Nominal Rigidity

Question 1

What is Nominal Rigidity

Answer 1

The term ‘nominal rigidity’ refers to prices quoted in money not adjusting as required to clear markets immediately

Question 2

Factors that affect the stickiness of prices for goods (3)

Answer 2

Menu Costs
Decision-making costs
Coordination problem

Question 3

What is nominal interest rates

Answer 3

Percentage of money lent or borrowed

Question 4

What are real interest rates

Answer 4

This reflects the real return from saving or the real cost of borrowing. An increase in the real interest rate raises the price of goods in the present compared to the future, leading to a decrease in both consumption (𝐶𝑑) and investment (𝐼𝑑).

Question 5

With sticky prices, what will determine labor demand

Answer 5

Level of output that the firm needs to produce - change in demand for a specific product

Question 6

What is nominal wage

Answer 6

Nominal Wage (W): The monetary amount paid to workers per unit of time (e.g. hourly, weekly, monthly).

Question 6

Real wage meaning

Answer 6

Real Wage (w): The purchasing power of the nominal wage, adjusted for the price level. Calculated as w = W/P.

Question 6

What shifts the labor supply curve

Answer 6

Shifts with real interest rate

Question 7

What is real wage determined by

Answer 7

interaction of labor demand and supply

Question 8

With sticky prices how was real GDP determined

Answer 8

With sticky prices, the real GDP (Y0) is determined at the intersection of the aggregate demand (Yd) curve and the MM line. The output supply (Ys) curve plays no role here.

Question 9

What is marginal cost equal to

Answer 9

nominal wage/ marginal product of labor

Question 10

With imperfect competition and flexible prices, where can firms set their price

Answer 10

With imperfect competition, firms can set their prices (P) above their marginal cost (MC).

Question 11

how is efficiency measured with sticky prices

Answer 11

comparing MPN(Marginal Product of Labour) and MRScl (marginal rate of substitution between leisure and consumption). If MPN > MRScl then employment and production is efficiently low

Question 12

why cant we use the classic keynsian model for sticky prices

Answer 12

• Have a failure of marking clearing owing to this nominal rigidity
• Assumes prices are set by firms, not markets, so model features an imperfectly competitive goods marlet

Question 13

what does the fisher equation tell us

Answer 13

• How to calculate real interest rate from nominal (eg from a bond, saving, loan, etc)
• Eg what’s the real return to saving? You buy 1 less unit of good, you save p more units of money for savings.

Question 14

Creation of the fisher equation

Answer 14

Imagine you save 1 unit of goods. This means you are saving P amount of money, where P is the current price level.

If the interest rate is i, then in the future you will get back 1 + i amount of money.

However, the value of that money depends on the future price level P’. If prices have gone up (inflation rate π’ = (P’ - P)/P), then the 1 + i amount of money you get back will only buy 1 + i P/P’ units of the future goods.

This ratio of 1 + i P/P’ is equal to 1 + r, where r is the real interest rate (the real return on your savings).

The Fisher equation states this relationship formally:
1 + r = (1 + i)/(1 + π’)

For example, if the nominal interest rate i is 5% and the expected inflation rate π’ is 3%, then the real interest rate r would be approximately:
r ≈ i - π’ = 5% - 3% = 2%

So the key point is that the real interest rate you earn on your savings is the nominal interest rate minus the expected inflation rate.

Question 15

Assumptions of New Keynesian Model

Answer 15

imperfect competition and sticky prices in the goods market.

Assumptions:

• All goods prices (P) are completely fixed at a level Pbar and are expected to remain so in the near term. If a firm has a fixed price (P-bar) that it cannot change, it cannot choose how much to sell.
• Wages (W) and real wages (w = W/P) are fully flexible.
  As long as the real wage (w) is less than or equal to the MPN, the firm will want to hire more workers.

Impact of Sticky Prices:
- The assumption of sticky prices affects the analysis of firms’ labor demand and the implied level of output supply.

Question 16

What shifts firm’s labor demand in imperfect competition

Answer 16

the firm’s labor demand shifts with changes in the demand for its product, rather than directly with the real wage. Labor demand is perfectly wage inelastic

Question 17

Why is there no Y2 curve with sticky prices

Answer 17

With sticky prices, labor demand depends on aggregate demand:
firms do not make an independent decision about how much to sell
* No 𝑌𝑠 curve: supply of output passively responds to aggregate demand

Question 18

What is inflation when prices are sticky. Relate it to the Fisher equation. Who then sets the real interest rate ?

Answer 18

When prices are completely sticky, inflation is zero (𝜋 = 0).
According to the Fisher equation 𝑖 = 𝑟 + 𝜋′𝑒, this means that the real interest rate 𝑟 equals the nominal interest rate 𝑖.
With sticky prices, monetary policy effectively sets the real interest rate 𝑟, which determines a point on the labor demand curve (𝑌𝑑).

Question 19

What does the interaction between the labor demand curve and the MM line tell us

Answer 19

The intersection between the labor demand curve (𝑌𝑑) and the MM line determines the real interest rate 𝑟 and the output level.

Question 20

What happens to the Yd and MM line with negative demand shock from decreased confidence

Answer 20

The negative demand shock from decreased confidence shifts the aggregate demand and investment curve left. With no monetary policy response, this leads to lower output, employment, and real wages, but higher average labor productivity. The negative wealth effect also causes the labor supply to shift, further reducing employment.

Question 21

What happens if its costly for firms to adjust their workforce

Answer 21

If it is costly for firms to adjust their workforce, they may choose to retain workers even when demand is down. This means the actual work being done falls more than the measured labor input. As a result, measured productivity can appear to be procyclical, falling during recessions even if the workers’ true productivity has not changed. The rigidity in employment adjustments is the key driver of this effect.

Question 22

4 causes of Negative demand shock

Answer 22

Potential sources of negative demand shocks include:
- Decreases in consumption (𝐶𝑑) or investment (𝐼𝑑) due to reduced confidence, often triggered by greater pessimism about future economic growth.
- Decreases in consumption or investment due to a perception of greater risk, leading to increased precautionary saving by households and reluctance by firms to invest.
- Worsening credit-market frictions, where borrowers face higher loan interest rates (𝑟𝑙) than the rates received by savers. This can occur due to asymmetries of information about which borrowers can be trusted to repay loans, leading to a higher spread (𝑟𝑙 − 𝑟) between interest rates when credit-market frictions worsen. Investment demand depends on 𝑟𝑙, so declines in investment (𝐼𝑑) occur when the spread rises.
- Lower government spending (𝐺) can also act as a demand shock.

Question 23

expand on what happens with decline in households’ and firms’ confidence

Answer 23

This implies lower consumption (𝐶𝑑) and investment (𝐼𝑑).
The aggregate demand curve (𝑌𝑑) shifts to the left.
Assuming no response from monetary policy (horizontal MM line), the interest rate 𝑟 remains unchanged.
GDP (𝑌) decreases.
Lower GDP reduces labor demand, shifting the labor demand curve (𝑁𝑑) to the left.
This results in lower employment (𝑁) and a lower real wage (𝑤).
However, average labor productivity (𝑌/𝑁) increases due to diminishing returns.
The negative wealth effect shifts the labor supply curve (𝑁𝑠) to the right, causing a further decline in output.

Question 24

For a firm that can adjust its’ price what is labor determined by

Answer 24

• A firm that can adjust its price, labor demand is determined by the Marginal Revenue Product of Labor (MRPN), not the MPN.
• The MRPN curve is simply a scaled-down version of the MPN curve, reflecting the firm’s desired profit margin.

Question 25

when are demand-management policies to address economic fluctuations needed for sticky prices

Answer 25

When prices are sticky, shocks to the economy can lead to deviations of actual GDP 𝑌 from the supply curve 𝑌𝑠.
The difference between actual GDP 𝑌 and its natural level 𝑌∗ is termed the ‘output gap.’
Deviations from the natural level of output 𝑌∗ suggest a potential role for demand-management policies to address economic fluctuations.

Question 26

How is efficiency determined with sticky prices

Answer 26

Efficiency is determined by comparing what can be produced (𝑀𝑃𝑁) to what people value their time (𝑀𝑅𝑆𝑙,𝐶).
If 𝑀𝑃𝑁 is greater than 𝑀𝑅𝑆𝑙,𝐶, it means production and employment are lower than they could be.

Question 27

2 main reasons for inefficieny

Answer 27

Imperfect competition leads firms to lower output to boost profits even when it’s not optimal.
Sticky prices, combined with negative demand shocks, push GDP below its natural level, exacerbating the inefficiency.

Question 28

What should the CB get r* to to close the output gap

Answer 28

To close the output gap between 𝑌 and 𝑌∗
, the central bank should set 𝑖 (and 𝑟) equal to the natural rate of interest 𝑟∗

Question 29

what is the efficiency wage?

Answer 29

Efficiency wage is a concept in labor economics where employers pay wages higher than the market-clearing wage to motivate workers to be more productive, reduce turnover, and improve overall efficiency. By offering higher wages, employers aim to attract better-quality workers, reduce shirking, and enhance morale and loyalty among employees. This practice can lead to better performance and profitability for the firm in the long run, despite the higher wage costs in the short term.