EC2B3 Topic 4: Nominal Rigidity Flashcards
What is nominal rigidity?
Nominal rigidity refers to the slow adjustment of nominal variables, like wages and prices, in response to changes in the economy.
It implies that these nominal variables do not change instantly or proportionately to real economic changes.
What are the implications of nominal rigidity in economics?
Nominal rigidity can lead to unemployment and economic inefficiencies during downturns because wages do not adjust downward.
This rigidity can prolong recessions and slow down recovery.
How does nominal rigidity affect monetary policy?
Nominal rigidity can limit the effectiveness of monetary policy, as changes in interest rates may not lead to immediate adjustments in wages and prices.
This can result in delayed responses to economic stimuli.
Fill in the blank: Nominal rigidity primarily involves the slow adjustment of _______ and _______.
wages and prices
These adjustments are crucial for balancing supply and demand in the economy.
True or False: Nominal rigidity allows for instant adjustments in wages and prices to economic changes.
False
Nominal rigidity is characterized by slow adjustments.
What can cause nominal rigidity?
Nominal rigidity can be caused by contracts, menu costs, and psychological factors.
Contracts may lock in wages, while menu costs refer to the costs of changing prices.
List three factors contributing to nominal rigidity.
- Contracts
- Menu costs
- Psychological factors
These factors hinder the flexibility of wages and prices in the economy.
How does nominal rigidity relate to unemployment?
Nominal rigidity can lead to higher unemployment during economic downturns as firms are unable to reduce wages.
This can create a mismatch between labor supply and demand.
Fill in the blank: Nominal rigidity can prolong _______ and slow down _______.
recessions; recovery
The inability to adjust nominal variables can hinder economic growth.
What role does nominal rigidity play in economic models?
Nominal rigidity is a key assumption in many economic models, particularly in explaining short-run fluctuations.
It helps economists understand the dynamics of business cycles.
Why would prices be sticky
menu costs
cost of maaking pricing decisions
relationship with customers
How do keynsian models account for nominal rigidity
- Failure of market clearing owing to this nominal rigidity
- Price stickiness assumes prices set by firms not markets –> imperfectly competitive goods market
- Pricess eventually adjust so long term clearing
diff between nominal and real rates
nominal; cost of borrowing in money markets
CB controls it
Real; IR is one affecting AD
Market clearing rate with flexible prices
What is transmision mechanism w sticky prices
Inflation slow to adjust so nominal rate affects real rates
MM IR are short term rates, while real rates that matter most for AD are long-term rates
link between nominal and real rates is ____
q
The Fischer Equation
What is the fischer equation (and approx. form)
1 + r = (1+i) / (1+π’)
r = i - π’ when (r * π ‘ is small)
How are wages and labour decided with sticky prices
Labour demand perfectly wage inelastic (at andd past the sale point) and shifts with the aggreagte demand for goods
draw the labour market diagram with sticky prices
With sticky prices what does labour demand depend on
Depends on aggregate demand: firms do not make an independent decision on how much to sell
–> no Ys curve: supply of output passively responds to AD
AD determined by output demand curve (C + I + G)
What does stickiness of prices suggest about inflation
implies zero inflation (π=0)
thus due to fischer ( i = r + π’e) and r = i
What does sticky prices imply about Monetary Policy
How do you represent this on a graph
Monetary Policy sets the real interest rate (r) as r = 1 as π = 0
CB choice of nominal rate (i) is represented by MM line (‘Money and Monetary Policy’); assumed to be flat or upward sloping’)
Intersection between Y Demand curve and MM Line determined real interest rate (r) and output Y
Draw the goods market with sticky prices and the MM line
excess supply iff Y to left of Ys
Draw tehe effect of a cut in nominal rates with sticky prices, in the goods market
inflation does not adjust due to sticky prices
Shifts MM line downward as the real IR falls –> economy moves along the output demand curve
source off -ve demanad shocks in new keynsian model
- Decline in C or I from low confidence or perception to greater risk
- Worsening of credit-market frictionsn
- Lower G spending
New Keynesian model emphasis demand shocks and unexpected fallls in AD as the main cause of business cycles
Describe and draw the effects of negative demand shocks (fall in confidence) to goods, labour and production
1. Goods:
- Leftward shift of Ys from fall in AD
2. Labour:
- N(d) shift to left from a lower Y
- Causes a lower employment –> lower w
- But N(S) shifts to right from -ve wealth effect
but higher avg. labour productivity (Y/N) due to diminishing returns
3. Production:
Move along production function curve to Y2
How does the model prediction match up with the empirial evidence
Matches obserbed cyclicality of macro variables except prooductivity and real IR
Avg. labour producitivity may be mis measured owing to ‘labour hoarding’
If MM line upward sloping, real IR is procylical; same as recent decades
What is labour hoarding and draw the effect
If adjusting employment is costly for firms, not want to dismiss workers following a temporary demand shock
‘Hoard’ labour in recession –> actuala labour input falls more than measured labour input in recession.
Measasured productivity can fall; making it procyclical
What represents a firms profit margin
The gap between MPn and real wage w is firm’s profit margin as p>MC
MRPn is also below MPn
Draw the labour and goods market with flexible pricess in the New Keynesian model
MRPn is scaled down MPn curve
Nd behaves in same way as with per
What is r * in the new Keynesian model
market clearing interest rate if prices are flexible
Hypothetical equilibriuim real interest rate if no nominal rigidities in the economy
also for output and labour
What is the output gap
gap between actual GDP Y and its natural level Y *
How is efficiency of the economy judged in new Keynesian
Comparing MPn to households’ marginal rate of substitution between leisure and consumption
MPn: produced if people were able to work more
MRS (l,c): What value (measured in goods) people put on their time
inefficiiently low if MPn > MRS (l,c)
Thus how is efficiency judged on the goods market diagram
- Looking at hypotheticcal perfect competition output supply curve Y (s) on which MPn = MRS (l,c)
so MPn = MRS l,c = w *
two reasons why output is inefficiently low in new keynesian model
- Natural level of output Y * is already too low because imperfect competition
- Sticky prices –> -ve demand shocks push GDP below Y *
What is the optimal stabilisation policy in response to a decline in confidence about the future
MP Response:
CB lowers rates –> move along Y(D) curve raising real Y
To close output gap between Y and Y * , CB sshould set i and r equal to natural rate of interest r * –> positions MM line so it intersects Y(D)
Fiscal policy could also provide a demand stimulus
Draw the optimal stabilisation polixy and the steps
Problems with opitmal stabilisation policy?
- Best policy achieves same outcome as if pricees flexiible
- Need to know R *
- Must be possible to adjust the nominal interest rate i
- Not sustainable to reach natural rate
Draw efficiency wages diagram
- incorporating wage rigidity into the New Keynesian model
What is the cylicality of the unemplyoment rate relative to the movement of real GDP
