1. Macroeconomics Chapter 161 Money and Business Cycles II: Sticky Prices and Nominal Wage Rates C h a p t e r 1 6

2. Macroeconomics Chapter 162 The New Keynesian Model  2 Extensions: Imperfect competition: the typical producer actively sets its price. Sticky prices: nominal goods prices that do not react rapidly to changed circumstances.  menu cost  Journal price

3. Macroeconomics Chapter 163 The New Keynesian Model  Price Setting Under Imperfect Competition Let P( j ) be the price charged for a good by firm j. the quantity demanded of firm j ’ s goods is q( j )

4. Macroeconomics Chapter 164 The New Keynesian Model  Price Setting Under Imperfect Competition Typically, q(j) depends on relative price P( j )/P and the income of consumers

5. Macroeconomics Chapter 165 Extra: Price Setting Under Imperfect Competition  Pure Monopoly A single seller, who chooses price and quantity to maximize profits. Entry into the market is completely blocked by technological or legal barriers. The monopolist ’ s profit-maximization problem:

6. Macroeconomics Chapter 166 Extra: Price Setting Under Imperfect Competition  FOC: is the elasticity of market demand at output.

7. Macroeconomics Chapter 167 Extra: Price Setting Under Imperfect Competition Cournot Oligopoly: The choice variable is the quantity. All firms choose simultaneously. J identical firms produce a homogeneous good. Their cost function is same: The inverse market demand is :

8. Macroeconomics Chapter 168 Extra: Price Setting Under Imperfect Competition  The profit function of firm j is: FOC:

9. Macroeconomics Chapter 169 Extra: Price Setting Under Imperfect Competition

10. Macroeconomics Chapter 1610 Extra: Price Setting Under Imperfect Competition  Under imperfect competition, each firm can set P( j ) above its nominal marginal cost.  The ratio of P( j ) to the nominal marginal cost is called the markup ratio  firm j ‘ s markup ratio = P( j)/MC( j)

11. Macroeconomics Chapter 1611 Extra: Price Setting Under Imperfect Competition  P( j) = (markup ratio) · MC( j)  The production function for firm j looks like the function we have used before: Y( j) = F[κ( j) · K( j), L( j) ]  MPL( j) = ∆Y( j)/ ∆L( j)

12. Macroeconomics Chapter 1612  MC(j) = w/ MPL( j)  P( j) = (markup ratio) · [w/ MPL( j)] Extra: Price Setting Under Imperfect Competition

13. Macroeconomics Chapter 1613 The New Keynesian Model  Short-Run Responses to a Monetary Shock Imagine M doubles.  In this setting, each nominal price, P( j ), doubles when M doubles.  The average price, P, doubles  The economy-wide nominal wage rate, w, also doubles as before.  These changes leave unchanged the real variables in the economy.  The real variables now include not only the economy-wide real wage rate, w/P, but also the ratio of each firm ’ s price to the average price, P( j )/P.

14. Macroeconomics Chapter 1614 The New Keynesian Model  Short-Run Responses to a Monetary Shock with Sticky Prices The average price, P, would then also be fixed. If P is constant and M doubles, each household would have twice as much real money, M/P, as before. However, nothing has changed to motivate households to hold more money in real terms. Each household would therefore try to spend its excess money, partly by buying the goods produced by the various firms. Each firm j would then experience an increase in the quantity demanded of its goods, Y d ( j ).

15. Macroeconomics Chapter 1615 The New Keynesian Model To raise its production, Y( j ), firm j has to increase its quantity of labor input, L( j ). Therefore, the quantity of labor demanded, L d (j), rises by the amount: ∆L d ( j) = ∆Y(j)/MPL(j) With a fixed price P( j ), an increase in the nominal quantity of money, M, leads to an expansion of labor demand by each firm j.

16. Macroeconomics Chapter 1616 The New Keynesian Model

17. Macroeconomics Chapter 1617 The New Keynesian Model An increase in the nominal quantity of money from M to M ’ raises the market-clearing labor input from L ∗ to (L ∗ ) ’ on the horizontal axis. With the increase in labor input, each firm produces more goods. Thus, real GDP increases. We therefore have that a monetary expansion is non- neutral. An increase in the nominal quantity of money raises real GDP. Moreover, labor input, L, moves in a procyclical manner — it rises along with Y.

18. Macroeconomics Chapter 1618 The New Keynesian Model  New Keynesian Predictions The predictions from the new Keynesian model are similar to those from the price-misperceptions model. That model also gave the result that a monetary expansion raised real GDP, Y, and labor input, L.

19. Macroeconomics Chapter 1619 The New Keynesian Model  Difference between the two models: w/P the price-misperceptions model, an expansion of L had to be accompanied by a fall in w/P in order to induce employers to use more labor input.  that model predicted — counterfactually — that w/P would be countercyclical. that a monetary expansion increases the market-clearing real wage rate from (w/P) ∗ to [(w/P) ∗ ] ’ on the vertical axis. Therefore, the model generates a procyclical pattern for w/P.

20. Macroeconomics Chapter 1620 The New Keynesian Model  New Keynesian Predictions Keynesian model predicts, counterfactually, that Y/L would be countercyclical. Keynesian economists have used the idea of labor hoarding to improve the model ’ s predictions about labor productivity.

21. Macroeconomics Chapter 1621 The New Keynesian Model  Price Adjustment in the Long Run In the long run, the prices adjust, and tend to undo the real effects from a change in M. P(j) = (markup ratio) · [ w/ MPL( j) ] The real effect of a monetary shock in the new Keynesian model is a short-run result that applies only as long as prices fail to adjust to their equilibrium levels.

22. Macroeconomics Chapter 1622 The New Keynesian Model Data do reveal stickiness of some prices. However, a tentative conclusion from empirical research with these new data is that price stickiness is insufficient to explain a major part of economic fluctuations.

23. Macroeconomics Chapter 1623 The New Keynesian Model  Comparing Predictions for Economic Fluctuations The new Keynesian model correctly predicts a procyclical pattern for the real wage rate, w/P, and a countercyclical pattern for the price level, P. The new Keynesian model errs by predicting a countercyclical pattern for Y/L, although the idea of labor hoarding might fix this problem.

24. Macroeconomics Chapter 1624 The New Keynesian Model

25. Macroeconomics Chapter 1625 The New Keynesian Model  Shocks to Aggregate Demand Each firm j experienced an increase in the demand for its goods, Y d (j), while its price, P(j), was held fixed. The same results apply if Y d (j) rises for each firm j for reasons having nothing to do with money. The essential ingredient is an increase in the aggregate demand for goods.

26. Macroeconomics Chapter 1626 The New Keynesian Model  Shocks to Aggregate Demand One way for aggregate demand to rise is for households to shift exogenously away from current saving and toward current consumption, C. Another possibility is that the government could boost the aggregate demand for goods by increasing its real purchases, G.

27. Macroeconomics Chapter 1627 The New Keynesian Model  Shocks to Aggregate Demand An increase in the aggregate demand for goods may end up increasing real GDP, Y, by even more than the initial expansion of demand. That is, there may be a multiplier in the model — the rise in Y may be a multiple greater than one of the rise in demand.

28. Macroeconomics Chapter 1628 Money and Nominal Interest Rates  In practice, central banks — such as the Federal Reserve — tend to express monetary policy as targets for short-term nominal interest rates, rather than monetary aggregates.  In the United States, especially since the early 1980s, the Fed focuses on the Federal Funds rate — the overnight nominal interest rate in the Federal Funds market, which comprises financial institutions, such as commercial banks.

29. Macroeconomics Chapter 1629 Money and Nominal Interest Rates  The Federal Reserve ’ s Federal Open Market Committee (FOMC) meets eight or more times a year. At each meeting, the FOMC adopts a target for the Federal Funds rate.

30. Macroeconomics Chapter 1630 Money and Nominal Interest Rates  The central idea is that, in the short run with sticky prices, open-market operations affect nominal interest rates — the Federal Funds rate in the United States and the nominal interest rate, i, in our model.

31. Macroeconomics Chapter 1631 Money and Nominal Interest Rates  M= P · L( Y, i)  In the new Keynesian model, P is fixed in the short run.  Thus, if M increases, equilibrium requires some combination of higher Y or lower i to raise the nominal quantity of money demanded by the same amount.  For a given Y, a higher M has to match up with a lower i

32. Macroeconomics Chapter 1632 Money and Nominal Interest Rates  In our previous analysis, we thought of an expansionary monetary shock as an increase in the nominal quantity of money, M.  Now we can think of an expansionary monetary action as a decrease in the nominal interest rate, i.

33. Macroeconomics Chapter 1633 Money and Nominal Interest Rates  It nearly impossible for the Fed to designate in advance the precise time path for the monetary base or some other monetary aggregate needed to achieve a desired part for i.  Central banks have rejected proposals, originally put forward by Milton Friedman, to have a constant-growth-rate rule for a designated monetary aggregate.

34. Macroeconomics Chapter 1634 Money and Nominal Interest Rates  Because of the shortcomings in rules based on monetary aggregates, the Fed and other central banks tend to frame their policies in terms of targeted adjustments in nominal interest rates, i  An important point is that the Fed does not have to know the exact specification for L(Y, i). The Fed just keeps raising M until it sees the nominal interest rate that it wants.

35. Macroeconomics Chapter 1635 Money and Nominal Interest Rates

36. Macroeconomics Chapter 1636 The Keynesian Model—Sticky Nominal Wage Rates  Sticky nominal wage rates — that is, a failure of nominal wage rates to react rapidly to changed circumstances.  Perfect competition. — In this setting, the single nominal price, P, applies to all goods.

37. Macroeconomics Chapter 1637 The Keynesian Model—Sticky Nominal Wage Rates  Keynes focused on a case in which w was higher than its market- clearing level.  This assumption will imply that the real wage rate, w/P, will be above its market-clearing value.

38. Macroeconomics Chapter 1638 The Keynesian Model—Sticky Nominal Wage Rates

39. Macroeconomics Chapter 1639 The Keynesian Model—Sticky Nominal Wage Rates  The excess of the quantity of labor supplied (at the given real wage rate, [w/P]) over L ’ is called involuntary unemployment.

40. Macroeconomics Chapter 1640 The Keynesian Model—Sticky Nominal Wage Rates  Suppose, now, that a monetary expansion raises the price level, P. If the nominal wage rate, w, does not change, the rise in P lowers the real wage rate, w/P.  This fall in w/P raises the quantity of labor demanded, L d, and, thereby, increases labor input on the horizontal axis from L ’ to L ’’.

41. Macroeconomics Chapter 1641 The Keynesian Model—Sticky Nominal Wage Rates

42. Macroeconomics Chapter 1642 The Keynesian Model—Sticky Nominal Wage Rates  With sticky nominal wage rates, a monetary expansion raises labor input, L. The increase in L leads through the production function to an expansion of real GDP, Y.

43. Macroeconomics Chapter 1643 The Keynesian Model—Sticky Nominal Wage Rates  The Keynesian model is similar to the new Keynesian model in predicting that M and L would be procyclical.  However, unlike the new Keynesian model, the Keynesian model predicts that w/P would be countercyclical.  We have stressed that w/P typically moves in a procyclical manner. Therefore, the Keynesian model has difficulty explaining the observed cyclical behavior of w/P.

44. Macroeconomics Chapter 1644 Long-Term Contracts and Sticky Nominal Wage Rates  For many workers, nominal wage rates are set for one or more years by the terms of agreements made with employers. These agreements are sometimes formal contracts between firms and labor unions.  More commonly, firms and workers have implicit contracts that specify in advance the nominal wage rate over some period, often a fiscal or calendar year.

45. Macroeconomics Chapter 1645 Long-Term Contracts and Sticky Nominal Wage Rates  Suppose that an employer and employee agree on a fixed nominal wage rate, w, for the next year.  A natural choice is to set w equal to the best estimate of the average market- clearing nominal wage rate, w ∗, that will prevail over the year.  Although the chosen w may be a rational expectation of w ∗, unanticipated events lead to mistakes.

46. Macroeconomics Chapter 1646 Long-Term Contracts and Sticky Nominal Wage Rates  When the contract expires, the employer and employee agree on a new nominal wage rate, w, for the next year. This new w takes account of events during the current year, including the inflation rate, π.  Thus, if expectations are rational, mistakes in the setting of w for this year — due perhaps to underestimation of inflation — tend not to be repeated the next year.

47. Macroeconomics Chapter 1647 Long-Term Contracts and Sticky Nominal Wage Rates  At any point in time, the economy has an array of existing labor contracts, each of which specifies a nominal wage rate, w, that likely deviates somewhat from the market clearing value, w ∗.  Some of these agreements have w greater than w ∗, and others have w less than w ∗.

48. Macroeconomics Chapter 1648 Long-Term Contracts and Sticky Nominal Wage Rates  Important empirical works: Ahmed(1987): index contracts Olivei et al. (2007): shocks in different seasons have different effect.

49. Macroeconomics Chapter 1649 Long-Term Contracts and Sticky Nominal Wage Rates  An important lesson from the contracting approach: Stickiness of the nominal wage rate, w, need not lead to the unemployment and underproduction that appears in the Keynesian model.

50. Macroeconomics Chapter 1650 Extra: IS-LM model r I, S S(y) I(r)

51. Macroeconomics Chapter 1651 Extra: IS-LM model r Y

52. Macroeconomics Chapter 1652 Extra: IS-LM model i=r M/P Assume now that P is fixed

53. Macroeconomics Chapter 1653 Extra: IS-LM model r Y Monetary policy: M increases

54. Macroeconomics Chapter 1654 Extra: IS-LM model r Y Equilibrium: Monetary policy: M increases

55. Macroeconomics Chapter 1655 Extra: AD-AS model r Y Aggregate Demand : M fixed and P decreases LM curve moves down R decreases and Y increases

56. Macroeconomics Chapter 1656 Extra: AD-AS model P Y Aggregate Demand: P decreases and Y increases

57. Macroeconomics Chapter 1657 Extra: AD-AS model P Y Aggregate Supply : Long run: Y is fixed Short run: P is fixed

58. Macroeconomics Chapter 1658 Extra: AD-AS model r Y Aggregate Supply : Long run: Y is fixed Short run: P is fixed

59. Macroeconomics Chapter 1659 Extra: AD-AS model P Y AD-AS: