Menu Costs Pricing Theory and Endogenous Conditional Heteroskedasticity

Macroeconomic theories in which there is a fixed cost to changing prices have proliferated recently. This paper solves a menu-cost pricing problem faced by a monopolistic firm in continuous time and subject to both the stochastic aggregate price level emphasized by Sheshinski and Weiss (1983) and the stochastic demand and cost disturbances emphasized by Barro (1972). It finds closed-form expressions for the time-varying trigger points of an optimal pricing strategy. These controls are forward-looking since the economy is not assumed to be in a steady state. The analysis suggests some guidelines for microeconomic tests of menu-cost pricing hypothesis. It also provides an example of how conditional heteroskedasticity can arise endogenously in an optimizing model.