Small price change response to a large devaluation in a menu cost model

In an empirical paper based on five large devaluation episodes in Argentina, Brazil, Korea, Mexico and Thailand, Burstein and al. (2005a) find a very slow adjustment in the prices of non-tradable goods and services after large devaluations. Burnstein and al. (2005b) develop a quantitative general-equilibrium model that can account for this phenomenon. I consider an alternative, simpler model and explore under which conditions moderate menu costs can explain the muted response of the prices of non-tradables. The key new element in this alternative model is a nominal friction in wage-setting (generated by menu costs for changing wages). I find, for example, that although my model is based on menu costs, it is able to deliver not only constant prices of non-tradables, but also small price changes (in reality these prices do change, albeit by far less than the exchange rate). I also discuss the existence of multiple equilibria and the role of central-bank credibility.