Lectures 4
Partha Ray
29 July 2016
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Implementation lag
Impact lag
Some Basics
By definition, the log of nominal GNP (X) must be divided between the log of
the GNP deflator (P) and the log of real GNP (Q)
X = P + Q.
or, in % term, x = p + q
which states that any change in nominal GNP must be divided between a change in
the aggregate price level and a change in real GNP.
Next, we subtract from both sides of the above expression, the long-run
equilibrium or natural growth rate of real GNP (q*),:
x- q*= p + (q - q*)
This states that an excess of nominal GNP growth over the long-run growth rate
of real output (x) must be accompanied by some combination of inflation (p) and
a deviation of real output from that same long-run growth rate (q).
If the rate of change of prices over the business cycle is always equal to some
constant fraction () of the excess nominal GNP movement, then businesscycle movements in real output (q) must soak up the remaining fraction (1 - ):
p = (x- q*)
q-q*= (1- ) (x- q*)
Thus, an economy with relatively sticky prices (a small ) must exhibit
correspondingly large fluctuations in real output, as long as fluctuations in
nominal demand (x - q*) are independent of the price stickiness parameter ()
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Basic Tenets of RE
(1) Rational Expectation: yte = E(yt| It-1)
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New Keynesians
Rational expectations + microfoundations
But real / nominal wage / price rigidity
Offer theoretical support at the firm profit
maximization level for Keynesian features in the
economy
Contracting models
Menu/transactions costs
Efficiency wages
Insider-Outsider theory
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New Keynesians
In the new classical model, all wages and prices are completely
flexible with respect to expected changes in the price level.
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For example, workers might find themselves at the end of the first
year of a three-year wage contract that specifies the wage rate for
the coming two years. Even if new information appeared that would
make them raise their expectations of the inflation rate and the
future price level, they could not do anything about it because they
are locked into a wage agreement. Even with a high expectation
about the price level, the wage rate will not adjust.
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Although the new Keynesians do not agree with the complete wage and
price flexibility of the new classical macroeconomics, they nevertheless
recognize the importance of expectations to the determination of short-run
aggregate supply and are willing to accept rational expectations theory as a
reasonable characterization of how expectations are formed.
The model they have developed, the new Keynesian model, assumes that
expectations are rational but does not assume complete wage and price
flexibility; instead, it assumes that wages and prices are sticky.
Anticipated policy does affect aggregate output and the business cycle
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Micro-Foundation
of Wage and Price
Rigidity
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SAS(W0)
P0
P1
SAS(W1)
A
B
C
AD0
AD1
Y1
YN
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(2) 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.
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TR = ?
TC = ?
Profits = ?
MC
MR
0
D
Q
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P0
Y
W
P1
D0
MR1 MR0
0
Q* Q1
D1
Q
Q0
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P0
Y
W
P1
MC
D0
MR1 MR0
0
Q* Q1
Q0
D1
Q
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P0
Y
W
P1
MC
D0
MR1 MR0
0
Q* Q1
D1
Q
Q0
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Menu Costs
Profits equal total revenues minus total
costs.
P0
Y
W
P1
MC
D0
MR1 MR0
0
Q* Q1
Q0
D1
Q
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P0
A
P1
B
S
Q* Q1
D1
Q0
MC
Q
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e(w), e '(w) 0
EN e(w) N
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To Sum up.
Monetary Policy can influence both output
and inflation as long as there is some real /
nominal rigidities in the system even with
rational expectation.
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