HYSTERESIS, MENU COSTS, AND PRICING WITH RANDOM EXCHANGE-RATES

This paper develops a model to explain price stickiness to nominal shocks. It is the first model to allow two-sided general shocks. In an international environment, a firm that sells in its domestic market and abroad faces a stochastic exchange rate and menu costs. We obtain significant stickiness with very small menu costs. With exchange rate variance of 10% p.a., the exchange rate can fluctuate 25% without the firm having to adjust prices. An optimal control problem is solved whereby the firm allows marginal revenue to oscillate between two boundaries. It only regulates, by changing prices, at those boundaries.