Answer:

Nominal rigidities, also known as price stickiness, refer to the slow adjustment of prices and wages to changes in economic conditions. In Keynesian models, this friction is crucial because it explains why monetary policy can have real effects on output and employment in the short run.

If prices and wages were perfectly flexible, any change in the nominal money supply would be immediately offset by a proportional change in all prices and wages, leaving real variables like output and employment unchanged (the classical dichotomy and monetary neutrality). However, with sticky prices, an increase in the money supply leads to an increase in aggregate demand that firms meet by increasing production rather than just raising prices, thus boosting output and employment.

Source: EC3115 Subject Guide, Chapter 9; McCallum (1989), Chapter 9.

Answer:

Several theories explain why firms might not adjust prices immediately to a change in demand:

• Menu Costs: This is the most direct explanation. It refers to the physical costs of changing prices, such as printing new menus, updating catalogs, or changing price tags. If these costs are significant, firms may wait until the desired price change is large enough to justify incurring them.
• Customer Relationships (Implicit Contracts): Firms may prefer to keep prices stable to avoid upsetting their regular customers. Frequent price changes can be perceived as unfair, leading customers to search for alternative suppliers. This idea is central to Okun's "customer market" theory.
• Coordination Failure: A firm may be reluctant to be the first to change its price. If a firm lowers its price but its suppliers do not, its profit margin shrinks. If it raises its price but competitors do not, it loses market share. This creates an incentive to wait and see what other firms will do.

Source: Blanchard (1987), "Why Does Money Affect Output?"; Gordon (1982), "Wages and Prices are Not Always Sticky".

Answer:

An expansionary monetary policy (e.g., an increase in the money supply) has the following short-run effects:

1. Aggregate Demand (AD) shifts right: The increased money supply lowers interest rates (shifting the LM curve right), stimulating investment and consumption, which shifts the AD curve to the right.
2. Price Level Rises: The rightward shift in AD leads to a higher price level.
3. Real Wage Falls: With the nominal wage (W) sticky, the rise in the price level (P) causes the real wage (W/P) to fall.
4. Employment Increases: A lower real wage makes it profitable for firms to hire more workers, so employment increases.
5. Output Increases: With more workers employed, output increases along the production function.

Thus, money is non-neutral in the short run, having a positive effect on real output and employment.

Source: EC3115 Subject Guide, Chapter 9; EC3115 Monetary Economics Unit I Lectures.

Answer:

In the long run, nominal wages are no longer sticky. Workers and firms will adjust their wage expectations and contracts to account for the higher price level caused by the monetary expansion.

The process is as follows:

1. Workers realize their real wages have fallen and renegotiate their nominal wages upwards.
2. The nominal wage (W) rises until the real wage (W/P) returns to its original, market-clearing level.
3. As the real wage rises, firms reduce employment back to its original "natural" level.
4. Consequently, output returns to its "natural" or potential level.

The final result is a higher price level and a higher nominal wage, but no change in real variables like output, employment, or the real wage. This demonstrates the principle of long-run monetary neutrality.

Source: EC3115 Subject Guide, Chapter 9; McCallum (1989), Chapter 9.

Answer:

The original Phillips curve, based on the work of A.W. Phillips (1958), described a stable, inverse empirical relationship between the rate of unemployment and the rate of nominal wage inflation (and by extension, price inflation).

The relationship can be expressed as:

\[ \Delta w_t = f(UN_t) \]

where \( \Delta w_t \) is the rate of wage inflation and \( UN_t \) is the unemployment rate, with \( f' < 0 \).

This suggested a permanent policy trade-off: policymakers could choose a point on the curve, achieving lower unemployment at the cost of higher inflation, or vice versa. For example, they could accept a higher rate of inflation to maintain a lower rate of unemployment indefinitely.

Source: McCallum (1989), Chapter 9; Phelps (1967), "Phillips Curves, Expectations of Inflation and Optimal Unemployment over Time".

Answer:

The expectations-augmented Phillips curve, developed by Milton Friedman and Edmund Phelps, modifies the original curve by adding the expected rate of inflation as a key determinant of nominal wage changes.

The equation is:

\[ \Delta w_t = f(UN_t) + \Delta p_t^e \]

where \( \Delta p_t^e \) is the expected rate of price inflation. This formulation is based on the idea that workers and firms are concerned with real wages, not nominal wages. When they negotiate wages, they will build their inflation expectations into the nominal wage settlement.

The key difference is that it eliminates the idea of a permanent trade-off between inflation and unemployment. In the long run, when expected inflation equals actual inflation (\( \Delta p_t^e = \Delta p_t \)), the Phillips curve becomes vertical at the "natural rate of unemployment" (NRU). Any attempt to hold unemployment below the NRU will lead to accelerating inflation, not just a higher stable rate of inflation.

Source: McCallum (1989), Chapter 9; Friedman (1968), "The Role of Monetary Policy".

Answer:

The natural rate of unemployment (NRU), a concept introduced by Milton Friedman and Edmund Phelps, is the unemployment rate that exists when the economy is in long-run equilibrium. It is the rate at which the actual inflation rate equals the expected inflation rate.

Key characteristics:

• It is "natural" in the sense that it is determined by real factors in the economy, such as the structure of the labor market, labor market institutions, demographic changes, and the efficiency of job search. It is not determined by monetary factors.
• It is the unemployment rate toward which the economy gravitates in the long run.
• It is the only unemployment rate that can be sustained without causing accelerating or decelerating inflation.
• It is not necessarily optimal or socially desirable, and it can change over time due to structural changes in the economy.

The expectations-augmented Phillips curve is vertical at the NRU in the long run.

Source: Friedman (1968), "The Role of Monetary Policy"; Phelps (1967).

Answer:

John B. Taylor's model (1979, 1980) is a key New Keynesian model that explains how monetary policy can have persistent effects on output. Its main features are:

• Staggered Contracts: Not all wage contracts are set at the same time. For example, half the workforce might set their wages in even periods, and the other half in odd periods.
• Multi-period Contracts: Contracts are set for more than one period (e.g., two years). This introduces nominal rigidity because wages are fixed for the duration of the contract.
• Relative Wage Concerns: When setting their nominal wage, workers care about the wages of other workers who will have contracts in place during the same period. This creates a "wage-wage" inertia. A group setting a new contract will look at the existing contracts and contracts expected to be set in the future.
• Forward-Looking Expectations: Wage setters form rational expectations about future economic conditions and the wages of other groups.

The combination of these features means that the overall wage level adjusts only slowly to shocks, as only a fraction of wages are reset in any given period. This slow adjustment of the aggregate wage level allows monetary policy to have real, and importantly, persistent effects on the economy.

Source: McCallum (1989), Chapter 9; Blanchard (1987).

Answer:

The persistence of monetary effects in Taylor's model is a direct result of the staggered nature of wage setting and the concern for relative wages.

Consider a two-period staggered contract model. When an unexpected monetary shock occurs, only the group of workers currently negotiating can react. The other group's wages are fixed by their pre-existing contract.

The currently negotiating group will not fully adjust their wages to the new economic conditions. This is because they care about their wage relative to the other group, whose wages are still fixed at the old, pre-shock level. To avoid a large relative wage disparity, they will set their new wage somewhere between the old wage and the new, fully-adjusted equilibrium wage.

In the next period, when the other group renegotiates, they will look at the wage set by the first group in the previous period. They too will only partially adjust. This process of partial, leapfrogging adjustments continues over several periods, causing the aggregate wage level to converge slowly to its new long-run equilibrium. This slow wage adjustment is what creates the prolonged, or persistent, real effects of the monetary shock on output and employment.

Source: McCallum (1989), Chapter 9; Blanchard (1987).

Answer:

Stanley Fischer's model (1977) also uses multi-period, staggered contracts but differs from Taylor's model in a crucial way:

• In Fischer's model, nominal wages are predetermined but not necessarily fixed. When a contract is set for two periods, the wage for the first period is set, and the wage for the second period is also set, but it can be a different value. The wage for each period is set to equal the expected market-clearing real wage for that period, based on information available at the time the contract is signed.
• In Taylor's model, nominal wages are fixed for the entire duration of the contract. The same nominal wage applies to both periods of a two-period contract.

This difference has important implications. In Fischer's model, the effects of a monetary shock only last for the length of the longest contract. Once all contracts have been renegotiated with knowledge of the shock, the economy returns to the natural rate. In Taylor's model, due to the relative wage concerns and fixed wages, the effects persist for much longer than the contract length.

Source: McCallum (1989), Chapter 9; Blanchard (1987).

Answer:

The Lucas misperceptions model (1972, 1973) provides a micro-foundation for a short-run, upward-sloping aggregate supply curve without relying on sticky wages or prices. It is based on the idea of imperfect information.

The core idea is that individual producers (or "islands") can observe the price of their own product but cannot perfectly observe the aggregate price level in the economy. When a producer sees the price of their good increase, they don't know if it's due to:

1. A relative price change: an increase in the real demand for their specific product. The optimal response is to increase output.
2. An aggregate price change: an increase in the general price level, driven by, for example, an expansionary monetary policy. The optimal response is not to change output, as their real price has not changed.

Because they cannot distinguish perfectly between these two, they attribute part of the price change to a relative shift and part to an aggregate shift. Therefore, an unexpected increase in the aggregate price level (caused by an unexpected monetary expansion) leads all producers to mistakenly believe their relative price has increased, causing them all to increase output. This generates a positive relationship between unexpected inflation and output—a Phillips-curve-like correlation.

Source: McCallum (1989), Chapter 9.

Answer:

The Policy Ineffectiveness Proposition (PIP), most famously associated with Thomas Sargent and Neil Wallace, states that systematic, predictable monetary policy has no effect on real variables like output and employment, even in the short run.

The logic is that if economic agents have rational expectations, they will fully anticipate the effects of any systematic policy rule and build this anticipation into their price- and wage-setting behavior. For example, if the central bank systematically expands the money supply in a recession, agents will expect this and raise their prices and wages accordingly, neutralizing any potential real effects.

Only unsystematic, random, or "surprise" components of monetary policy can affect real output.

PIP holds in models like:

• The Lucas misperceptions model.
• Simple sticky price models where prices are reset every period based on expectations (like Fischer's one-period contract model).

PIP does NOT hold in models with multi-period staggered contracts, like those of Taylor and Fischer, because the pre-existing contracts prevent the economy from fully and immediately adjusting to systematic policy changes.

Source: EC3115 Subject Guide, Chapter 9; McCallum (1989), Chapter 11.

Answer:

Nominal Rigidity refers to the stickiness of a price or wage in nominal (e.g., dollar) terms. It is the failure of a nominal price to adjust to changes in demand or supply. This is the key friction that allows nominal variables (like the money supply) to affect real variables. Examples include menu costs or long-term nominal wage contracts.

Real Rigidity refers to the stickiness of a real price or wage (e.g., the real wage W/P, or a firm's price relative to its competitors). It is the tendency for real prices/wages to not respond much to changes in real economic conditions (like a shift in demand or productivity). For example, if a firm's desired markup of price over cost is insensitive to the level of demand, this is a form of real rigidity.

In models like Taylor's, both are necessary for monetary policy to have large and persistent effects. Nominal rigidity (from contracts) creates the initial non-neutrality. Real rigidity (a low sensitivity of desired real wages to employment) makes the effects persistent, as it reduces the incentive for large wage adjustments during renegotiations.

Source: Blanchard (1987), "Why Does Money Affect Output?".

Answer:

Menu costs are the small, fixed costs a firm incurs when changing its prices (e.g., printing new menus or catalogs). The "menu cost" argument for price stickiness, developed by economists like Mankiw and Akerlof & Yellen, shows how these small microeconomic costs can lead to large macroeconomic effects.

The key insight is the presence of a pecuniary externality in a monopolistically competitive economy. When a firm decides whether to change its price, it only considers its own lost profit (the "private cost"), which is second-order (very small) for a small deviation from the optimal price. However, its decision not to lower its price (or not to raise it following a monetary expansion) has a first-order effect on the rest of the economy. A lower price would increase real money balances, boosting aggregate demand for all firms.

Because the private cost of not adjusting is small, even a tiny menu cost can be enough to deter a firm from changing its price. If all firms face this situation after a monetary expansion, none will raise their prices. Instead, they will meet the increased aggregate demand by increasing production. Thus, a small menu cost can prevent price adjustment and lead to a large, first-order increase in real output.

Source: Blanchard (1987), "Why Does Money Affect Output?".

Answer:

Okun's Law describes the empirical negative relationship between the unemployment rate and the output gap (the deviation of actual output from its potential or natural level).

It can be expressed as:

\[ (Y - Y^*)/Y^* = -\beta (u - u^*) \]

where \(Y\) is actual output, \(Y^*\) is potential output, \(u\) is the actual unemployment rate, \(u^*\) is the natural rate of unemployment, and \(\beta\) is a coefficient (typically around 2 in the US).

In simpler terms, for every 1 percentage point that the unemployment rate is above the natural rate, real output is approximately \(\beta\)% below its potential. It provides a useful rule of thumb for translating changes in output into changes in unemployment, and vice versa. It is used, for example, to derive the expectations-augmented Phillips curve from the aggregate supply curve.

Source: McCallum (1989), Chapter 9; EC3115 Subject Guide, Chapter 9.

Answer:

The original Keynesian model (as in the General Theory) implied that real wages should be counter-cyclical. The logic was that an increase in aggregate demand would raise prices, and with nominal wages sticky, the real wage (W/P) would fall, inducing firms to hire more and produce more. Thus, high output (booms) would be associated with low real wages, and low output (recessions) with high real wages.

This was a problem because early empirical studies by Dunlop (1938) and Tarshis (1939) found that this was not the case. The data suggested that real wages were often pro-cyclical (moving with the business cycle) or at least a-cyclical (having no clear correlation with the business cycle).

This empirical contradiction was a major weakness of the simple sticky-wage model and led economists to search for alternative explanations for business cycles that did not rely on counter-cyclical real wages, such as models with sticky prices or imperfect competition.

Source: Blanchard (1987), "Why Does Money Affect Output?".

Answer:

In the basic sticky price model presented in McCallum (1989, Ch. 10), the key assumption is that firms set their prices one period in advance. The aggregate price level for the current period, \( p_t \), is set at the end of the previous period (\( t-1 \)) based on the information available at that time.

Specifically, firms set their price equal to the price they expect will clear the market in the current period. Therefore, the aggregate price level is determined by the rational expectation of the market-clearing price, conditional on information from the previous period:

\[ p_t = E_{t-1}[p_t^*] \]

where \( p_t^* \) is the (flexible) price that would equate aggregate demand and the natural level of output in period \( t \). This market-clearing price itself depends on expectations of future prices and the money supply. This forward-looking nature of price setting is a hallmark of New Keynesian models.

Source: McCallum (1989), Chapter 10; EC3115 Subject Guide, Chapter 9.

Answer:

When prices are set for multiple periods and these price-setting decisions are staggered, monetary policy shocks have persistent effects. Consider a model where half the firms set prices for two periods at a time.

In any given period \( t \), the aggregate price level \( p_t \) is an average of:

1. Prices set at \( t-1 \) for period \( t \).
2. Prices set at \( t-2 \) for period \( t \).

Now, imagine an unexpected monetary shock (\( e_t \)) occurs at time \( t \). This shock was not in the information set when any of the prices currently in effect were set. Therefore, it will have a full real effect on output in period \( t \).

In the next period, \( t+1 \), half the firms will reset their prices, and they can incorporate the information about the shock \( e_t \). However, the other half of firms are still bound by prices they set at \( t-1 \), before the shock was known. Because the aggregate price level does not fully adjust, the monetary shock \( e_t \) continues to have real effects in period \( t+1 \). This creates persistence: the effect of a shock at time \( t \) is felt at \( t, t+1, \dots \) until all contracts have been renegotiated.

Source: EC3115 Subject Guide, Chapter 9; McCallum (1989), Chapter 10.

Answer:

The Lucas Critique (1976) is a fundamental criticism of using historical macroeconomic models for policy evaluation. It argues that the parameters of such models are not structural (i.e., not invariant to policy changes) but instead depend on the policy regime in place.

Forward-looking, rational agents form their expectations based on the systematic way policy is conducted. If the government changes its policy rule, agents will change their expectations, which in turn will change their behavior and thus alter the estimated parameters of the model.

Application to the Phillips Curve: In the 1960s, the Phillips curve appeared to be a stable relationship, suggesting a permanent trade-off. Policymakers believed they could "buy" lower unemployment with higher inflation. The Lucas Critique argues that this relationship only held because inflation expectations were relatively stable. If policymakers tried to exploit this trade-off by systematically creating more inflation, agents would raise their inflation expectations. This would cause the Phillips curve itself to shift upwards, and the trade-off would disappear. The policy would be ineffective in permanently lowering unemployment and would only result in higher inflation.

Source: EC3115 Subject Guide, Chapter 9; McCallum (1989), Chapter 11.

Answer:

Lucas Misperceptions Model:

• Short Run: An anticipated monetary expansion has no real effect. Because agents rationally expect the policy, they know the general price level will rise. They do not misperceive this as a relative price increase and therefore do not change their output. Only the price level rises.
• Long Run: Same as the short run. There are no real effects from anticipated policy.

Taylor Staggered Contracts Model:

• Short Run: An anticipated monetary expansion does have real effects. Even though the policy is known in advance, many firms are locked into pre-existing nominal wage contracts. The policy raises aggregate demand and prices. For firms with fixed nominal wages, this lowers their real wage costs, inducing them to increase output. Because not all wages can adjust instantly, the anticipated policy is non-neutral.
• Long Run: Monetary policy is neutral. Eventually, all contracts are renegotiated, and wages and prices fully adjust to the higher money supply. Output and employment return to their natural rates.

The key difference is that the pre-existing nominal contracts in the Taylor model prevent immediate adjustment, even to perfectly anticipated shocks, thus violating the Policy Ineffectiveness Proposition.

Source: Blanchard (1987); McCallum (1989), Chapters 9 & 10.

Answer:

The time inconsistency problem arises when a policy that is optimal for a government to announce ex-ante (before private agents act) is no longer optimal to carry out ex-post (after private agents have acted).

In the context of monetary policy, a central bank might announce a zero-inflation policy. Rational agents, believing this, will form low inflation expectations and set their wages accordingly. However, once these wages are set, the central bank has an incentive to renege on its promise and create surprise inflation. This surprise inflation would lower real wages and temporarily boost output and employment, which is tempting for the policymaker.

Rational agents understand this incentive. They will not believe the zero-inflation promise and will expect the central bank to create inflation. They will set higher wages in anticipation. The result is an "inflationary bias": the economy ends up with a positive average rate of inflation but with no average gain in output or employment compared to the zero-inflation outcome. The discretionary, period-by-period optimization leads to a worse outcome than could be achieved by credibly committing to a fixed rule (like zero inflation).

Source: Hargreaves Heap (1992), Chapter 5.

Answer:

Imperfect competition can contribute to real price rigidity (a low sensitivity of price to output changes) through several channels:

• Flat Marginal Cost: If imperfectly competitive firms operate with excess capacity, they may be able to increase production without a significant increase in marginal cost over a wide range of output. If prices are a relatively constant markup over marginal cost, then prices will also be insensitive to demand changes.
• Counter-cyclical Markups: The degree of monopoly power, and thus the markup of price over marginal cost, may be counter-cyclical (i.e., it falls during booms). This could happen if the elasticity of demand faced by firms increases when aggregate demand is high, forcing them to keep price increases in check to avoid losing customers. If the markup falls as marginal cost rises during a boom, the overall price level may not change much.

These factors mean that the firm's desired relative price does not change much when demand changes, contributing to a flat implicit aggregate supply curve and making the real effects of nominal demand shocks larger.

Source: Blanchard (1987), "Why Does Money Affect Output?".

Answer:

The Lucas misperceptions model has faced several significant criticisms:

1. Information Availability: The model assumes producers have poor information about the aggregate price level. In modern economies, data on inflation and monetary aggregates are published frequently and with short delays. It seems implausible that producers would remain ignorant long enough to explain the duration of business cycles.
2. Source of Persistence: The basic model explains an initial output response to a surprise shock, but it struggles to explain why business cycles are persistent. While channels like capital accumulation or adjustment costs can be added, they create other tensions in the model.
3. Empirical Evidence on Anticipated Money: The model's strongest prediction is that anticipated money has no real effects (the PIP). Empirical work by Mishkin and others has found that anticipated money does, in fact, affect real output, contradicting the model.

For these reasons, most economists today doubt the relevance of the monetary misperceptions model for explaining business cycles in modern economies, although it may have been more applicable in historical periods with poorer data.

Source: McCallum (1989), Chapter 9; Blanchard (1987).

Answer:

The "right to manage" is a common assumption in Keynesian models with sticky nominal wages. It states that while wages are determined by a negotiation or contract, the firm has the unilateral right to determine the level of employment after the wage is set.

This assumption is crucial for explaining how a fall in the real wage leads to an increase in employment. When an expansionary monetary policy raises the price level, the real wage (W*/P) falls. Under the "right to manage," the firm is not bound by the labor supply curve at this new, lower real wage. It can move along its labor demand curve and choose to hire more workers (up to l" in the standard diagram) to maximize its profits, even if this requires existing workers to work overtime or is more than workers would willingly supply at that real wage.

Without this assumption, employment would be determined by the minimum of labor demand and labor supply, and a fall in the real wage below the market-clearing level would not necessarily increase employment.

Source: EC3115 Subject Guide, Chapter 9.

Answer:

A "wage-price spiral" is a macroeconomic feedback loop where rising wages lead to rising prices, which in turn lead to demands for even higher wages, and so on.

Staggered contract models, like Taylor's, can generate this dynamic. After a demand shock, one group of workers renegotiates their wages upward. This pushes up firms' costs, leading to higher prices. When the next group of workers renegotiates, they react to these higher prices by demanding even higher nominal wages to maintain their desired real wage. This next round of wage increases feeds into another round of price increases.

This leapfrogging process, where wage and price increases chase each other, creates an endogenous persistence mechanism. The spiral continues until the economy eventually settles at a new, higher level of wages and prices. This dynamic shows how staggering can explain the gradual and persistent inflation that often follows a demand shock.

Source: Blanchard (1986a), "The Wage Price Spiral".

Answer:

A policymaker might prefer to commit to a rule rather than use period-by-period discretion for several reasons, primarily related to credibility and the time inconsistency problem:

• Avoiding Inflationary Bias: As shown by Kydland and Prescott, discretionary policy can lead to an inflationary bias. By committing to a low-inflation rule, a central bank can anchor inflation expectations at a low level, achieving better long-run outcomes (low inflation with no loss of output) than it could under discretion.
• Credibility: A rule enhances the central bank's credibility. If the public believes the central bank will stick to its rule, policy announcements are more effective. For example, a disinflation announced by a credible, rule-bound central bank is more likely to be achieved without a deep recession.
• Reduces Uncertainty: A clear rule makes policy actions more predictable, reducing uncertainty for firms and households and allowing for more efficient planning and investment.

In essence, tying its own hands with a rule allows the central bank to manage public expectations more effectively and avoid the temptation of short-term gains that lead to poor long-term outcomes.

Source: Hargreaves Heap (1992), Chapter 5.

Answer:

Merits:

• Rational Expectations: It was one of the first models to successfully incorporate rational expectations into a framework with nominal rigidities.
• Role for Policy: It shows that systematic monetary policy can be effective in stabilizing output, even with rational expectations, because of the pre-set contracts. This provided a counter-argument to the Policy Ineffectiveness Proposition.
• Microfoundations: It provides a clear (though simple) micro-foundation for wage setting, where wages are set to equal the expected market-clearing level.

Drawbacks:

• Lack of Persistence: The real effects of a monetary shock only last as long as the longest contract. This is inconsistent with the high degree of persistence observed in actual business cycles.
• Counter-cyclical Real Wages: The model implies that an unexpected monetary expansion increases prices, lowering the real wage. This prediction of counter-cyclical real wages is generally not supported by empirical data.

Source: McCallum (1989), Chapter 9; Blanchard (1987).

Answer:

Merits:

• Persistence: The model's key strength is its ability to generate long-lasting, persistent real effects from monetary shocks, which is consistent with empirical observations of business cycles. The effects last much longer than the contract length itself due to the staggered, overlapping nature of wage setting.
• Rational Expectations and Policy Role: Like Fischer's model, it incorporates rational expectations while still providing a clear role for activist monetary policy to stabilize the economy.
• A-cyclical Real Wages: In its basic form, the model is consistent with the observation of a-cyclical or constant real wages, as prices are a constant markup over the average wage.

Drawbacks:

• Source of Rigidity: The model takes the existence of multi-year, staggered nominal contracts as given. It does not explain *why* such contracts exist in the first place.
• Real Rigidity Assumption: For persistence to be strong, the model requires a high degree of real rigidity (i.e., the desired real wage must be very insensitive to the level of employment). The model does not provide a deep explanation for this real rigidity.

Source: McCallum (1989), Chapter 9; Blanchard (1987).

Answer:

If policymakers repeatedly try to keep unemployment below the natural rate (\( u < u^* \)), they will trigger an accelerating inflation spiral.

The process works as follows:

1. Policymakers use expansionary policy to push unemployment below \( u^* \). This moves the economy up along a short-run Phillips curve (SRPC), leading to an actual inflation rate (\( \pi_1 \)) that is higher than the initially expected rate (\( \pi_0^e \)).
2. In the next period, workers and firms revise their inflation expectations upward to match the new, higher inflation rate (\( \pi_1^e = \pi_1 \)). This causes the SRPC to shift upward.
3. To keep unemployment at the same low level, policymakers must now generate an even higher rate of actual inflation (\( \pi_2 > \pi_1 \)) to create another "inflation surprise".
4. This process repeats. Each attempt to hold unemployment below the natural rate requires a larger and larger dose of inflation. The result is not a stable, low level of unemployment, but rather an ever-increasing rate of inflation.

This demonstrates that there is no long-run trade-off between inflation and unemployment.

Source: McCallum (1989), Chapter 9; Friedman (1968).

Answer:

The standard Phillips curve is a "wage-price" relationship. By using Okun's Law to substitute the output gap for unemployment, we can transform the aggregate supply curve directly into a "price-price" Phillips curve.

Starting with the Lucas aggregate supply curve:

\[ p_t = p_t^e + \gamma (y_t - y_t^*) \]

And using Okun's Law, \( y_t - y_t^* = -\beta (u_t - u_t^*) \), we can derive a relationship directly between price inflation and unemployment, without going through wages:

\[ p_t - p_{t-1} = p_t^e - p_{t-1} - \gamma \beta (u_t - u_t^*) \]

The key insight is that the aggregate supply curve and the expectations-augmented Phillips curve are essentially "two sides of the same coin." They represent the same underlying macroeconomic trade-off between real activity and unexpected inflation. Which one we use depends on whether the context of the analysis is focused on output gaps or the unemployment rate.

Source: EC3115 Subject Guide, Chapter 9.

Answer:

Efficiency wage models argue that it can be profitable for firms to pay wages above the market-clearing level. The core idea is that worker productivity (effort) depends positively on the real wage they are paid. A higher wage can increase effort for several reasons:

• Shirking: If monitoring effort is difficult, paying a higher wage (the "efficiency wage") increases the cost to a worker of being caught shirking and fired. This induces workers to put in more effort.
• Turnover: Higher wages reduce costly worker turnover, as employees are less likely to quit.
• Adverse Selection: A firm that offers higher wages can attract a higher-quality pool of job applicants.
• Sociological/Fairness: Higher wages can improve morale and be perceived as "fair," leading to greater effort.

Firms will choose to set the real wage at the level that minimizes labor cost per efficiency unit, not the wage per worker. This "efficiency wage" may not respond to shifts in labor demand or supply, leading to real wage rigidity and involuntary unemployment.

Source: Blanchard (1987), "Why Does Money Affect Output?".

Answer:

In the basic one-period sticky price model presented in McCallum (1989, Ch. 10), the solution for the output deviation is:

\[ y_t - y_t^* = \beta_1(m_t - E_{t-1}[m_t]) + v_t - u_t \]

Where:

• \( y_t - y_t^* \) is the output gap.
• \( m_t - E_{t-1}[m_t] \) is the unexpected component of the money supply (the monetary policy shock, \( e_t \)).
• \( v_t \) is a random aggregate demand shock.
• \( u_t \) is a random shock to the natural level of output (a supply shock).

This equation shows that output deviates from its natural rate only in response to unexpected or random shocks to monetary policy, aggregate demand, or the natural rate of supply. The systematic, predictable component of monetary policy has no effect on the output gap, which is a demonstration of the Policy Ineffectiveness Proposition in this model.

Source: EC3115 Subject Guide, Chapter 9; McCallum (1989), Chapter 10.

Answer:

The distinction is crucial because it determines whether the Policy Ineffectiveness Proposition (PIP) holds.

One-Period Pricing: In a model where all prices are reset every period (like Fischer's one-period model), firms can fully incorporate their expectations of systematic monetary policy into the prices they set. If the central bank is expected to increase the money supply, all firms will raise their prices proportionally. As a result, systematic, predictable policy is neutralized and has no real effects. Only surprise shocks matter. PIP holds.

Multi-Period Staggered Pricing: In a model where prices are set for multiple periods and not all at once (like Taylor's model), the economy cannot fully adjust to systematic policy. Even if a policy change is announced and fully anticipated, some firms are locked into old contracts set before the announcement. These existing rigidities prevent the aggregate price level from adjusting immediately. Therefore, systematic monetary policy can affect aggregate demand and have real effects on output by influencing the firms whose prices are currently flexible. PIP does not hold.

Source: EC3115 Subject Guide, Chapter 9.

Answer:

The natural rate hypothesis, closely associated with Friedman and Phelps, asserts that in the long run, the economy's unemployment rate will converge to its "natural rate," regardless of the rate of inflation. It posits that there is no permanent trade-off between inflation and unemployment.

The core tenets are:

1. There exists a natural rate of unemployment (NRU) determined by real, structural factors of the economy.
2. Monetary policy cannot permanently hold the unemployment rate below this natural rate.
3. Any attempt to do so will only lead to accelerating inflation as expectations continuously adjust upwards.

This implies that the long-run Phillips curve is vertical at the natural rate of unemployment. Monetary policy can affect unemployment in the short run through expectational errors, but not in the long run.

Source: McCallum (1989), Chapter 9; Phelps (1967).

Answer:

Hysteresis, in an economic context, is the idea that the natural rate of unemployment is not a fixed constant but can be affected by the past history of actual unemployment. A deep recession that causes a large increase in actual unemployment might also cause the natural rate itself to rise.

Mechanisms for hysteresis include:

• Insider-Outsider Models: During a recession, many workers (outsiders) lose their jobs. When the economy recovers, the remaining employed workers (insiders) may use their bargaining power to negotiate higher wages for themselves rather than allowing wages to fall to a level that would allow the outsiders to be rehired. The outsiders become disenfranchised from the wage-setting process.
• Skill Atrophy: The long-term unemployed may lose valuable job skills, making them less employable even when the economy recovers.

This challenges the natural rate hypothesis by suggesting that temporary nominal shocks (which cause a recession) could have permanent effects on the real economy by raising the long-run equilibrium rate of unemployment. It implies that the path of the economy matters for its long-run destination.

Source: Blanchard (1987), "Why Does Money Affect Output?".

Answer:

The main policy conclusion is that there is a clear role for activist, systematic monetary policy to stabilize the economy, even in a world with rational expectations.

Because contracts are staggered and set for multiple periods, the economy cannot instantly adjust to shocks. This pre-existing stickiness means that even predictable monetary policy can have real effects. A central bank with knowledge of the contract structure can design a systematic feedback rule (e.g., responding to past output gaps or shocks) to offset the effects of other economic disturbances.

For example, if a demand shock occurs, the central bank can adjust the money supply in the next period to cancel out the shock's effect on the price level that the next group of wage-setters will face. This helps to stabilize output and employment fluctuations. In short, these models provide a strong theoretical justification for counter-cyclical monetary policy, in direct contrast to the Policy Ineffectiveness Proposition that emerges from simpler flexible-price or one-period contract models.

Source: Blanchard (1987); McCallum (1989), Chapter 10.

Answer:

The stable, inverse relationship of the original Phillips curve broke down in the 1970s primarily for two reasons, both of which were predicted by Friedman and Phelps:

1. Rising Inflation Expectations: The 1960s saw policymakers attempting to exploit the Phillips curve trade-off, leading to persistently higher inflation. As this inflation continued, people's expectations of future inflation began to rise. According to the expectations-augmented Phillips curve, rising inflation expectations shift the short-run Phillips curve upwards. This meant that any given level of unemployment was now associated with a much higher rate of inflation than before.
2. Adverse Supply Shocks: The 1970s were hit by major adverse supply shocks, most notably the OPEC oil price increases of 1973-74 and 1979. These shocks directly increased the costs of production for firms, leading to higher prices at any given level of unemployment. This also had the effect of shifting the short-run Phillips curve upwards and to the right, a phenomenon known as "stagflation" (stagnant output/high unemployment combined with high inflation).

The combination of these two factors destroyed the simple, stable trade-off that had been observed in earlier data.

Source: McCallum (1989), Chapter 9; EC3115 Subject Guide, Chapter 9.

Answer:

Time-Dependent Rules: In these models, the timing of price changes is exogenous and based on the passage of time. Firms change their prices at fixed intervals (e.g., once a year) or with a certain probability per period, regardless of what is happening in the economy. The models of Taylor and Fischer, where contracts last for a fixed number of periods, are examples of time-dependent rules.

State-Dependent Rules: In these models, the decision to change prices is endogenous and depends on the state of the economy. A firm changes its price only when the economic environment has changed enough to make it worthwhile. The most common example is an (S,s) rule, where a firm adjusts its price whenever the deviation between its current price and its optimal price hits a certain threshold (S). Menu cost models naturally lead to state-dependent rules.

The distinction is important because they have different implications for monetary neutrality. As shown by Caplin and Spulber, state-dependent rules do not necessarily lead to monetary non-neutrality, whereas time-dependent rules generally do.

Source: Blanchard (1987), "Why Does Money Affect Output?".

Answer:

The empirical finding that real wages are not strongly counter-cyclical is highly significant because it casts doubt on the simplest Keynesian models.

• It contradicts the simple sticky-wage model (from Keynes's General Theory), where the main transmission mechanism for monetary policy is a fall in the real wage (due to a sticky nominal wage and a rising price level).
• It also contradicts Fischer's sticky-price model, which similarly predicts that an unexpected monetary expansion will lower real wages.

This empirical fact lends support to alternative models that are consistent with a-cyclical or pro-cyclical real wages, such as:

• Taylor's staggered contract model, where prices are a markup over the average wage, leading to a relatively stable real wage.
• Real Business Cycle (RBC) models, where pro-cyclical technology shocks drive both output and real wages up.
• Sticky-price models with counter-cyclical markups, where the price markup falls during a boom, potentially offsetting the rise in marginal cost and keeping the real wage from falling.

Source: Blanchard (1987); Gordon (1982).

Answer:

The assumption of rational expectations (RE) is a cornerstone of modern macroeconomics for several reasons:

1. Internal Consistency: RE imposes discipline and internal consistency on models. It assumes that agents within the model use all available information, including their understanding of how the economy and policy work, to form expectations. It avoids assuming that agents make systematic, predictable errors.
2. Lucas Critique: It is the foundation of the Lucas Critique. By assuming agents' expectations adapt to policy changes, RE highlights the danger of using models with non-structural parameters (like the original Phillips curve) for policy evaluation.
3. Microfoundations: It is a key part of building macroeconomic models on solid microeconomic foundations. It treats the expectations of households and firms with the same level of sophistication as their other decisions (e.g., utility or profit maximization).
4. Policy Analysis: It provides a more realistic framework for analyzing policy credibility and time inconsistency, as it focuses on the strategic interaction between policymakers and a public that tries to anticipate their actions.

While not always perfectly realistic, it serves as the benchmark assumption against which other theories of expectation formation are judged.

Source: McCallum (1989), Chapter 8; EC3115 Subject Guide, Chapter 9.

Answer:

The primary channel is through aggregate demand, enabled by nominal rigidities.

The sequence is as follows:

1. The central bank changes the nominal money supply.
2. Due to nominal rigidities (sticky prices or wages), the aggregate price level does not adjust immediately or fully.
3. This failure of the price level to adjust means the real money supply (M/P) changes.
4. A change in the real money supply shifts the LM curve, changing the nominal interest rate.
5. The change in the interest rate affects interest-sensitive components of aggregate demand, such as investment and consumption of durable goods.
6. Firms respond to this change in demand by adjusting output and employment.

In essence, nominal rigidities are the "grit" in the economic machine that prevents nominal changes from being instantly neutralized by price adjustments, thereby allowing them to have real effects through the aggregate demand channel.

Source: EC3115 Subject Guide, Chapter 9.

Answer:

Strategic complementarity exists when a firm's incentive to raise its own price increases as other firms raise their prices. It describes a situation where firms' price-setting decisions reinforce one another.

This concept is crucial for understanding how small menu costs can lead to large monetary non-neutrality. In the presence of menu costs and strategic complementarity:

• If a firm expects other firms *not* to raise their prices following a monetary expansion, its own incentive to be the sole firm to raise its price is very weak. It would lose competitiveness.
• Therefore, a small menu cost can be enough to persuade the firm to also keep its price fixed, waiting for others to move first.

If all firms think this way, no one adjusts their price, and the monetary expansion translates entirely into an increase in output. Strategic complementarity creates a coordination problem where individual inaction is privately optimal (given the inaction of others) but leads to a collectively large macroeconomic effect (monetary non-neutrality).

Source: Blanchard (1987), "Why Does Money Affect Output?".

Answer:

Empirically distinguishing between different sticky price models (e.g., Lucas vs. Taylor vs. Fischer) is difficult because they can have very similar reduced-form representations, even if their underlying structural assumptions and policy implications are vastly different.

For example, many of these models ultimately produce a reduced-form equation where output depends on unexpected money or unexpected inflation, and where there is persistence in output fluctuations. An equation like:

\[ y_t = \alpha y_{t-1} + \beta (m_t - E_{t-1}[m_t]) + \epsilon_t \]

could be generated by a Lucas model with capital adjustment costs, a Taylor model with staggered contracts, or a Fischer model with multi-period contracts. Since econometricians can only observe the final data on \(y_t\) and \(m_t\), it is hard to identify the true underlying structure from this reduced-form evidence alone. This is a classic example of an observational equivalence problem.

Source: Blanchard (1987); McCallum (1989).

Answer:

The IS-LM framework is the traditional tool for analyzing the aggregate demand side of the economy in Keynesian models.

• The IS (Investment-Saving) curve represents equilibrium in the goods market. It shows combinations of interest rates (R) and output (Y) where planned investment equals planned saving.
• The LM (Liquidity preference-Money supply) curve represents equilibrium in the money market. It shows combinations of R and Y where the demand for real money balances equals the supply.

In the context of monetary policy, the IS-LM model illustrates the first step in the transmission mechanism. An increase in the nominal money supply (M), for a given price level (P), increases the real money supply (M/P). This shifts the LM curve to the right. The new equilibrium with the IS curve occurs at a lower interest rate and a higher level of output. This gives us the inverse relationship between the price level and output along the Aggregate Demand (AD) curve.

Source: EC3115 Monetary Economics Unit I Lectures.

Answer:

In general, the longer the period for which prices or wages are set, the more persistent the effects of monetary policy will be.

In a model with staggered, multi-period contracts (like Taylor's), a monetary shock occurs when many agents are locked into old contracts. The economy's aggregate price level can only adjust as each cohort of agents gets a chance to renegotiate. If contracts last for N periods, it will take at least N periods for everyone to have had a chance to react to the shock. The staggering and relative wage concerns mean the adjustment process will take even longer than N periods.

Therefore, a longer contract length (a higher N) means that the initial nominal rigidity is more entrenched. The aggregate price level will adjust more slowly to any given shock, and consequently, the real effects of that shock on output and employment will be more prolonged and persistent.

Source: Blanchard (1987); EC3115 Subject Guide, Chapter 9.

Answer:

Sticky Price Model (e.g., New Keynesian):

• Short Run: Monetary policy is non-neutral. A change in the money supply affects real variables like output and employment because prices do not adjust fully. The aggregate supply curve is upward-sloping.
• Long Run: Monetary policy is neutral. Prices, wages, and expectations fully adjust to any change in the money supply. Output returns to its natural rate. The long-run aggregate supply curve is vertical.

Flexible Price Model (e.g., Classical or Real Business Cycle):

• Short Run: Monetary policy is neutral (or approximately neutral). Prices adjust instantly to clear markets. A change in the money supply leads to a proportional change in the price level, with no real effects. The short-run aggregate supply curve is vertical.
• Long Run: Same as the short run. Monetary policy is neutral.

The key distinction is the presence of nominal rigidities in the short run, which is the defining feature of Keynesian models.

Source: EC3115 Subject Guide, Chapter 9.

Answer:

Firms might choose to meet all demand at a preset price, a key assumption in many sticky price models, primarily to maintain good long-term customer relationships. This idea is central to Arthur Okun's theory of "customer markets".

The reasoning is that customers value price stability and predictability. If a firm refuses to sell to a customer at the posted price (i.e., it rations its goods) or frequently changes its prices, it risks alienating its customer base. A customer who is turned away empty-handed is very likely to become an "active searcher," looking for a more reliable supplier.

The potential long-term loss of a valuable repeat customer can be far greater than the short-term loss incurred by selling a few extra units at a price that is temporarily below the single-period profit-maximizing level. Therefore, firms willingly satisfy demand to invest in customer loyalty, even if it means short-term profit is not maximized.

Source: McCallum (1989), Chapter 10; Gordon (1982).

Answer:

The main weakness of the static menu cost argument is that it relies on a high degree of real rigidity to be plausible.

The argument states that a small menu cost can deter a price change because the private loss from not adjusting is second-order (very small). However, this private loss is only small if the firm's profit function is very flat around its optimum. This, in turn, requires the firm's desired price to be very insensitive to changes in aggregate demand. This insensitivity is known as real rigidity.

If there is significant real flexibility (i.e., if the firm's desired price changes a lot when demand changes), then the private loss from not adjusting becomes large. In this case, the menu cost required to prevent a price adjustment would have to be implausibly large. Therefore, the menu cost story is not a complete theory on its own; it must be combined with a convincing explanation for why real rigidities exist in the first place.

Source: Blanchard (1987), "Why Does Money Affect Output?".

Answer:

The Caplin and Spulber (1987) model shows that under certain conditions, a collection of firms following state-dependent (S,s) pricing rules can lead to a situation where money is neutral, even with menu costs.

The key assumptions are:

1. Firms follow a one-sided (S,s) rule: they let their price erode due to steady inflation and only adjust it upwards when the deviation from their optimal price hits a threshold S.
2. The shocks driving changes in firms' optimal prices are smooth and aggregate in nature (like steady money growth).

Under these conditions, the distribution of price deviations across all firms becomes uniform. When an aggregate monetary shock occurs, it pushes a certain fraction of firms (those at the edge of the S-band) to adjust their prices. The crucial insight is that these adjusting firms make very large price increases (equal to the width of the S-s band). The model shows that the aggregate effect of these few large price increases exactly cancels out the monetary shock, leading to a proportional change in the aggregate price level and leaving real money balances and output unchanged. Money is therefore neutral.

Source: Blanchard (1987), "Why Does Money Affect Output?".

Answer:

Various models explain monetary non-neutrality through price stickiness:

• Simple Sticky Wage Model: (Keynes)
  • Merit: Simple intuition.
  • Effects: Money is non-neutral in the SR, neutral in the LR.
  • Flaw: Predicts counter-cyclical real wages, which is empirically false.
• Lucas Misperceptions Model:
  • Merit: Built on rational expectations and micro-foundations without assuming rigidity.
  • Effects: Only *unexpected* money affects output in the SR. Policy is ineffective. Money is neutral in the LR.
  • Flaw: Implausible information assumptions for modern economies; struggles to explain persistence.
• Fischer's Model:
  • Merit: Combines rational expectations with nominal rigidities (predetermined wages), giving a role for activist policy.
  • Effects: Both expected and unexpected money can have SR effects. Persistence lasts only for the contract duration. Neutral in the LR.
  • Flaw: Still predicts counter-cyclical real wages.
• Taylor's Model:
  • Merit: Generates high persistence of monetary effects, consistent with data. Allows for a-cyclical real wages.
  • Effects: Both expected and unexpected money have persistent SR effects. Neutral in the LR.
  • Flaw: Assumes the existence of staggered contracts and real rigidities without explaining them.
• Menu Cost Models:
  • Merit: Provide a rationale for price stickiness based on profit maximization and small frictions.
  • Effects: Small menu costs can lead to large SR non-neutrality. Money is neutral in the LR.
  • Flaw: Results are sensitive to assumptions about real rigidities and whether pricing rules are time- or state-dependent.

Source: Synthesis of all provided readings.