Laurence Ball, N. Gregory Mankiw, and David Romer 5 SMALL NOMINAL FRICTIONS AND LARGE NOMINAL RIGIDITIES The recent literature on nominal rigidities enters an argument that Keynesians appeared to be losing. Members of the new classical school that developed in the 1970s challenged Keynesians to explain the rigidities in Keynesian models. In response, Keynesians sometimes cited costs of adjusting prices. But as the classicals pointed out, these costs, while surely present, appear small. Indeed, the frequently men- tioned"menu costs-the costs of printing new menus and catalogs, of replacing price tags, and so on-sound trivial. Thus the impediments to nominal flexibility in actual economies appear too small to provide a foundation for Keynesian models A common but mistaken response is that there are many obvious sources of large wage and price rigidities: implicit contracts, customer markets, efficiency wages, insider-outsider relationships, and so on. The problem is that these phenomena imply rigidities in real wages and prices, while the Keynesian theory depends on rigidities in nominal wages and prices. Real rigidities are no impediment to complete flexibility of nominal prices, because full adjustment to a nominal shock does not require any change in real prices. The absence of models of nominal rigidity reflects the microeconomic proposition that agents do not ca about nominal magnitudes. The only apparent departures from this proposition in actual economies are the small costs of nominal adjust ment Thus recent work begins with the premise that it is inexpensive to reduce nominal rigidity and asks how substantial rigidity nonethele arises. The central answer of the literature is presented by mankiw, Akerlof and Yellen, Blanchard and Kiyotaki, and Ball and romer. Journal of Economic Literature, vol. 19(June 1981), pp. 493-530, and the discussion of externalities from nominal rigidity in Charles L. Schultze, Microeconomic Efficiency nd Nominal Wage Stickiness, American Economic Review, vol. 75(March 1985) 6. N. Gregory Mankiw, ""Small Menu Costs and Large Business Cycles: A Macroe of Monopoly, Quarterly Journal of Economics, vol, 100(May 1985), pp A, Akerlof and Janet L, ye ics,vol.100(1985 Supplement), pp. 823-38; Oliv erican Economic Review, vol, 77 (September 1987), pp. 647-66 David Romer, Are Prices Too Sticky? Working Paper 2171(NBER, February 1987)