1. New Keynesian School Nominal Rigidities

2. Some Keynesian models rely on the failure of nominal wages and prices to adjust to their new market clearing levels following an aggregate demand disturbance. These models typically concentrate on the labor market and nominal wage stickiness to explain the tendency of market economies to depart from full employment equilibrium.

3. Saved by the Bell….. Fischer (1977) and Phelps and Taylor (1977) showed that nominal disturbances were capable of producing real effects in models incorporating rational expectations, providing the assumption of continuously clearing markets was dropped. This means that the acceptance of rational expectations did not mean the end of Keynesian economics.

4. Nominal Rigidities: Long Term Wage Contracts In developed markets, wages are not determined in spot markets. Rather, wages tend to be set for an agreed period in the form of an explicit (or implicit) contract. The existence of these contracts can generate sufficient nominal wage rigidity for monetary policy to be effective.

5. Long Term Contracts These models assume that economic agents negotiate contracts in nominal terms for periods longer than the time it takes the monetary authority to react to changing economic circumstances. Monetary policy, therefore, can have real effects in the short run, but will be neutral in the long run.

6. Long Term Contracts 0 Y 1 Y N Y AD 1 AD 0 P P1P1 P0P0 SAS(W 1 ) SAS(W 0 ) A B C LAS The initial equilibrium occurs at point A. An unexpected nominal demand shock such as a drop in velocity causes aggregate demand to shift from AD 0 to AD 1. If prices are flexible but nominal wages equal W 0 and are set by contract in the previous period, the economy moves to point B. Output falls from Y N to Y 1. If nominal wages were flexible, SAS(W 0 ) would shift to SAS(W 1 ) to re-establish the natural rate of output at point C.

7. Long Term Contracts Summary: –The existence of long term contracts prevents the rapid establishment of equilibrium at point C and provides the monetary authority with an opportunity to expand the money supply, which, even if anticipated, shifts the AD curve to the right and re- establishes equilibrium at point A. –If the central bank is free to act while workers are not, there is room for demand management, because the fixed nominal wage gives the central bank influence over the real wage and hence employment and output.

8. Long Term Contracts Why are long term contracts formed if they increase macroeconomic instability? There are private advantages to both firms and workers: –Wage negotiations are costly in time for both workers and firms. –The potential for wage negotiations to break down always exists, increasing the risk of a strike. –Decreasing wages following a negative shock may reduce the firm’s wage relative to other firms and increase labor turnover.

9. Long Term Contracts: Criticisms The existence of such contracts is not explained from solid microeconomic principles. The models predict that monetary expansion increases employment by lowering the real wage, but real wages do not appear to be counter-cyclical in the real world. Research switched to explaining business cycles by rigidities in the goods market.

10. Nominal Rigidities: Real Goods Market When firms face a downward sloping demand curve, price reductions increase sales but also result in less revenue per unit sold. However, if the drop in profits is not substantive compared to the cost of changing prices, the presence of even small costs to price adjustment can generate considerable aggregate nominal price rigidity. The presence of frictions or barriers to price adjustment are known as menu costs. –Examples of menu costs include the physical costs of resetting prices and expensive management time used in the supervision and renegotiation of purchase and sales contracts with suppliers and customers.

11. Menu Costs The key insight of this model is that the private cost of nominal rigidities to the individual firm is much smaller than the macroeconomic consequences of such rigidities.

12. Background: Definitions Profit maximization rule: –Produce where marginal cost equals marginal revenue. Marginal revenue is the revenue received from producing the next unit of output. Marginal cost is the cost associated with producing the next unit of output.

13. Background: MR = MC When a firm produces at the point where marginal revenue equals marginal cost, every unit of output that contributes to profit has been produced. When a firm produces at a point where marginal revenue exceeds marginal cost, units of output that contribute to profit are not produced. When a firm produces at a point where marginal revenue is less that marginal cost, units of output that decrease profit are produced.

14. Background: Profit Maximization D MR MC 0 Q P Q 1 Q 2 Q 3 At Q 1, MR > MC, the firm should produce more. At Q 3, MR< MC, the firm should produce less. At Q 2, MR = MC, profits are maximized..

15. Background: TR, TC, Profits D MR Q0 MC P S T V W TR = ? TC = ? Profits = ? Q

16. Menu Costs In imperfectly competitive markets, a firm’s demand curve depends on: –The relative price of its good –Aggregate demand The firm decides how much to produce by setting marginal cost equal to marginal revenue unless menu costs are significant.

17. Menu Costs 0 Q* Q 1 Q 0 Q P0P0 P1P1 S D0D0 MR 1 D1D1 MR 0 MC P Y W J T VX Given the demand curve D 0, the firm maximizes profits by setting price equal to P 0 and selling Q 0. A drop in aggregate demand causes the demand curve facing the firm to shift to the left to D 1. Given the demand curve D 1, the firm maximizes profits by setting price equal to P 1 and selling Q 1. If the firm chooses to continue to charge P 1 when its demand curve is D 1, it sells the amount Q* and no longer maximizes profits.

18. Menu Costs 0 Q* Q 1 Q 0 Q P0P0 P1P1 S D0D0 MR 1 D1D1 MR 0 MC P Y W J T VX Profits equal total revenues minus total costs. On demand curve D 0, before the decline in aggregate demand, the firm’s total revenue equals the area 0P 0 YQ 0 and the firms total costs equal 0SXQ 0. Its profits equal the area SP 0 YX.

19. Menu Costs 0 Q* Q 1 Q 0 Q P0P0 P1P1 S D0D0 MR 1 D1D1 MR 0 MC P Y W J T VX Profits equal total revenues minus total costs. After the decline in aggregate demand, on demand curve D 1, the firm’s total revenue equals the area 0P 1 WQ 1 and the firms total costs equal 0SVQ 1. Its profits equal the area SP 1 WV.

20. Menu Costs 0 Q* Q 1 Q 0 Q P0P0 P1P1 S D0D0 MR 1 D1D1 MR 0 MC P Y W J T VX Profits equal total revenues minus total costs. After the decline in aggregate demand, if the firm does not decrease price from P 0, the firm’s total revenue equals the area 0P 0 JQ* and the firms total costs equal 0STQ*. Its profits equal the area SP 0 JT.

21. Menu Costs The firm must decide whether or not to reduce price to the new profit maximizing point, W on the new demand curve, D 1. –With no adjustment costs, the firm makes a profit equal to SP 1 WV and would reduce output to Q 1. –But, if the firm faces non-trivial menu costs of z, the firm may decide to leave the price at P 0, thereby moving from point Y to point J.

22. Menu Costs MC Q* Q 1 Q 0 Q0 D1D1 P0P0 P1P1 S P A C B J W T V By reducing price from P 0 to P 1, the firm would increase its profits by B – A, but there is no incentive for the firm to reduce price if z > B – A. If z > B – A, the firm would to charge P 0 and sell Q*. The loss to society of producing Q* rather than Q 1 is the amount B + C, which equals the loss of total surplus. If B + C > z >B – A, then the firm will not cut its price even though doing so would be socially optimal

23. Summary: Menu Costs If the presence of menu costs causes nominal price rigidity, shocks to nominal aggregate demand will cause fluctuations in output and welfare. Such fluctuations are inefficient, indicating the need for stabilization policy. In addition if nominal wages are rigid because of contracts, the marginal cost curve will be sticky, thus reinforcing the impact of menu costs in producing price rigidities.