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

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

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

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

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

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

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

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

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

Extra: Price Setting Under Imperfect Competition Macroeconomics Chapter 16

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

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

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

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

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

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

The New Keynesian Model Macroeconomics Chapter 16

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

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

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

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

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

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

The New Keynesian Model Macroeconomics Chapter 16

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

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

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

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

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

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

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

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

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

Money and Nominal Interest Rates Macroeconomics Chapter 16

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

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

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

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

The Keynesian Model—Sticky Nominal Wage Rates Macroeconomics Chapter 16

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

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

The Keynesian Model—Sticky Nominal Wage Rates Macroeconomics Chapter 16

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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