1. Macroeconomics Chapter 16
Money and Business Cycles II:
Sticky Prices and Nominal Wage Rates
Macroeconomics Chapter 16

2. The New Keynesian Model
From equilibrium to disequilibrium model
Sticky price
Macroeconomics Chapter 16

3. The New Keynesian Model
2 Extensions:
Imperfect competition:
the typical producer actively sets its price.
Menu cost
Journal price
Macroeconomics Chapter 16

4. 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 )
Macroeconomics Chapter 16

5. The New Keynesian Model
Price Setting Under Imperfect Competition
Typically, q(j) depends on
relative price P( j )/P
the income of consumers
Macroeconomics Chapter 16

6. 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:
Macroeconomics Chapter 16

7. Extra: Price Setting Under Imperfect Competition
FOC:
is the elasticity of market demand at output .
Macroeconomics Chapter 16

8. Extra: Price Setting Under Imperfect Competition
Cournot Oligopoly:
J identical firms produce a homogeneous good.
The choice variable is the quantity.
All firms choose simultaneously.
Their cost function is same:
The inverse market demand is :
Macroeconomics Chapter 16

9. Extra: Price Setting Under Imperfect Competition
The profit function of firm j is:
FOC:
Macroeconomics Chapter 16

10. Extra: Price Setting Under Imperfect Competition
Macroeconomics Chapter 16

11. 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)
Macroeconomics Chapter 16

12. 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)
Macroeconomics Chapter 16

13. Macroeconomics Chapter 16
Extra: Price Setting Under Imperfect Competition
MC(j) = w/ MPL( j)
P( j) = (markup ratio) · [w/ MPL( j)]
Macroeconomics Chapter 16

14. The New Keynesian Model
Short-Run Responses to a Monetary Shock
Imagine M doubles.
P( j ) doubles when M doubles.
The average price, P, doubles
The nominal wage rate, w, also doubles
The economy-wide real wage rate, w/P,
Relative price, P( j )/P.
These changes leave unchanged the real variables in the economy.
Macroeconomics Chapter 16

15. 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, Yd( j ).
Macroeconomics Chapter 16

16. 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, Ld(j), rises by the amount:
∆Ld( 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 .
Macroeconomics Chapter 16

17. The New Keynesian Model
Macroeconomics Chapter 16

18. 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.
Macroeconomics Chapter 16

19. 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.
Macroeconomics Chapter 16

20. 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.
Macroeconomics Chapter 16

21. 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.
Macroeconomics Chapter 16

22. 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.
Macroeconomics Chapter 16

23. 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.
Macroeconomics Chapter 16

24. The New Keynesian Model
Macroeconomics Chapter 16

25. The New Keynesian Model
Back to assumption: sticky prices
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.
Macroeconomics Chapter 16

26. The New Keynesian Model
Shocks to Aggregate Demand
Each firm j experienced an increase in the demand for its goods, Yd(j), while its price, P(j), was held fixed. The same results apply if Yd(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.
Macroeconomics Chapter 16

27. 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.
Macroeconomics Chapter 16

28. 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.
Macroeconomics Chapter 16

29. Money and Nominal Interest Rates
In practice, central banks tend to express monetary policy as targets for short-term nominal interest rates, rather than monetary aggregates.
In the US, the Fed focuses on the Federal Funds rate—the overnight nominal interest rate in the Federal Funds market.
Macroeconomics Chapter 16

30. 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.
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.
Macroeconomics Chapter 16

31. 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
Macroeconomics Chapter 16

32. 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 .
Macroeconomics Chapter 16

33. Money and Nominal Interest Rates
Central banks have rejected proposals, originally put forward by Milton Friedman, to have a constant-growth-rate rule for a designated monetary aggregate.
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
Macroeconomics Chapter 16

34. Money and Nominal Interest Rates
Macroeconomics Chapter 16

35. Macroeconomics Chapter 16
Monetary Policy
The goal of monetary policy
Growth rate of GDP and unemployment rate?
--Greenspan
Inflation rate
--Bernanke
Macroeconomics Chapter 16

36. The Keynesian Model—Sticky Nominal Wage Rates
John Maynard Keynes:
The general theory of Employment, interest and money 1936
Did not explain the origins of the Great Depression
Active fiscal policy
Keynesian economics: government intervention at the macroeconomic level can help to improve the functioning of poorly performing market economies.
Milton Friedman:
The origin of the Great Depression is on government failure.
Macroeconomics Chapter 16

37. 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.
Macroeconomics Chapter 16

38. 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.
Macroeconomics Chapter 16

39. The Keynesian Model—Sticky Nominal Wage Rates
Macroeconomics Chapter 16

40. 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.
Macroeconomics Chapter 16

41. 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, Ld, and, thereby, increases labor input on the horizontal axis from L’ to L’’.
Macroeconomics Chapter 16

42. The Keynesian Model—Sticky Nominal Wage Rates
Macroeconomics Chapter 16

43. 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.
Macroeconomics Chapter 16

44. 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.
Macroeconomics Chapter 16

45. Long-Term Contracts and Sticky Nominal Wage Rates
Existence of long-term contracts: avoiding hold-up problems
Setting the nominal wage rate w in advance by rational expectation:
no systematical errors
hard to support Keynesian assumption that w is greater than w∗
Macroeconomics Chapter 16

46. Long-Term Contracts and Sticky Nominal Wage Rates
Another argument: aggregate shocks can create differences between w and w∗.
However, logic problem:
w/p > w∗/p  L=Ld<Ls happens in an impersonal market, not in a case of long-term contract
Long-term contract doesn’t necessarily cause errors in determination of L and Y.
Macroeconomics Chapter 16

47. 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.
Macroeconomics Chapter 16

48. 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.
Macroeconomics Chapter 16

49. Macroeconomics Chapter 16
Extra: IS-LM model r
S(y)
I(r)
I , S
Macroeconomics Chapter 16

50. Macroeconomics Chapter 16
Extra: IS-LM model r Y
Macroeconomics Chapter 16

51. Macroeconomics Chapter 16
Extra: IS-LM model
i=r
Assume now that P is fixed
M/P
Macroeconomics Chapter 16

52. Macroeconomics Chapter 16
Extra: IS-LM model r
Monetary policy: M increases Y
Macroeconomics Chapter 16

53. Macroeconomics Chapter 16
Extra: IS-LM model
Equilibrium: r
Monetary policy:
M increases Y
Macroeconomics Chapter 16

54. Macroeconomics Chapter 16
Extra: AD-AS model
Aggregate Demand : r
M fixed and P decreases
LM curve moves down
R decreases and
Y increases Y
Macroeconomics Chapter 16

55. Macroeconomics Chapter 16
Extra: AD-AS model
Aggregate Demand: P
P decreases and
Y increases Y
Macroeconomics Chapter 16

56. Macroeconomics Chapter 16
Extra: AD-AS model
Aggregate Supply : P
Long run:
Y is fixed
Short run:
P is fixed Y
Macroeconomics Chapter 16

57. Macroeconomics Chapter 16
Extra: AD-AS model
Aggregate Supply : r LM IS
Long run:
Y is fixed
Short run:
P is fixed Y
Macroeconomics Chapter 16

58. Macroeconomics Chapter 16
Extra: AD-AS model
Aggregate Supply : P
LRAS AD
Long run:
Y is fixed
Short run:
P is fixed
SRAS Y
Macroeconomics Chapter 16