New Keynesian Economics: Sticky Prices

Question 1

What are the key aspects of the NK model?

Answer 1

• 1. No full information
• 2. Sticky prices because of menu costs
• 3. Monopolistic markets
• Short run
• Demand Side Micrcofoundations

Question 2

What are the demand side microfoundations of the NK model?

Answer 2

• In the Keynesian model, the firm sets a price which is fixed (stickiness), produces enough to meet the demand and determines the labour demand from the production function
• Therefore the labour demand and output supply are not derived from the firm’s choices
• At a given level of r, the aggregate demand determines the consumption demand on the firm and as the firm supplies this amount, this determines the labour demand
• Given the labour demand curve, this quantity of labour demanded determines the market wage rate
• YD → YS → ND → w
• Money market is unchanged

Question 3

What are the two equilbrium differences between the RBC and the NK?

Answer 3

• The output gap is the difference between equilibrium output if prices were flexible and actual output
• The natural rate of interest is the equilibrium rate if prices were flexible

Question 4

How is money not neutral in the NK?

Answer 4

• A reduction in r supported by an increase in money supply acts to increase aggregate demand and output
• The demand for output rises at the fixed price of goods, and firms accommodate the increase in demand by hiring more workers

Question 5

What is the general mechanism of a TFP shock in the NK?

Answer 5

An increase in TFP shifts the production function up but does not increase output, the firm therefore reduces labour demanded at the same production level

Question 6

What is the effect of a negative TFP shock in the NK model?

Answer 6

• 1. ↓z → ↓YS → 0Δ(Y, r)
• 2. ND↑ to produce same Y → w↑
• Result: N↑, w↑

Question 7

What is the effect of a negative demand shock on the NK?

Answer 7

• 1. ↓YD → ↓Y, 0Δr
• 2. ↓Y → ↓ND → ↓w
• 3. ↓Y → ↓MD, central bank must ↓MS to keep P constant
• Result: Y↓, N↓, w↓

Question 8

What kinds of shocks are there in the NK?

Answer 8

TFP and demand

Question 9

What is the effect of a positive demand shock on the NK/

Answer 9

• Assume central bank buys government bonds to fianance
• 1. ↑G = ↑YD → ↑Y, 0Δr
• 2. ↑Y → ↑ND → ↑w
• 3. ↑Y → ↑MD, central bank must ↑MS to keep P constant
• Result: Y↑, N↑, w↑

Question 10

What is the effect of a decrease in the interest rate in the NK?

Answer 10

• 1. ↓r = ↑YD = ↑Y → ↑ND = ↑w
• 2. ↓r → ↓NS → ↑w at same ND
• Result: ↑Y, ↑N, ↑↑w, ↓r
• 3. ↑Y + ↓r = ↑MD but initial ↑MS hopefully means 0 effect on P

Question 11

How can the monetary authority create jobs in the NK?

Answer 11

• 1. r↓ = ↑YD = ↑Y
• 2. Y↑ → ↑ND = ↑N
• 3. r↓ → ↓NS → 0ΔN
• Result: Y↑, N↑, w↑

Question 12

What is the result of fiscal policy in the NK?

Answer 12

• 1. G↑ = YD↑ → ↑ND = ↑w
• 2. (T, T’)↑ → NS↑ = ↑w at previously determined ND
• Result: Y↑, N↑, w↑, r unchanged, P↓

Question 13

What explains the business cycle in the NK?

Answer 13

• AD Shocks

* Interest Rate

Question 14

How do interest rates cause the business cycle in NK?

Answer 14

If r changes for a given aggregate demand curve, output will fluctuate

Question 15

What is stabilisation policy in the NK?

Answer 15

• Increasing government spending can stabilise a recession by increasing everything except the interest rate and causing deflation, up to a point because of the future tax burden
• Lowering the interest rate to 0 increased output in line with an aggregate demand curve not bound to an aggregate supply

Question 16

How is monetary policy stabilisation effectively done in the NK?

Answer 16

To increase Y, decrease r, and increase MS to stabilise P