In the expectations-augmented Phillips curve, what is the significance of the coefficient on expected inflation (\(\alpha\)) in the equation \(\Delta w_t = f(UN_{t-1}) + \alpha \Delta p_t^e\)?
The coefficient \(\alpha\) represents the extent to which expected inflation is passed through into nominal wage growth. The value of \(\alpha\) is central to the debate over the long-run inflation-unemployment trade-off.
Early empirical work in the 1960s found \(\alpha < 1\), but as inflation became more persistent, subsequent studies found \(\alpha\) to be statistically indistinguishable from 1, supporting the natural rate hypothesis.
Source: McCallum (1989), Chapter 9.
What is the "Lucas supply curve" and how is it derived from the misperceptions model?
The Lucas supply curve is an aggregate supply equation that relates output to unexpected changes in the price level. It takes the form:
\[ y_t = y_t^* + \alpha (p_t - E_{t-1}[p_t]) \]
where \(y_t\) is output, \(y_t^*\) is the natural rate of output, \(p_t\) is the price level, and \(E_{t-1}[p_t]\) is the expectation of the price level based on information at \(t-1\). The term \((p_t - E_{t-1}[p_t])\) is the "price surprise."
It is derived from the Lucas misperceptions model. Individual producers increase their own supply based on their perceived relative price, \(p_i - E_i[p]\). When aggregated across all producers, the total output \(y_t\) increases only when the aggregate price level \(p_t\) is higher than what was generally expected, \(E_{t-1}[p_t]\). This aggregate "price surprise" is what drives fluctuations in total output around its natural rate.
Source: McCallum (1989), Chapter 9.
How can the existence of labor unions contribute to real wage rigidity?
Labor unions can contribute to real wage rigidity (insensitivity of real wages to employment levels) through their bargaining objectives. One prominent model is the bilateral monopoly model of McDonald and Solow (1981).
In this model, a union bargains with a firm over both wages and employment. If the union and firm decide to share the gains from trade "fairly" in response to a demand shock, the outcome is often a contract curve that is nearly vertical in wage-employment space. This means that as demand fluctuates, the optimal response is to allow for large swings in employment while keeping the real wage relatively stable.
The intuition is that the union may prioritize keeping the wages of its employed members (insiders) high and stable, even if it means that employment levels must fluctuate significantly. This behavior leads to a flat implicit labor supply curve, a form of real rigidity.
Source: Blanchard (1987), "Why Does Money Affect Output?".
What is the "accelerationist hypothesis" of the Phillips curve?
The accelerationist hypothesis, which stems from the expectations-augmented Phillips curve with a coefficient of 1 on expected inflation, states that in order to keep unemployment permanently below the natural rate, the monetary authority must continuously accelerate the rate of inflation.
The logic is as follows:
Therefore, a stable unemployment rate below the natural rate is not possible; it requires an ever-increasing rate of inflation. This reinforces the conclusion that there is no long-run trade-off.
Source: Friedman (1968), "The Role of Monetary Policy"; Phelps (1967).
Explain the full sequence of events in the IS-LM-AD-AS model as the economy returns to long-run equilibrium after an expansionary monetary policy shock.
The return to long-run equilibrium is the reverse of the short-run effect:
Source: EC3115 Monetary Economics Unit I Lectures.
What is the key difference in the source of monetary policy persistence between the Lucas model (with capital adjustment costs) and the Taylor model?
The source of persistence is fundamentally different:
Source: Blanchard (1987), "Why Does Money Affect Output?".
Why is gradualism often necessary for a successful disinflation policy in a world with staggered contracts?
In a world with staggered wage contracts (like in the Taylor model), a rapid, sharp disinflation (a "cold turkey" approach) is likely to cause a deep recession. This is because many wage contracts are already in place, with wage increases based on the previously high expected rate of inflation.
If the central bank suddenly tightens policy to bring inflation down to zero, aggregate demand will plummet. However, nominal wage growth will continue to be high due to the existing contracts. This will lead to a sharp increase in real wages, causing firms to lay off workers and cut production, resulting in a recession.
A gradualist approach, as analyzed by Taylor, allows for a disinflation path that accommodates the pre-existing contracts. The central bank slowly reduces money growth, allowing time for the old, high-inflation contracts to expire and be replaced by new contracts based on lower inflation expectations. This allows inflation to be reduced without causing a large increase in unemployment.
Source: Blanchard (1987), "Why Does Money Affect Output?".
What is the "pecuniary externality" associated with price adjustment in monopolistically competitive models?
A pecuniary externality is an effect that one agent's economic decision has on the welfare of others, which operates through prices.
In menu cost models of monopolistic competition, when a single firm decides whether to cut its price, it creates a positive externality for all other firms. By cutting its price, it slightly lowers the aggregate price level. This increases the real money supply (M/P), which boosts aggregate demand for all firms in the economy.
The individual firm does not take this aggregate demand benefit into account when making its decision; it only considers its own profit. The private gain to the firm from adjusting its price is very small (second-order), but the social gain (from the aggregate demand externality) is much larger (first-order). This discrepancy between the private and social gains from price adjustment is the key reason why small menu costs can be sufficient to prevent firms from cutting prices, leading to large output effects from nominal shocks.
Source: Blanchard (1987), "Why Does Money Affect Output?".
According to Gordon (1982), is the inertia in U.S. wage and price behavior a universal phenomenon?
No. A key finding in Robert J. Gordon's (1982) paper, "Wages and Prices are Not Always Sticky," is that the high degree of inertia (or sluggishness) in U.S. wage and price behavior is a purely postwar phenomenon.
His empirical analysis over a long historical period shows that:
This suggests that the degree of nominal rigidity is not a universal constant but depends on the country and the historical period, likely due to differences in institutions like the three-year staggered wage contracts unique to the postwar U.S.
Source: Gordon (1982), "Wages and Prices are Not Always Sticky".
Why might more price flexibility be destabilizing for output?
While price stickiness causes monetary policy to have real effects, making prices more flexible is not always stabilizing for output. This argument, dating back to Fisher and Keynes and re-examined by DeLong and Summers, focuses on the effect of price changes on aggregate demand.
If aggregate demand depends not just on the price level (the Pigou effect) but also on expected inflation (the Mundell-Tobin effect), then flexibility can be destabilizing. For example, in a recession, falling prices (deflation) can hurt aggregate demand:
If these negative effects of falling prices on demand are strong enough, they can overwhelm the positive effect of a higher real money supply, causing a recession to deepen. In this case, some degree of price stickiness can actually be a macroeconomic stabilizer.
Source: Blanchard (1987), "Why Does Money Affect Output?".
What is the difference between the short-run aggregate supply (SRAS) curve in a simple sticky-wage model and the long-run aggregate supply (LRAS) curve?
The key difference lies in their slope and what it represents:
Source: EC3115 Subject Guide, Chapter 9.
In the McCallum sticky price model with multi-period pricing, how does the output deviation \(y_t - y_t^*\) depend on monetary shocks?
In the two-period staggered pricing model, the solution for the output deviation is:
\[ y_t - y_t^* = \frac{1}{2} \beta_1 (m_t - E_{t-1}[m_t]) + \frac{1}{2} \beta_1 (m_t - E_{t-2}[m_t]) + v_t \]
Substituting the monetary policy rule \(m_t = \mu_0 + \mu_1 m_{t-1} + e_t\), this becomes:
\[ y_t - y_t^* = \beta_1 e_t + \frac{1}{2} \beta_1 \mu_1 e_{t-1} + v_t \]
This shows two key results:
Source: EC3115 Subject Guide, Chapter 9.
What is the "inflationary bias" of discretionary monetary policy?
The inflationary bias of discretionary policy refers to the tendency for economies with discretionary central banks to end up with a higher average rate of inflation than is optimal, without any corresponding long-run gain in output or employment.
This arises from the time inconsistency problem. A central bank that optimizes on a period-by-period basis always has an incentive to create surprise inflation to get a temporary boost in output. However, rational private agents anticipate this incentive and adjust their inflation expectations upwards. In equilibrium, the central bank creates just enough inflation to match expectations, so there is no "surprise" and no output gain. The economy ends up at the natural rate of unemployment but with a positive, suboptimal rate of inflation.
A central bank that could credibly commit to a zero-inflation rule would avoid this bias and achieve a better outcome (zero inflation and the natural rate of unemployment).
Source: Hargreaves Heap (1992), Chapter 5.
How do implicit contract theories attempt to explain real wage rigidity?
Implicit contract theories explain real wage rigidity as the outcome of an optimal risk-sharing arrangement between risk-neutral firms and risk-averse workers.
The core idea is that firms provide a form of insurance to their workers. Workers dislike income fluctuations, while firms, being better able to diversify risk, are less concerned. The optimal implicit contract, therefore, involves the firm paying a relatively stable real wage to its workers, regardless of whether the firm is experiencing good times or bad times (i.e., high or low demand).
In this arrangement, the firm absorbs most of the income risk, while workers receive a steady wage. This results in real wage rigidity. However, a major criticism of early implicit contract models is that while they explain wage stability, they do not explain employment fluctuations. An optimal contract should stabilize both wages and employment. Later models incorporating asymmetric information have tried to address this, but with mixed success.
Source: Blanchard (1987), "Why Does Money Affect Output?".
What is the primary argument against the empirical relevance of the Lucas misperceptions model in modern economies?
The primary argument against the empirical relevance of the Lucas misperceptions model is the implausibility of the information assumptions.
The model requires that producers cannot easily distinguish between changes in the aggregate price level and changes in their own relative price. In modern economies, however, data on key aggregate variables like the Consumer Price Index (CPI) and monetary aggregates (M1, M2) are collected and published with relatively short delays (weeks or months).
Given this ready availability of information, it is difficult to believe that rational producers would remain confused about the source of price changes for long enough to explain the length and persistence of real-world business cycles, which can last for many quarters or even years. The informational friction at the heart of the model seems too small to be the main driver of macroeconomic fluctuations.
Source: McCallum (1989), Chapter 9; Blanchard (1987).
In the context of the Phillips curve, what is stagflation and how did the 1970s experience support the Friedman-Phelps view?
Stagflation is a period of economic stagnation (slow growth and high unemployment) combined with high inflation. This combination is impossible to explain with the original, stable Phillips curve, which posits an inverse relationship between inflation and unemployment.
The experience of stagflation in the 1970s provided strong support for the Friedman-Phelps expectations-augmented Phillips curve. According to their view, the short-run Phillips curve is not stable but shifts with changes in expected inflation.
In the 1970s, a combination of past expansionary policies and adverse supply shocks (oil crises) caused inflation expectations to rise dramatically. This shifted the short-run Phillips curve upwards and to the right. The result was that the economy experienced both higher unemployment and higher inflation simultaneously, exactly as the Friedman-Phelps model would predict. It demonstrated that there was no stable long-run trade-off to be exploited.
Source: EC3115 Subject Guide, Chapter 9.
Why does the effectiveness of monetary policy in a sticky price model depend on the source of economic shocks (demand vs. supply)?
The effectiveness and appropriate response of monetary policy depend on the source of shocks because demand and supply shocks push inflation and output in different directions.
Therefore, while monetary policy is well-suited to stabilizing demand-driven fluctuations, it faces a difficult trade-off when responding to supply shocks.
Source: General macroeconomic principles.
What is the "Mundell-Tobin effect" and how can it make price flexibility destabilizing?
The Mundell-Tobin effect describes the impact of expected inflation on aggregate demand via the real interest rate.
The real interest rate is defined as \( r = i - \pi^e \), where \(i\) is the nominal interest rate and \(\pi^e\) is expected inflation. The IS curve shows that aggregate demand is a decreasing function of the real interest rate.
The effect can be destabilizing in a model with price flexibility. Suppose the economy enters a recession and prices begin to fall (deflation). If this leads to expectations of further deflation (\(\pi^e < 0\)), the real interest rate \(r\) will rise for any given nominal rate \(i\). A higher real interest rate discourages investment, causing aggregate demand to fall even further and worsening the recession. In this scenario, price flexibility, by creating expectations of deflation, has a perverse, destabilizing effect on output.
Source: Blanchard (1987), "Why Does Money Affect Output?".
In Taylor's model, what is the interpretation of the wage-setting equation \(w = (1/2)[w(-1)+E(w(+1)|-1)] + ...\)?
This equation can be interpreted as workers caring about their wage relative to the wages of other workers in the economy.
In the staggered setting, a group of workers setting their wage \(w\) for the current and next period will be working alongside other workers whose wages were set in the previous period, \(w(-1)\), and workers who will set their wages in the next period, \(E(w(+1)|-1)\).
The term \((1/2)[w(-1)+E(w(+1)|-1)]\) represents the average wage of the other half of the labor force over the two-period life of the new contract. The equation shows that the newly set wage \(w\) is based on this average wage, plus a term reflecting labor market conditions (e.g., employment). This concern for relative wages is the source of the "wage-wage" inertia in the model. Workers are reluctant to set a wage that is too different from the prevailing and expected wages of others, which causes the aggregate wage level to adjust slowly and creates persistence in the effects of monetary shocks.
Source: Blanchard (1987), "Why Does Money Affect Output?".
Why is the assumption of imperfect competition a necessary ingredient in menu cost models?
Imperfect competition is necessary because in a perfectly competitive market, firms are price takers. They have no ability to set their own price; they must accept the market price. The concept of a "menu cost" is meaningless for a perfectly competitive firm, as it has no menu to change.
Menu cost models require firms to be price setters, which is a defining characteristic of imperfect competition (e.g., monopolistic competition or oligopoly). Only a firm with some degree of market power faces a downward-sloping demand curve and has the ability to choose its own price. It is this choice—whether to pay the menu cost and change the price or to keep it fixed—that lies at the heart of the model and provides the micro-foundation for nominal price rigidity.
Source: Blanchard (1987), "Why Does Money Affect Output?".
What is the "classical dichotomy" and how do nominal rigidities break it?
The classical dichotomy is the theoretical separation of real and nominal variables in classical macroeconomic models. It holds that real variables, such as output, employment, and real interest rates, are determined purely by real factors (technology, resource endowments, preferences) and are not influenced by nominal variables, such as the money supply or the price level.
In this view, money is a "veil" that only determines the nominal price level but has no effect on the real economy. This is also known as monetary neutrality.
Nominal rigidities break the classical dichotomy in the short run. When prices and/or wages are sticky, a change in a nominal variable like the money supply cannot be immediately offset by a proportional change in all other nominal variables. For example, if the money supply (M) doubles but the price level (P) is sticky, the real money supply (M/P) increases. This change in a real variable affects aggregate demand, output, and employment. The dichotomy is broken, and nominal variables have real effects.
Source: General macroeconomic principles.
In the McCallum model, if the aggregate demand shock \(v_t\) is serially correlated, can systematic monetary policy stabilize output?
Yes. If the demand shock \(v_t\) is serially correlated (e.g., \(v_t = \rho v_{t-1} + \epsilon_t\)), then part of the shock is predictable. The value of \(v_{t-1}\) gives information about the likely value of \(v_t\).
In the one-period sticky price model, prices for period \(t\) are set at \(t-1\). At that time, the shock \(v_t\) is unknown. However, if the central bank observes \(v_{t-1}\), it can use a systematic feedback rule to adjust the money supply \(m_t\) to offset the predictable component of the shock, \(\rho v_{t-1}\).
By setting its policy rule to react to \(v_{t-1}\), the central bank can cancel out the expected part of the demand shock, thereby stabilizing output. This is another instance where, even with rational expectations, activist monetary policy can be effective as long as there is some form of nominal rigidity that prevents prices from adjusting to all information contemporaneously.
Source: McCallum (1989), Chapter 11.
What is the main difference between the policy implications of the Fischer and Taylor models?
The main difference lies in the duration and persistence of monetary policy effects, which affects the nature of optimal policy.
In short, the persistence mechanism in the Taylor model makes the case for activist stabilization policy much stronger than in the Fischer model.
Source: Blanchard (1987), "Why Does Money Affect Output?".
How does the presence of a "chain of production" affect price level inertia?
The presence of a chain of production, where firms buy inputs from other firms to produce their output, can significantly increase aggregate price level inertia, as shown by Blanchard (1983).
Even if each individual firm adjusts its own prices relatively quickly to changes in its costs, the aggregate price level for final goods will adjust slowly. This is because a shock to final demand must work its way backward through the production chain.
For example, a fall in demand for cars will first lead car manufacturers to cut their prices/output. They will then reduce their orders for steel. Steel manufacturers will then cut their prices/output and reduce their orders for iron ore, and so on. At each stage, there is a delay in price adjustment. The price of final goods only fully adjusts after the price changes have propagated all the way down the chain of intermediate goods. This interaction between staggered price decisions at different stages of production can create substantial aggregate price inertia, even if individual price-setting is not particularly sluggish.
Source: Blanchard (1987), "Why Does Money Affect Output?".
What is the "Great Depression puzzle" regarding the Phillips curve?
The "Great Depression puzzle" refers to the empirical finding that the Phillips curve relationship seemed to disappear during the 1930s. Specifically, despite a massive and prolonged increase in unemployment (the output gap was huge and negative), there was a mysterious absence of the significant downward pressure on prices and wages (deflation) that the Phillips curve would have predicted.
In his empirical work, Gordon (1982) finds that the coefficient on the lagged output ratio (the "level effect") in his price and wage equations becomes statistically insignificant for the period 1929-41. This suggests that the mechanism through which high unemployment was supposed to cause deflation broke down. This could suggest an asymmetry where wages and prices are much stickier downwards than they are upwards, although Gordon notes that formal tests do not confirm this asymmetry.
Source: Gordon (1982), "Wages and Prices are Not Always Sticky".
Why is the assumption of a vertical long-run Phillips curve now widely accepted by macroeconomists?
The assumption of a vertical long-run Phillips curve (LRPC) is widely accepted due to both strong theoretical arguments and compelling empirical evidence:
The combination of a coherent theoretical argument and its validation by historical events led to a consensus that there is no permanent trade-off between inflation and unemployment.
Source: McCallum (1989), Chapter 9.
What is the role of intertemporal substitution of labor in the Lucas model?
Intertemporal substitution of labor is a key mechanism in the Lucas model for explaining why monetary surprises can have large effects on output.
The idea is that workers are willing to adjust the amount they work in response to perceived changes in their real wage over time. When a positive monetary surprise occurs, workers misperceive the resulting general price increase as an increase in their own real wage. They believe this is a temporary opportunity to earn a high real wage. In response to this perceived temporary high wage, they choose to work more today and substitute leisure from the present to the future (when they expect the real wage to be lower). This large supply response from many workers leads to a significant increase in aggregate employment and output.
A strong intertemporal substitution effect is therefore necessary in the Lucas model to translate small price misperceptions into the large quantity fluctuations we observe in business cycles.
Source: Blanchard (1987), "Why Does Money Affect Output?".
Why does Gordon (1982) argue that the postwar inertia in the U.S. is linked to three-year staggered wage contracts?
Gordon argues that the emergence of significant price and wage inertia in the U.S. after 1950 is strongly linked to the unique American institution of three-year staggered wage contracts.
Before the postwar era, U.S. contracts were typically shorter (one year) and more synchronized, similar to those in Europe and Japan. This allowed for more rapid wage and price adjustment to shocks. However, after a period of significant labor strife in the late 1940s, long-term contracts became the norm in the U.S. unionized sector.
These long, overlapping contracts mean that at any point in time, a large fraction of the workforce is covered by old agreements based on outdated expectations. When a shock hits, the aggregate wage level can only adjust very slowly as contracts come up for renegotiation one by one. This institutional feature creates the high degree of inertia (dependence on past inflation) and sluggish response to demand that Gordon finds in the postwar U.S. data, but not in prewar data or in other countries that lack this specific contractual structure.
Source: Gordon (1982), "Wages and Prices are Not Always Sticky".
What is the "intellectual crisis" of the 1970s that Blanchard (1987) refers to?
According to Blanchard, the intellectual crisis of the 1970s was not that the prevailing Keynesian models (the "neoclassical synthesis") failed to explain the facts. In fact, the wage-price mechanisms in large macroeconometric models, based on the expectations-augmented Phillips curve, performed decently empirically, especially after being adjusted for supply shocks.
The crisis was one of theory. The theoretical foundations of the wage-price mechanism were weak and at sharp variance with standard microeconomic theory. Key issues included:
The introduction of rational expectations (the Lucas Critique) brought these theoretical weaknesses to the forefront, showing that the empirical relationships could be misleading. The crisis was the realization that the dominant paradigm, while empirically adequate, lacked rigorous and coherent theoretical underpinnings.
Source: Blanchard (1987), "Why Does Money Affect Output?".
How does wage indexation affect the economy's response to nominal versus real shocks in the Fischer-Gray model?
In the Fischer-Gray model of wage indexation, the degree of indexation (how much nominal wages automatically adjust to price changes) determines the economy's response to shocks.
The conclusion is that the optimal degree of indexation is typically partial (between 0 and 1) and involves a trade-off: more indexation provides better insulation from nominal shocks but worse insulation from real shocks.
Source: Blanchard (1987), "Why Does Money Affect Output?".
What is the key difference between the aggregate supply curve in the original Keynesian model and in the New Keynesian models of Taylor and Fischer?
The key difference lies in the underlying assumption about wage and price setting behavior.
In short, the New Keynesian models provide microfoundations and a dynamic, expectations-based story for the aggregate supply curve, whereas the original model simply assumed its key friction.
Source: Synthesis of provided readings.
Why might a central bank's attempt to hit money stock targets be less accurate with lagged reserve requirements, as was the case for the Fed from 1979-1982?
As analyzed in McCallum (1989, Ch. 11), lagged reserve requirements weaken the link between the central bank's instrument (reserves) and its target (the money stock), making control less precise.
With lagged requirements, the reserves a bank must hold today depend on its deposits from a previous period (e.g., two weeks ago). This breaks the contemporaneous link between the current money stock and the current demand for reserves.
When the Fed tries to control the money stock by controlling the supply of non-borrowed reserves, the mechanism works indirectly: a change in reserves affects the federal funds rate (the interest rate), which in turn influences banks' decisions and the public's demand for money. With lagged requirements, this connection is more tenuous and subject to more noise from various demand and supply shocks (\(\epsilon_t, v_t, \zeta_t\)). McCallum's analysis shows that the mean-squared error of money stock control is unambiguously greater under a reserves-targeting procedure with lagged requirements than under a straightforward interest-rate instrument.
Source: McCallum (1989), Chapter 11.
What is the "natural-rate hypothesis" as formulated by Lucas (1972b)?
As formulated by Lucas, the natural-rate hypothesis asserts that there is no path of prices (or inflation rates) that will keep output permanently above or below its normal, market-clearing level.
This is a stronger and more general statement than the simple vertical long-run Phillips curve. It implies that no monetary policy, no matter how sophisticated or dynamic, can systematically hold output away from its natural rate in the long run. While policy can create temporary deviations through surprises, it cannot create permanent ones. Any attempt to do so will eventually be incorporated into agents' rational expectations, and the real effects will be neutralized.
This hypothesis is a fundamental tenet of New Classical macroeconomics and is satisfied by models like those of Lucas, Fischer, and the basic sticky-price model in McCallum (1989), but it is violated by models like Taylor's, which can imply that monetary policy has a permanent effect on the variance of output.
Source: McCallum (1989), Chapter 9.
In the context of the Lucas Critique, what is a "structural" model?
A "structural" model is one whose equations and parameters are invariant to changes in the policy regime. The parameters describe the deep, underlying features of the economy: the preferences of agents (e.g., utility functions), the technology (e.g., production functions), and the institutional constraints.
For example, an equation describing how much labor a household wishes to supply based on its utility function and the real wage is structural. In contrast, a reduced-form equation, like the original Phillips curve, which describes a historical correlation between inflation and unemployment, is not structural. Its parameters implicitly bundle together deep parameters and the expectations formed under a specific policy regime.
The goal of the research program inspired by the Lucas Critique was to build macroeconomic models based on these deep, structural parameters, as only such models could be reliably used to evaluate the effects of alternative policy rules.
Source: McCallum (1989), Chapter 11.
Why does Phelps (1967) argue that optimal employment policy depends on society's time preference?
Phelps argues that the choice of an optimal employment policy involves an intertemporal trade-off, which necessarily depends on how society weighs present benefits against future costs (its time preference, or discount rate).
The trade-off is as follows: A policy of over-employment (pushing unemployment below the natural rate) today yields a current benefit in the form of higher output and consumption. However, this policy also creates inflation that raises inflation expectations. This leads to a permanent future cost in the form of a higher steady-state rate of inflation and thus a higher nominal interest rate, which reduces welfare by increasing the cost of holding money.
A society with a high rate of time preference (a high discount rate, \(\delta\)) is impatient. It will place a large weight on the current benefits of high employment and a small weight on the future costs of high inflation. It will therefore choose a more inflationary policy. Conversely, a society with a low discount rate will be more willing to accept under-employment today to "invest" in a lower future rate of inflation. Thus, the optimal policy is dynamic and depends crucially on the social discount rate.
Source: Phelps (1967), "Phillips Curves, Expectations of Inflation and Optimal Unemployment over Time".
What is the "Barro-Gordon" model of monetary policy?
The Barro-Gordon model (1983) is a formal game-theoretic model that illustrates the time inconsistency problem and the resulting inflationary bias of discretionary monetary policy.
In the model, the central bank has two objectives: it dislikes inflation, and it wants to increase output (reduce unemployment). The public forms rational expectations about inflation. The sequence of the game is:
The central bank has an incentive to choose inflation higher than expected to cause a surprise, lower real wages, and boost output. The public, knowing this, will not believe a zero-inflation promise. The only credible equilibrium is one where the central bank creates just enough inflation to match the public's expectations. At this point, the marginal cost of creating more inflation equals the marginal benefit of the (unrealized) output gain. The result is a positive rate of inflation but no gain in output, which is a suboptimal outcome.
Source: Hargreaves Heap (1992), Chapter 5.
How does the assumption of a "cash-in-advance" constraint lead to monetary non-neutrality?
A cash-in-advance (CIA) constraint, or Clower constraint, is the requirement that households must hold cash before they can purchase goods. This constraint can be a source of monetary non-neutrality.
When the central bank conducts an open market operation, it injects money into the economy by buying bonds from a subset of agents (e.g., financial institutions). This new money is not distributed evenly across the entire population. The agents who receive the money first are able to go and purchase goods before the price level has had time to adjust. This gives them a temporary real purchasing power gain at the expense of those who do not receive the new money first.
This is known as a liquidity effect or a limited participation model. The change in the money supply has real effects because it temporarily redistributes purchasing power. The non-neutrality arises from the combination of the CIA constraint and the fact that not all agents participate immediately in financial markets.
Source: EC3115 Subject Guide, Chapter 9.
What is the key difference between the aggregate supply assumptions in Real Business Cycle (RBC) models and New Keynesian models?
The key difference is the assumption about price flexibility and the source of fluctuations.
Source: Blanchard (1987), "Why Does Money Affect Output?".
In the McCallum sticky price model, what is the role of the parameter \(\beta_2\), the coefficient on expected inflation in the aggregate demand function?
The aggregate demand function is: \( y_t = \beta_0 + \beta_1(m_t - p_t) + \beta_2 E_{t-1}[p_{t+1} - p_t] + v_t \).
The parameter \(\beta_2\) captures the effect of expected inflation on aggregate demand, known as the Mundell-Tobin effect. A higher expected rate of inflation (\(E_{t-1}[p_{t+1} - p_t]\)), for a given nominal interest rate, implies a lower real interest rate. This lower real interest rate stimulates investment and consumption, thus increasing aggregate demand. Therefore, \(\beta_2 > 0\).
This parameter is crucial for analyzing whether the Policy Ineffectiveness Proposition holds. If \(\beta_2 = 0\), then PIP holds in the model. However, if \(\beta_2 > 0\) and expectations are formed at time \(t\) instead of \(t-1\), then systematic monetary policy can affect the public's expectation of future inflation, which in turn affects current aggregate demand and output. This provides a channel through which even anticipated policy can have real effects, causing PIP to fail.
Source: McCallum (1989), Chapter 10; EC3115 Subject Guide, Chapter 9.
Why is the empirical evidence on the intertemporal substitution of labor supply generally considered weak?
The empirical evidence is considered weak because most microeconomic studies find a very small elasticity of labor supply with respect to temporary changes in real wages. This is the "intertemporal substitution elasticity."
Models like the Lucas misperceptions model and Real Business Cycle models rely on a strong substitution effect to explain large fluctuations in employment. They require that workers are very willing to change their hours worked in response to small, temporary wage changes. However, most empirical studies using panel data on individuals find that hours worked do not respond very much to transitory wage movements. The estimated elasticities are too small to account for the large employment swings seen in business cycles.
This empirical failure is a major challenge for flexible-price models and provides a key motivation for New Keynesian models that rely on nominal rigidities and involuntary unemployment instead of intertemporal substitution.
Source: Blanchard (1987), "Why Does Money Affect Output?".
What is the "Calvo pricing" assumption and what are its implications?
The Calvo pricing assumption, developed by Guillermo Calvo (1983), is a model of time-dependent price setting that provides a convenient alternative to the Taylor model.
Instead of assuming a fixed contract length, Calvo assumes that in any given period, each firm has a constant probability, \(1-\theta\), of being able to reset its price. This means there is a constant probability, \(\theta\), that the firm's price will remain fixed. This implies that the average duration of a price is \(1/(1-\theta)\).
Implications:
It is a popular modeling device because it captures the essence of staggered price setting in a mathematically convenient way.
Source: Blanchard (1987), "Why Does Money Affect Output?".
How do Real Business Cycle (RBC) models explain the pro-cyclical behavior of employment and real wages?
In RBC models, the primary driver of business cycles is a shock to technology (a total factor productivity shock).
A positive technology shock directly increases the marginal product of labor. This shifts the labor demand curve to the right. In a competitive labor market, this leads to:
Since the technology shock causes output, employment, and real wages to all rise together, the model naturally generates pro-cyclical employment and pro-cyclical real wages. This is seen as a key strength of RBC theory, as it matches this empirical regularity without resorting to nominal rigidities.
Source: Blanchard (1987), "Why Does Money Affect Output?".
What is the main argument for why staggered price or wage setting might not be a stable equilibrium?
The stability of a staggered equilibrium depends on whether price setting exhibits strategic complementarity or strategic substitutability.
In the more likely case of strategic complementarity (where a firm's incentive to raise its price increases when others raise their prices), staggering is not a stable equilibrium. The intuition, as shown by Ball and Romer, is that a firm wants to time its price changes to coincide with the price changes of other firms.
If, for example, a majority of firms change their prices in even periods, the aggregate price level will be more volatile in even periods. A firm currently setting prices in odd periods has an incentive to move its price-setting to an even period. By doing so, it can better coordinate its price with the majority, reducing the fluctuations in its relative price. This incentive to "move with the herd" means that any small deviation from a perfectly staggered 50/50 split will cause firms to converge on a single, synchronized price-setting time. Staggering unravels.
Source: Blanchard (1987), "Why Does Money Affect Output?".
What is the difference between the effects of anticipated and unanticipated money in Fischer's two-period contract model?
In Fischer's model with two-period staggered contracts, both anticipated and unanticipated money can have real effects, but the effects differ.
The output equation is:
\[ y_t = \frac{1}{2} [\frac{1}{3}(m_t - E_{t-1}[m_t]) + \frac{2}{3}(m_t - E_{t-2}[m_t])] + ... \]
The key is that as long as some contracts currently in force were signed based on older information, even policy actions that are anticipated today can have real effects because they were not anticipated when those old contracts were written.
Source: Blanchard (1987), "Why Does Money Affect Output?".
Why is the concept of "real rigidity" important for the persistence of monetary effects in the Taylor model?
Real rigidity refers to the insensitivity of the desired real wage to the level of employment. In the Taylor model, this is captured by the parameter \(a\) in the wage-setting equation. A small value of \(a\) signifies high real rigidity.
Real rigidity is crucial for persistence because it determines how aggressively workers adjust their wages during renegotiations. If real rigidity is high (small \(a\)), workers do not demand a large wage increase when the labor market is tight. When setting a new contract, they will choose a nominal wage that is very close to the existing nominal wages of other workers, even if demand is high.
This small adjustment means that the aggregate wage level moves very slowly back to its long-run equilibrium after a shock. This slow adjustment of the nominal wage level is what translates the initial monetary shock into a long, persistent deviation of output from its natural rate. Without real rigidity, wages would adjust more quickly, and the effects of monetary shocks would die out faster.
Source: Blanchard (1987), "Why Does Money Affect Output?".
What is the "insider-outsider" model and how can it explain unemployment persistence (hysteresis)?
The insider-outsider model provides a micro-foundation for hysteresis, where the natural rate of unemployment depends on the history of actual unemployment.
The key distinction is between:
Following a recession that causes layoffs, the number of insiders shrinks. When the economy recovers, the now-smaller group of insiders may use their bargaining power to negotiate for higher wages for themselves, rather than allowing the wage to fall to a level that would permit the firm to re-hire the unemployed outsiders. The outsiders are effectively locked out of the labor market.
As a result, the equilibrium (or "natural") rate of unemployment rises. A temporary negative shock can have a permanent or highly persistent effect on unemployment because it reduces the number of insiders, which in turn alters the wage-setting dynamic in the future.
Source: Blanchard (1987), "Why Does Money Affect Output?".
How does the assumption about the information set (e.g., \(E_t[.]\) vs \(E_{t-1}[.]\)) in the aggregate demand function affect the Policy Ineffectiveness Proposition?
The timing of expectations in the aggregate demand function is crucial for whether the Policy Ineffectiveness Proposition (PIP) holds in a sticky price model.
Source: McCallum (1989), Chapter 11; EC3115 Subject Guide, Chapter 9.
What is the main theoretical objection to the original Phillips curve formulation?
The main theoretical objection, raised by Milton Friedman and Edmund Phelps, was that the original Phillips curve was misspecified because it related a nominal variable (wage inflation) to a real variable (unemployment).
Economic theory suggests that rational agents (workers and firms) are ultimately concerned with real quantities, not nominal ones. They should not suffer from "money illusion." Therefore, the rate of change of the real wage, not the nominal wage, should be related to the state of the labor market (i.e., the level of unemployment).
The rate of change of the real wage is \(\Delta w_t - \Delta p_t\). By relating this to unemployment, Friedman and Phelps argued that the correct specification must include the expected rate of price inflation:
\[ \Delta w_t = f(UN_t) + \Delta p_t^e \]
The failure of the original Phillips curve to include an expectations term was its fundamental theoretical flaw, a flaw that became empirically obvious during the high and variable inflation of the 1970s.
Source: McCallum (1989), Chapter 9.
In what sense is the intellectual heritage of New Classical (Lucas) and New Keynesian (Taylor/Fischer) models the same?
Both the New Classical and New Keynesian schools of thought emerged from the same intellectual environment of the early 1970s and share a common heritage in the work of Edmund Phelps and the "Phelps volume" (Microeconomic Foundations of Employment and Inflation Theory, 1970).
This work was the first systematic attempt to provide micro-foundations for the Phillips curve and to understand macroeconomic phenomena by analyzing the behavior of individual agents in environments with imperfect information and frictions.
As Blanchard (1987) notes, both approaches can be traced back to the same origin: the attempt to build more rigorous, micro-founded models to explain the relationship between money, inflation, and output that the original Phillips curve had described.
Source: Blanchard (1987), "Why Does Money Affect Output?".
What is the primary unresolved issue in the theory of nominal rigidities?
According to Blanchard (1987), a primary unresolved issue is providing a convincing, general explanation for the high degree of real rigidity observed in the economy.
Theories of nominal rigidity (like menu costs or staggered contracts) can explain why nominal variables have real effects. However, for these effects to be large and persistent, as they appear to be in reality, there must also be a high degree of real rigidity. This means that desired real wages must be insensitive to employment, and firms' desired price markups must be insensitive to demand.
While many different theories have been proposed to explain real rigidities (efficiency wages, implicit contracts, customer markets, etc.), Blanchard notes that the "sheer number of unrelated explanations is distressing." There is no single, unifying theory for why we observe such significant real rigidities. Finding a general explanation for this phenomenon is arguably the most urgent task for research on why money affects output.
Source: Blanchard (1987), "Why Does Money Affect Output?".