalcost. The
same explanationappliesto households.
9LaurenceBall and David Romer(1987) derivethe
equilibriumfor such an economy.
VOL. 77 NO. 4 AND KIYOTAKI:
BLANCHARD
MONOPOLISTIC
log(8/( 8 - ))
_ X
X: \aA
3 4 , v ~ (labor supply)
2
o competitive
" ltog (oJ(o-l))
log Y ( log (M/P)+ constant)
FIGURE 2. M,ONOPOLISTICALLY AND
COMPETITIVE
EQUILIBRIA
COMPETITIVE
Again, symmetryrequiresin equilibrium
all nominal and all wages to be the same;
this gives equations identical to (12) and
(13), but without the terms O/(6 -1) and
-/(a-1). The price wage ratio consistent
with firms'behavioris lowerin the competi-
tive case by O/(6 -1) at any level of output;
the real wage consistent with household's
behavioris lower in the competitivecase by
,/(a -1) at any level of output. The mo-
nopolistically competitive and competitive
aggregatewage and pricerules are drawnin
Figure 2. Point A' gives the competitive
equilibrium;point A gives the monopolisti-
cally competitiveequilibrium.
The equilibriumlevel of real money bal-
ances is lower in the monopolistic equi-
librium; the price level is higher. Employ-
ment and output are lower.Whathappensto
the real wage is ambiguousand dependson
the degreesof monopolypowerin the goods
and the labor markets.If, for example,there
is monopolistic competition in the goods
marketbut perfect competitionin the labor
market,then the real wageis unambiguously
lower undermonopolisticcompetition.
Denoting by R the ratio of output in the
monopolisticallycompetitiveequilibriumto
output in the competitiveequilibrium,R is
given by
where R is an increasingfunctionof a and
0. The higher the elasticity of substitution
COMPETITION
653
betweengoods or betweentypesof labor,the
closer is the economy to the competitive
equilibrium.R is an increasingfunctionof a
t ~ / K
competitive
and /B.If a and ,Bare both close to unity, R
, wage rule
is small: the existenceof monopolypowerin
either the goods or the labor marketscan
price rule1 have a largeeffecton equilibriumoutput.10
\ (labor demand)
B. AggregateDemandExternalities
Under monopolistic competition,output
of monopolisticallyproducedgoods is too
low. We have shown above that this follows
from the existence of monopoly power in
price and wage setting. An alternativeway
of thinkingabout it is thatit followsfroman
aggregatedemandexternality.
The argumentis as follows. In the mo-
nopolistically competitiveequilibrium,each
price (wage)setterhas, givenotherprices,no
incentive to decrease its own price (wage)
and increase its output (labor). Suppose
however that all price settersdecreasetheir
prices simultaneously; this increases real
money balancesand aggregatedemand.The
increasein output reducesthe initial distor-
tion of underproductionand underemploy-
ment and increasessocialwelfare.11
We now make the argumentmoreprecise.
By the definitionof a monopolisticallycom-
petitive equilibrium,no firmhas an incentive
to decreaseits price, and no workerhas an
incentive to decreaseits wage, given other
prices and wages. Considernow a propor-
tional decrease in all wages and all prices,
(dP1/Pi)=(dWj/wj)<O, for all i and j,
" Note that, as there are distortionsin two sets of
interrelatedmarkets,the economyis operatinginside
its production frontier. This point is developed by
Rotemberg(1982).
llAn alternativeway of stating the argumentis as
follows: If startingfrom the monopolisticallycompeti-
tive equilibrium,a firmdecreasedits price, this would
lead to a smalldecreasein the pricelevel and thus to a
small increase in aggregatedemand.While the other
firms and householdswouldbenefitfrom this increase
in aggregatedemand,the originalfirmcannot capture
all of these benefits and thus has no incentiveto de-
crease its price. We have chosen to presentthe argu-
ment in the text to facilitatecomparisonwith the argu-
ment of SectionIII.
654 THE AMERICAN ECONOMIC REVIEW
that leaves all relativepricesunchangedbut
decreasesthe price level.
Considerfirst the changein the real value
of firms.12 At a given level of output and
employment,the real value of each firm is
unchanged.The decreasein the price level,
however,increasesreal money balancesand
aggregatedemand. This in turn shifts out-
ward the demand curve faced by each firm
and increasesprofit: an increasein demand
at a given relative price increasesprofit as
price exceeds marginalcost. Thus, the real
value of each firmincreases.
Considerthen the effectof a proportional
reductionof prices and wages on the utility
of each household. Considerhousehold j.
We have seen that, once the householdhas
chosen the allocationof his wealth between
real money balances and consumption,we
can write its utility as
U}=(Ij/P) - NO
where ,u is the constant marginalutility of
real wealth and I1 is the total wealth of the
jth household. Using the budget constraint,
we can expressutility as
Uj=[ ( Wj/P) Nj - NJ
m that movementsin aggregatedemandaffect
+ tLVij1P +it(Mj/P)
i =1
Utility is the sum of three terms. The
second is profit income in terms of utility;
we have seen that each firm'sprofitgoes up
after an increasein aggregatedemand.Thus,
this term increases. The first term is the
household's surplus from supplying labor.
At a given level of employmentNj, the pro-
portional change in wages and prices leaves
this term unchanged. But the increase in
aggregatedemand and the implied derived
increasein employmentimpliesthatthis term
increases:at a given real wage, an outward
12What happens to the real value of firms is obvi-
ously of no direct relevance for welfare. This step is
however required to characterize what happens to the
utility of households below.
SEPTEMBER 1987
shift in the demandfor labor increasesutil-
ity as the real wage initially exceeds the
marginalutility of leisure.The thirdtermis
the real value of the money stock, which
increases with the fall in the price level.
Thus, utilityunambiguouslyincreases."3
The aggregatedemandexternalityimplies
that underproductionis magnifiedthrough
macroeconomic interactions.Consider the
problem faced by an individualfirm, with
upward-slopingmarginal cost and down-
ward-slopingdemand,takingas given other
prices and aggregatedemand. Because the
marginalutility of wealthis constantunder
our assumptions,we can measurewelfareby
looking at the sum of consumers'and pro-
ducers' surplus. If the firm acted competi-
tively ratherthan as a monopolist,the price
would be lower and the surpluswould be
larger. This is the familiar partial-equi-
librium effect. But here, in addition, if all
firmsacted competitivelyand decreasedtheir
prices, aggregatedemand would be higher
and the demandcurvefacingeachfirmwould
shift to the right and welfarewould be fur-
ther increased.This is the additionalgeneral
equilibriumeffectpresenthere.
Identifyingthe inefficiencyassociatedwith
monopolistic competition as an aggregate
demandexternalitydoes not, however,imply
output. Aggregate demand changes associ-
ated with changesin the demandelasticities
facing firms and workers will have real
effects, and these effects are likely to be
different under perfect and monopolistic
competition. These are not, however, the
effectswe want to focus on. For that reason,
13Note that, if we wereperforming the sameexperi-
ment in the neighborhoodnot of the monopolistically
competitivebut of the competitiveequilibrium,the first
two termswould be equalto zero. The third,however,
would still be present.Thisis one of the implicationsof
our use of real money as the nonproducedgood. If real
moneyentersutility,thenthe competitiveequilibriumis
not Paretooptimal,as a smalldecreasein thepricelevel
increaseswelfare.This inefficiencyof the competitive
equilibriumdisappearsif moneyis replacedby a non-
producedgood, while the aggregatedemandexternality
under monopolisticcompetitionremains(see Kiyotaki,
1985a).
VOL. 77 NO. 4 AND KIYOTAKI:
BLANCHARD COMPETITION
MONOPOLISTIC
we shall concentrateon changesin nominal
money. But then it is clearthat, as equations
(12) and (13) are homogeneousof degree
zero in P, W, and M, nominal money is
neutral, affecting all nominal prices and
wages proportionately,and leaving output
and employment unchanged. Thus some-
thing else is needed to obtain real effects of
nominal money. We examinethe effects of
costs of price settingin the next section.
III. Menu CostsandRealEffectsof
NominalMoney
We now introducesmall costs of setting
prices, small "menu" costs. Akerlof and
Yellen (1985a, b) and Mankiwhave shown
how such small costs can lead to large wel-
fare effectsin imperfectlycompetitiveecono-
mies." We apply their argument to the
specificcontext of monopolisticcompetition,
derive welfare and output effects as explicit
functions of the underlyingparameters,and
relate these effects to the externalityiden-
tified earlier.
A. TheEffectsof SmallChangesin
NominalMoney
We start by consideringthe effects of a
small change in nominal money, dM. The
intuitive argumentis the following.
At the initial nominal prices and wages,
the change in nominal money leads to a
changein aggregatedemand,thusto a change
in the demandfacingeachfirm.If demandis
satisfied, the change in output implies in
turn a change in the derived demand for
labor, thus a change in the demand facing
each worker. Unless firms operate under
constant returns,each firmwants to change
its relative price. Unless workershave con-
stant marginalutility of leisure,each worker
wants to change his relativewage. The loss
in value to a firm which does not adjustits
relative price is, however,of second order;
14Akerlofand Yellen assume"nearrationality"that
is equivalentto rationalitysubjectto second-ordercosts
of takingdecisions.
655
the same is true of the utility of a worker
who does not adjusthis relativewage. Thus
second-ordermenu costs may preventfirms
and workers from adjustingrelative prices
and wages. The implicationis that nominal
prices and nominal wages do not adjust to
the change in nominal money. The second
part of the argumentis to show that the
changein real moneybalanceshas first-order
effects on welfare;we show that it is indeed
first order, and of the same sign as the
change in money. The argumenthas very
much the same structureas the aggregate
demandexternalityargumentof the previous
section; this coincidence is not accidental
and we returnto it below.
The firstpart is a directapplicationof the
envelope theorem. Considerfirms first. Let
Vi be the value of firm i. Vi is a functionof
Pi as well as of P, W, and M (Vi=
Vi(Pi,P, W, M)). Let ViJ*be the maximized
value of firm i, after maximizationover Pi;
Vi* =Vi *(P, W, M). The envelope theorem
then says that
dVl*/dM = aVadM + (daViaPJ)(dPIydM)
= av1/aM.
To a first order, the effect of a changein
M on the value of the firm is the same
whetheror not it adjustsits price optimally
in responseto the changein M. Exactlythe
same argumentapplies to the utility of the
household. Thus, second-ordermenu costs
(larger than the second-orderloss in utility
or in value) will prevent each firm from
changing its price given other prices and
wages and each worker from changing its
wage given other prices and wages.The im-
plicationis that all nominalpricesand wages
remain unchanged,and that the increasein
nominal money implies a proportionalin-
creasein real moneybalances.
What remains to be shown is that the
increasein real moneybalanceshas positive
first-ordereffects on welfare. However,we
have already shown in the previoussection
that the increase in real money balances,
associatedwith the increasein aggregatede-
mand and employment,raises firms'profits
and the households'surplusesfrom supply-
656 THEAMERICANECONOMICREVIEW
ing labor. Thus, it increaseswelfare in the
neighborhoodof the monopolisticallycom-
petitive equilibrium.
There is clearly a close relationbetween
the aggregate demand externality and the
menu cost argument of this section. This re-
lation is most simply shown in the special
case where the marginalutility of leisureis
constant, where there are no menu costs in
wage setting and wherewe can concentrate
on the interactionsbetweenpricesettersonly.
Equation (14), which gives the individual
price rules in the absenceof menucosts, can
be rewrittenas
(15) Pi/M
= k ( P/M)[' ?(O - 1)(a -1)1/(l+
Figure 3 plots the price chosen by firm i
as a functionof the pricelevel,both as ratios
to nominal money. In the presenceof mo-
nopoly power,the pricerulehas slopesmaller
than one. We also drawiso-profitloci, giving
combinations of (Pi/M) and (P/M) that
yield the same level of real profit for the
firm.'5The symmetricmonopolisticallycom-
petitive equilibriumis given by the intersec-
tion of the price rule and the 450 line, point
E. Point A gives the highestrealprofitpoint
on the 450 line.
The aggregate demand externalityargu-
ment can then be statedas follows.Consider
a small proportional decrease of prices, keep-
ing nominal money constant. The equi-
libriummoves from point E to a point like
E' along the 450 line. The profit of each firm
rises with the increasein aggregatedemand.
However,in the absenceof coordination,no
firm has an incentiveto reduceprices away
from the equilibriumpoint E.
The menu cost argumentconsidersinstead
a small increase in nominal money. At the
initial set of prices, real money balances
would increaseand the economywouldmove
from point E to a point like point E'. But,
15 The figure assumes decreasing returns to scale.
Note also that, as firms take the price level as given
when choosing their own price, iso-profit loci are verti-
cal along the price rule.
SEPTEMBER1987
log (Pi /M)
iso profit locus
- - price ruleof
(Pi(P1
loglog
/M)
~~~~~~~~~~th
firm
Pi /M=Ri(P/M)
log (Pi/ M)
--
A
i sing real profit
/ ~~~~~~~~I
I
A45? I I
log(P/MI) log(P/M) log(P/M)
FIGURE 3. AGGREGATEDEMAND EXTERNALITIES
AND MENU COSTS
O(a-1))
absent menu costs, each firm would find in
its interest to increase its price until the
economy had returnedto point E. In the
presenceof menu costs,however,thesemenu
costs, if largeenough,can preventthis move-
ment back to E, so that the economy re-
mains at E' and all firmsend up with higher
real profits. (A similar argument,although
slightlymore complicated,holds for the gen-
eral model. We shall not presentit here.)
It is also importantto note the specificrole
played by money in this section. The pres-
ence of an aggregatedemandexternalitydoes
not depend on the nature of the nonpro-
duced good, or on the nature of the
numeraire.The resultsof this sectiondepend
on money being the nonproducedgood and
the numeraire.That moneyis the numeraire
implies that, given menu costs, unchanged
prices and wages mean unchangednominal
prices and wages.Thatmoneyis the nonpro-
duced goods impliesthat, as the government
can vary the amount of nominalmoney, it
can, if nominal prices and wages do not
adjust, change the amount of real money
balances, the real quantity of the nonpro-
duced good.
B. The Effects of Larger Changesin
Nominal Money
For largerchangesin money, the private
opportunitycosts of not adjustingprices in
VOL. 77 NO. 4 AND KIYOTAKI:
BLANCHARD MONOPOLISTIC
COMPETITION
response to the change in money (private
costs, for short) are no longernegligibleand
depend on the parametersof the model. We
now investigatethis dependence.
The privatecosts faced by a firmdepends
on the size of the demandshiftsas well as on
the two parametersa and 9. As we have
seen, these costs are of second order in re-
sponse to a change in aggregatedemand,
thus roughly proportionalto the squareof
the change in aggregatedemand.More pre-
cisely, define L(A; a, 9) to be the private
opportunity cost to a firm expressedas a
proportion of initial revenues, associated
with not adjustingits price in responseto a
changeof 100A%in aggregatedemand,when
all other firms and households keep their
prices and wages unchanged.Then, by sim-
ple computation,we get
_
L(A; at,0) = (a-_1)2( 1)]
/[2(1+ 0(a-1))] }A2 +0(A2)
where 0(A2) is of thirdorder.
The closer a is to one, thatis, the closerto
constant returns to scale, the smaller the
privatecost. In the limit,if a is equalto one,
then privatecosts of not adjustingpricesare
equal to zero as the optimal responseof a
monopolist to a multiplicativeshift in iso-
elastic demandunderconstantmarginalcost
is to leave the priceunchanged.Thusprivate
costs are an increasingfunctionof a. They
are also an increasing function of 9; the
higher the elasticityof demandwith respect
to price, the higher the privatecosts of not
adjustingprices.
Exactly the same analysis applies to
workers.The two importantparametersfor
them are ,B and a. If we definethe function
L in the same way as above, the private
opportunitycost to a worker(measuredin
terms of consumption and expressedas a
proportion of initial consumption),associ-
ated with not adjustingthe wage in response
to a change of 100A%in aggregatedemand,
when all other firms and householdskeep
their prices and wages unchanged,is given
by
r{1 1. D _)
[(O _1)/a L(.l A)a
657
where (0 - 1)/Oa is the initial shareof wage
income in GNP.
If ,B is close to unity, that is, if the elas-
ticity of the marginaldisutility of labor is
close to unity, privatecosts of not adjusting
wages are small; in the limit, if marginal
disutility of labor is constant,privatecosts
are equal to zero. If a is very large, if
differenttypes of labor are close substitutes,
privatecosts of not adjustingwagesare high.
Table 1, Part a, gives the size of menu
costs as a proportionof the firm'srevenues
(GNP produced by the firm) that are just
sufficientto preventa firmfromadjustingits
price in response to a change in demand;
Table 1, Part b, gives the size of menu costs
as a proportionof initialconsumption(GNP
consumedby the worker)that arejust suffi-
cient to preventa workerfrom adjustinghis
(her)wage.
Thus, given the unit elasticityof aggregate
demandwith respectto real moneybalances
and the assumptionthat all otherpriceshave
not changed, Part a of Table 1 gives the
private costs associatedwith not changing
pricesin the face of 5 and 10 percentchanges
in demand to the firm.The main conclusion
is that very small menu costs, say less than
.08 percentof revenues,may be sufficientto
prevent adjustment of prices. Results are
qualitativelysimilar for workers.Part b of
Table 1 gives the privatecosts of not chang-
ing wages in responseto changesof + 5 and
+10 percent in the demand for goods. It
assumesthat a is equalto 1.1, so thatchanges
in the derived demandfor labor are of 5.5
and 11 percent approximately.We expect /B
to be higherthan a so that Partb of Table 1
looks at valuesof /3between1.2 and 1.6. For
values of ,B close to unity, requiredmenu
costs are again very small; as /3 increases
however,requiredmenu costs become non-
negligible: for /3= 1.6 and a 11 percent
change in demand,they reach.45 percentof
initial consumption,a numberwhich is no
longer negligible.
The more relevantcomparison,however,
at least from the point of view of welfare,is
between private costs and welfare effects,
that is, the change in utility resultingfrom
the changesin output,employment,and real
money that are impliedby a changein nomi-
658 THEAMERICANECONOMICREVIEW SEPTEMBER1987

TABLE1-CHANGE IN AGGREGATEDEMAND AND MENU COSTS

(a): Lossin valueto a firmfromnot (b): Lossin utility(in termsof consumption)

adjustingprices(as a proportion to a workerfromnot adjustingwages(as
of initialrevenues)a a proportionof initialconsumption)ab
M1/MD = M1/M =

a 9 1.05 1.10 ,B a 1.05 1.10

1.0 5 .000 .000 1.2 5 .025 .100
1.1 5 .003 .013 1.4 5 .066 .265
1.1 2 .001 .004 1.4 2 .027 .111
20 .008 .031 20 .105 .418
1.3 5 .018 .071 1.6 5 .112 .451
Note: MOis the initiallevel of nominalmoney, M1 the level afterthe change.
a
Shownin percent.
bo =5; a=1.1.

TABLE2-MENU COSTSAND WELFAREEFFECTS

M1/MO = 1.05 M1/MO = 1.10

Menu Welfare Menu Welfare
a /3 Costsa Effectsa Ratio Costsa Effectsa Ratio
1.1 1.2 .03 1.79 60 .11 3.54 32
(=a =5) 1.4 .07 1.83 26 .28 3.60 13
1.6 .11 1.91 17 .46 3.72 8
1.2 1.2 .04 1.82 45 .15 3.57 24
1.4 .08 1.87 24 .33 3.67 11
1.6 .13 1.98 15 .53 3.85 7
1.1 1.2 .03 .94 31 .11 1.86 17
(= a =10) 1.4 .06 1.02 17 .23 1.93 8
1.6 .09 1.11 12 .36 2.05 6
1.2 1.2 .04 .99 25 .16 1.87 12
1.4 .07 1.07 16 .29 2.01 7
1.6 .11 1.27 12 .44 2.24 5
aShownin percent.

nal moneyat givenpricesandwages.Welfare adjustingtheir prices and workersfrom ad-

effects depend on the size of the changein justing their wages, given other wages and
nominal money as well as on the parameters prices. The second columngives the welfare
a, 1, 0, and a; the dependenceis a complex effects of an increasein nominal nmoneyat
one and we shall not analyze it here in unchanged prices and wages, expressedin
detail. Table 2 gives numericalexamples.It termsof consumption,againas a proportion
gives the requiredmenu costs and welfare of GNP. The thirdgives the ratio of welfare
effects associatedwith two differentchanges effects to menu costs.
in nominal money, 5 and 10 percent, and Welfare effects turn out not to be much
differentvaluesof the structuralparameters. affectedby the specificvaluesof the parame-
For each of the two changesin money,the ters, at least for the range of values we
first column gives the minimum value of consider in the table. Thus, the ratio of
menu costs, expressed as a proportionof welfare effects to menu cost has the same
GNP, that prevents adjustmentof nominal qualitativebehavioras that of the ratio of
prices and wages; this value is the sum of outputmovementsto menucosts.It is largest
menu costs requiredto preventfirms from for values of a, /3, 6, and a close to unity,
VOL. 77 NO. 4 AND KIYOTAKI:
BLANCHARD COMPETITION
MONOPOLISTIC 659

and decreasesas these parametersincrease. text, unambiguous:the relativeprice effect

In the table, it variesfrom 60 for low values dominates the aggregatedemand effect, so
of a, 13,6 and a to 5 for highvaluesof these that an increasein P leads to an increasein
parameters. Pi, althoughless than one for one. Thus, the
model exhibits strategic complementarity.
C. Strategic Complementaritiesand This is not, however,a robustfeatureof the
Multiple Equilibria model: if the elasticityof aggregatedemand
with respect to real money balances ex-
We have shown that, if menu costs were ceeded one, the aggregatedemand effect
sufficientlylarge, there was an equilibrium could dominate the relativeprice effect; an
where,in responseto an increasein nominal increasein P could lead the firmto decrease
money, nominal prices and wages remained ratherthan increasePi and the modelwould
unchanged and nominal money had real exhibit instead strategicsubstitutability.It is
effects.Whatwe havenot shown,however,is clear that the results derivedabove on the
that this was the only equilibrium.It turns inefficiencyof the monopolisticallycompe-
out that, if the condition that Cooper and titive equilibrium,the existenceof an aggre-
John have called "strategiccomplementar- gate demandexternalityand the roleof menu
ity" is satisfied,thereexists a rangeof menu costs do not depend on whetherthe model
costs for which the equilibriumis not unique. exhibits strategic complementarityor sub-
This has been shown by Julio Rotemberg stitutability.But, if the model exhibits stra-
and Garth Saloner (1986a, b) and, in the tegic complementarityhowever, the equi-
context of this model,by LaurenceBall and libriumwith menu costs may not be unique.
David Romer (1987).We give a brief sketch Considerwhat a particularfirmshoulddo
of their argumentbut refer the reader to after an increasein nominalmoney.If other
those papersfor details. firmsdo adjusttheirprices,and if pricesare
To discuss the existence and the role of strategic complements, the firm's optimal
strategiccomplementarityin this context, it price, Pi, increasesbecause of both the in-
is again easiest to study the special case creasein M and the increasein P. If, instead,
where the marginalutility of leisureis con- other firmsdo not adjusttheirprices,so that
stant and where there are no menu costs in the price level does not change,the optimal
nominal wage setting, so that real wage is price Pi increases,but by less. Put another
constant and we can concentrateon the in- way, the largerthe proportionof firmswhich
teractions between price setters. Following do not adjust their prices, the lower the
Cooper and John'sdefinition,strategiccom- opportunitycost to a firm of not adjusting
plementaritycorrespondsthen to the case its price. Thus, for some valuesof the menu
where an increasein the price level leads a costs, there will be two equilibria,one in
firm, absent menu costs, to increaseits own which all firmsadjust,makingit costly for a
nominal price. Strategicsubstitutabilitycor- given firm not to adjust, and the other in
respondsto the case wherean increasein the which no firm adjusts,makingit less costly
price level leads the firminsteadto decrease for a given firmnot to adjust.
its nominal price. Strategic complementaritycan therefore
In the special case we are considering,the lead to multiple equilibriain the context of
price that each firm would choose, absent monopolisticcompetitionwith menucosts."6
menu costs, is given by equation (14). An These equilibriaare associatedwith different
increase in P has two effects on Pi. At a levels of welfare, and to the extent that the
given level of aggregatedemand, the firm economy ends at a low welfareequilibrium,
wants to keep the same relativeprice, and
increase Pi in proportionto P. But an in-
crease in the price level also decreasesreal
money balances and aggregate demand, 16Strategic complementarityturns out to play an
leading the firm to want a decreasein its importantrole in dynamicmodelswith menucosts. See
relative price. The net effect is, in our con- the surveysby Blanchard(1987)and Rotemberg(1987).
660
this can be seen as a "coordinationfailure,"
the termused by Cooperand John.
D. Demand Determinationof Output
We have until now assumedthat increases
in real money balances at constant prices
and wages led to increasesin output and
employment.When analyzingthe effects of
small changesin money,this assumptionwas
clearly warranted;in the initial equilibrium,
as price exceeds marginalcost, firms will
always be willing to satisfy a small increase
in demandat the existingprice.The same is
true of workers: as the real wage initially
exceeds the marginal disutility of labor,
workerswill willinglyaccommodatea small
increase in demand for their type of labor.
When we considerlargerchangesin money,
this may no longerbe the case. Evenif firms
do not adjust their price, they have the op-
tion of either accommodatingor rationing
demand; they will resort to the second op-
tion if marginalcost exceedsprice.The same
analysis applies to workers.From standard
monopoly theory, we know that firms and
workerswill accommodaterelativeincreases
in demand,respectively,of
9 _ l)) l(a -1)
(01/(O
and (a/(a - 1))1/G81)
This raises the question of whether, as-
suming menu costs to be large enough, an
increase in demand can increaseoutput all
the way to its competitivelevel. The answer
is providedin Figure4. This figurereplicates
Figure 2 and draws the aggregateprice and
wage rules under competitiveand monopo-
listically competitiveconditions.Point A is
the monopolisticcompetitiveequilibriumand
A' the competitiveone. Along the monopo-
listicallycompetitivepricerule,priceexceeds
marginal cost; thus firms will satisfy de-
mand, at a given price wage ratio, until
marginalcost equalsprice,that is, until they
reach the competitive locus. In our case,
firmswill supply up to point B. The shaded
area F is the set of output-realwage at
which firms will ration rather than supply.
THEAMERICANECONOMICREVIEW SEPTEMBER1987
competitive
FL / 0
wage rule
0'
o competitive
price rule
0 log Y log (MIP) + constant)
FIGURE 4. DEMAND DETERMINATION
OF OUTPUT
By a similar argument,workerswill supply
up to point B'. The shadedarea H is the set
of real wage combinationswhereworkersdo
not satisfy labor demand.The figuremakes
it clear that an increasein nominalmoney
will increaseoutputand employment.It also
makes clear that, no matterhow largemenu
costs are, it is impossible,unless the compe-
titive and monopolisticallycompetitivereal
wages are equal, to attain the competitive
equilibriumthroughan increasein nominal
money.
What happens, therefore,as demand in-
creases depends on both menu costs and
supply constraints.If menu costs are large,
supply constraintswill come into effectfirst.
If menu costs are small, a more likely case,
prices and wages adjustbefore supply con-
straintscome into effect.
IV. Fixed CostsandAggregate
DemandMovements
Until now, we have taken the numberof
firmsas given and fixedcosts haveplayedno
role in our analysis.Both the aggregatede-
mand externalityand the menu costs argu-
ments hold, irrespectiveof the presenceof
fixed costs.
In this section, we want to study further
the effects of aggregatedemandon activity,
taking as given that, becauseof menu costs,
such movementsin aggregatedemandaffect
output. It is then essentialto introducefixed
costs, as they have importantimplications
for productivity,profitability,and the poten-
tial for entry by new firms in response to
VOL. 77 NO. 4 AND KIYOTAKI:
BLANCHARD MONOPOLISTIC
movements in output induced by aggregate
demand.
A. Fixed Costsandthe
GeneralEquilibrium
To introduce fixed costs, we change the
specificationof the productionfunctionto
(1) Yi+F= Ni(.a- ')/a
j =1
where F can be interpretedas being in terms
of the firm's own output, or as overhead
labor requiringall typesof laborin the same
proportions as regular production."7For
convenience,we also assumethat,apartfrom
the fixed cost, firmsoperateunder constant
returnsto scale, so that a = 1.
Given this specification of fixed costs,
equationscharacterizingequilibriumarevery
similarto equations(5) to (13). The relation
between real money balancesand aggregate
demand is unchanged.The demand func-
tions for goods are still given by equation
(7), while in the demandfunctionsfor labor,
equation (8), Y is replaced by (Y+ mF).
The price rules are still given by equation
(10), which becomes under the assumption
that a is equal to unity:
(10') (P,/P) = (O,/(0-1))Kp(W/P)
i=l,...,
The wage rules are given by equation (11)
where Y is replacedby (Y + mF).
Equations (12) and (13) which give the
aggregateprice and wage rulesbecome
(12') (P/1W) =(0(-1))Kp
(13') (W/P) = (oa/(a-1))Kw
(Y + mF) 1.
17Analternativeis to assumethat fixed costs for a
given firmare in the formof othergoods.A convenient
assumptionis to assume that the fixed cost is a CES
function of all goods, with elasticityof substitution9.
This assumptioninsuresthat the demandfunctionsfor
goods still have elasticity0.
COMPETITION 661
Together they determineas before equi-
librium aggregate output and real wages.
From the assumptionof constantreturnsin
this section, the markup,or its inverse the
real wage, is independentof the level of
demand and is determinedby (12'). Given
the real wage, (13') determinesthe level of
output.
We can now go furtherand determinethe
equilibriumnumber of firms. For a given
number of firms, m, the real profit of each
firm after profit maximizationis givenby
(16) VJ/'P=KV(1/m)(W/P) 1-Y
- Kp(/P)F,
where Kv and Kp dependon the structural
parametersbut not on the numberof firms.
An increase in m has two effects on the
profit of each firm. Given Y and (W/P), it
decreasesthe salesof eachfirmand decreases
profit: this effect is capturedby the term
(1/m) in (16). But it also affects the equi-
librium value of Y; while the constants K
and Kw in (12') and (13') do not dependon
m, the level of employmentassociatedwith a
given level of output increaseswith aggre-
gate fixed costs and thereforewith m. This
leads to a lower equilibriumvalue of Y;
given the assumption of constant returns,
and given that K., is independentof m, the
m.
value of (W/P) is unaffectedby m; lower
aggregateoutput in turndecreasesprofit.
Assumingthatentrytakesplaceuntilprofit
is equal to zero, equations(12') to (16) and
the zero-profitconditiondeterminethe equi-
libriumnumberof firms.We shall assumein
what follows that the number of firms is
initially given by zero-profitconditionsbut
is going to be fixed in the shortrun.
B. Movements in Aggregate Demand,
Profit, and Entry
Aggregatedemanddependson realmoney
balances, the ratio of nominalmoney to the
price level. Under constant retums with a
fixed markupof prices on wages, aggregate
demand is thereforea functionof the ratio
of nominal money to the nominal wage,
662 THEAMERICANECONOMICREVIEW
money in wage units. We now considerthe
effects of movementsin (M/W). This may
be due to a movementin nominal money,
with no adjustmentin nominal wages be-
cause of menu costs as in the previoussec-
tion. Or it may be due to a change in the
nominalwage givennominalmoney;the rea-
son need not concern us in this section.
Movementsin (M/W) lead to one for one
movements in aggregate demand and
employment.
The firstobviousimplicationof fixedcosts
is that productivity,givenby (Y/(Y+ mF)),
varies procycically. We focus on a related
implication, the procycical behavior of
profit. From equation (16), profit is, given
that nominal wages and prices are fixed, an
increasingfunction of output. If profit was
initially equal to zero, it becomes negative
with a decreasein (M/W), positivewith an
increase in (M/W). Both procycical pro-
ductivity and profitabilityseem to be in
accordancewith the facts.
Procycical profitabilityhas interestingim-
plications for entry. Keepingthe numberof
firms constant, we examine the return to
entry as a function of aggregatedemand.18
Considerthe effectsof a decreasein nominal
money in wage units and the associatedre-
ductionin output.Existingfirmsmakenega-
tive profits and thus, if a potential entrant
has to pay the prevailingwage, it will not
want to enter. We can go furtherand derive
the shadowwage,say W*,whichwouldmake
a potential entrantindifferentto entry, as a
functionof (M/W). Goingbackto equation
(5), (12'), and (16), given M and the aggre-
gate nominal wage W, if a firm can pay its
workersW*,it will makeprofitsof
[K(K,/m)((O 1)/K )-2
x (W*/W)1-0(M/W)
- -
[(e 1)/el (W*/W)F].
18An alternativewould be to determinethe equi-
librium numberof firmsas a functionof the level of
aggregatedemand.This is the routepursuedby Robert
Solow (1984).
SEPTEMBER1987
For a potential entrantto be indifferentto
entry,this expressionhas to be equalto zero.
Assuming zero profit for the potential en-
trant, we can derive the elasticity of the
relative wage (W*/W) to the money stock
in wage units (M/W). Denoting it by q, we
have
B= (1/0).
Equivalentlythe elasticityof the shadow
nominalwage to the aggregatenominalwage
is given by 1- (1/0).19 Thus, the higher are
aggregatenominal wages, the more difficult
is entry, the lower the relativewage a new
entrant can offer to its workers.This result
depends on both the presenceof monopolis-
tic competitionand fixed costs. Fixed costs
imply that when highernominal wages de-
crease aggregatedemand, the profit of all
firmscan be negative;the fact that products
are imperfect substitutesimplies that new
entrants face downward-slopingdemands
and cannot captureall of demandby simply
undercuttingthe pricesof existingfirms.
This result has two implications.In the
previous section, we showed that, if the
numberof firmswas given,menucosts could
lead firms not to changeprices in response
to changes in nominalmoney. We see that,
with respectto decreasesin money,allowing
for entry will not change the result. More
generally(and steppingoutside our model)
this result implies that if nominalwages are
too high, perhaps because of union push,
and lead to unemployment,new firms will
not want to enter,evenif theycan pay wages
to the unemployedthat are far below those
paid to the employed.20Absent fixed costs,
"9As9 is greater than unity, the elasticityof the
shadow wage with respect to the aggregatewage is
positive. If we had, however,formalizedfixed costs in
terms of a basket of goods, the sign of the elasticity
woulddependon whether9 is greateror smallerthan2.
The differencecomes from the fact that, in our case, a
decreasein the shadowwage decreasesthe fixed cost
whereas,underthis alternativeassumption,it does not.
20We are indebtedto LarrySummersfor suggesting
this argument.
VOL. 77 NO. 4 AND KIYOTAKI:
BLANCHARD COMPETITION
MONOPOLISTIC 663

entry would occur and unemploymentsub- tending the model to look at the dynamic
side.21 effectsof aggregatedemandon outputin the
presenceof menu costs.
V. Conclusion The firstis that we haveassumedall prices
to be initially equal and set optimally.In a
The results of this paper are tantalizingly dynamic economy and in the presence of
close to those of traditionalKeynesianmod- menu costs, such a degeneratepricedistribu-
els: under monopolisticcompetition,output tion is unlikely.But,if pricesare initiallynot
is too low, because of an aggregatedemand all equal or optimal,it is no longer obvious
externality. This externality,together with that even a small changein nominalmoney
small menu costs, impliesthat movementsin will leave all pricesunaffected.It is no longer
demand can affect output and welfare. In obvious that money,or aggregatedemandin
particular,increasesin nominal money can general,will have largeeffectson output.
increase both output and welfare. In the The second is that, even if nominalmoney
presenceof fixed costs, output,productivity, has large effects on output, it must be the
and profitabilitymove in the same direction. case that money is sometimes unantic-
We believe these resultsto be importantto ipatedly high, sometimes unanticipatedly
the understandingof macroeconomicfluc- low. When money is high, output increases
tuations; we want to point out the obvious and so does welfare to a first order.When
limitationsof the analysisas it stands. money is low, output decreasesand so does
The scope for small menucosts to lead to welfare,again to a firstorder.These welfare
large output effects in our model depends effects would appearto cancel out to a first
critically on the elasticity of labor supply order. It is thereforeno longerobviousthat,
with respect to the real wage being large even if menu costs lead to largeoutputfluc-
enough (on (/3-1) being small). Evidence tuations, the welfare loss of those fluctua-
on individuallabor supplysuggestshowever tions exceeds the menucosts whichgenerate
a small elasticity. Thus the "menu cost" them.
approachruns into the same problemas the Fortunately,all theseissuesare the subject
imperfect information approach to output of active research.Recent developmentsare
fluctuations;neithercan easilygeneratelarge reviewedin Blanchardand Rotemberg.
fluctuationsin outputin responseto demand
if the real wage elasticityof labor supplyis APPENDIX
low. As in the imperfectinformationcase,
the theorymay be rescuedby the distinction This Appendix derives the market equi-
between temporaryand permanentchanges librium conditions (5) to (11) given in the
in demand.Anotherpossibilityis thatunions text. It proceeds in three steps. The first
have a flatterlabor supply than individuals, derives the demand functionsof each type
or do not representthe whole labor force. of labor and each type of productby solv-
More likely, the assumption that labor ing part of the maximizationproblems of
markets operate as spot markets(competi- firms and households.These functionshold
tive or monopolistically competitive) will whetheror not prices and wages are set by
have to be abandoned.22 workers and firms at their profit or utility
The analysisof this paperis purelystatic. maximizinglevel. The second derives price
There are two main issues involved in ex- rules from firms' profit maximizationand
wage rules from workers'utility maximiza-
tion. The third characterizesmarket equi-
librium.
21This is our interpretation of Weitzman's argument
that increasing returns are a necessary condition for A. Demands for Productand Labor
unemployment to persist. Types
22This is indeed the direction taken by Akerlof and
Yellen (1985b) who formalize the goods market as
monopolistically competitive and the labor market using (a) Demand for product of type i. In
the "efficiency wage" hypothesis. order to maximize utility, each household
664 THEAMERICANECONOMICREVIEW SEPTEMBER1987

chooses the optimal composition of con- ney balances:

sumption and money holdings for a given
level of total wealth I, and productprices: (A7) Y = (y/(1-y )) M'/P
m #z/(0)7(01) n
max A C- E where M'= E M1'.
Cij, M/ ' Xi=1 Y j =1
(b) Demandfor laborof typej. In order
to maximizeprofit, each firm minimizesits
m productioncost for a given level of output
subjectto EPC +MJ'=Ij. and wages:
i=1
n

Solving this maximizationproblemgives min , WjNij

Nij j=1

(Al) cii= (Pi/P) 6(yIj/mP) / (a/(-1) ) l/ax

subjectto N - Wa Y.
(A2) MJ'=(1 - )Ij j =1
Solving this minimizationproblemgives
(A3) Aj = IIIj1P
Nij= (nW/(1 j/W) Yi*
where
and
(A4) P= (l/m) E Pi1- and n
i =1
(A8) WjNij= n
j=l
= yY(l1 -)l-,
where
p can be interpretedas the marginalutility
of real wealth.
The demandfor productof type i is there- (A9) W=(lln E W1-
fore given by j =1
n
The demand for labor of type j is there-
(AS) Yi= E Cij = (PiP) (Ylm), fore given by
j=1
m
where (AlO) Nj= Nij= (Wj/W) N/n,
i =1
n m n
where
(A6) Y= E EPI2Ci )/P = ( Y/P)
j i
?I;.
j=1
m n
(All) N- WjNij IW
Y denotes real aggregateconsumptionex- ij
penditures of households and will be re-
m
ferred to as "aggregatedemand."Equation 'Al/l -a)
m
y
(AS) is equation (7) in the text. Note also n Yi
i =1
that equations (Al), (A2), (A5), and (A6)
imply the following relationbetweenaggre- N can be interpretedas the aggregatelabor
gate demandand aggregatedesiredreal mo- demandindex.
VOL. 77 NO. 4 AND KIYOTAKI:MONOPOLISTIC
BLANCHARD
B. Price and Wage Rules
(a) Taking as givenwagesand the price
level, each firm choosesits price and output
so as to maximizeprofit:
n
(A12) Vi= Pry,- E WjNij,
j =1
subject to the cost function (A8) and the
demand function for its product(A5). Solv-
ing the above maximizationproblemgives
(A13) Pi1P= [((01(0#-l))n11(l
X (W/P) Y x-1I1A1 +O(Ca-
Equation(A13) impliesthatthe priceis equal
to 0/(6 -1) times the marginalcost. Equa-
tion (A13) is equation(10) in the text.
(b) Taking as given prices and other
wages, each householdchoosesits wage and
labor supply so as to maximizeutility.Using
(A3),
(A14) Uj= ,IjIP-N
subject to the demandfor its type of labor
(AIO)and the budgetconstraint:
m
(A15) Ij=WJNJ+ E fj+Mj.
X-1
Solving this maximizationproblemgives
(/(-
(A16) WjIW=
X ( PI W) 0,8-1] 1/(1+ a(-1))
Equation(A16) impliesthat the realwage,in
terms of utility, is equal to a/(a -1) times
the marginaldisutilityof labor.
C. Market Equilibrium
In equilibrium,desired real money bal-
ances must be equalto actualbalances.Thus
M = M'. Replacingin (A7) gives
(A17) Y= (y/(1-y))M/P.
COMPETITION 665
This gives equation(5) in the text.
Replacingthe Yi'sin (All) by theirvalue
from (AS) gives
(Al8) N [n/l(- a) m-a
-
X F (Pi/P) alY.
If all firmschoose the same (not necessarily
optimal)price, this reducesto
(A19) N= [nl/(1 Uml a]ya
-?)am1 a
Substituting N from equation (A19) into
1)). (AlO) gives the demandfunctionfor laborj,
equation (8) in the text. Note that the de-
mand functionsfor goods and labor,and the
relation between aggregatedemandand real
money balances,have been derivedwithout
use of the price and wagerulesand therefore
hold whetheror not wagesand pricesare set
optimally.
SubstitutingN from equation(A19) into
equation(A16) gives the wage rule,equation
(11) in the text. This completesthe deriva-
tion.
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