Nominal Rigidity Flashcards
What is Nominal Rigidity
The term βnominal rigidityβ refers to prices quoted in money not adjusting as required to clear markets immediately
Factors that affect the stickiness of prices for goods (3)
Menu Costs
Decision-making costs
Coordination problem
What is nominal interest rates
Percentage of money lent or borrowed
What are real interest rates
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 (πΆπ) and investment (πΌπ).
With sticky prices, what will determine labor demand
Level of output that the firm needs to produce - change in demand for a specific product
What is nominal wage
Nominal Wage (W): The monetary amount paid to workers per unit of time (e.g. hourly, weekly, monthly).
Real wage meaning
Real Wage (w): The purchasing power of the nominal wage, adjusted for the price level. Calculated as w = W/P.
What shifts the labor supply curve
Shifts with real interest rate
What is real wage determined by
interaction of labor demand and supply
With sticky prices how was real GDP determined
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.
What is marginal cost equal to
nominal wage/ marginal product of labor
With imperfect competition and flexible prices, where can firms set their price
With imperfect competition, firms can set their prices (P) above their marginal cost (MC).
how is efficiency measured with sticky prices
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
why cant we use the classic keynsian model for sticky prices
- 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
what does the fisher equation tell us
- How to calculate real interest rate from nominal (eg from a bond, saving, loan, etc)
- Eg whatβs the real return to saving? You buy 1 less unit of good, you save p more units of money for savings.
Creation of the fisher equation
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 Pβ. If prices have gone up (inflation rate Οβ = (Pβ - P)/P), then the 1 + i amount of money you get back will only buy 1 + i P/Pβ units of the future goods.
This ratio of 1 + i P/Pβ 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 + Οβ)
For example, if the nominal interest rate i is 5% and the expected inflation rate Οβ is 3%, then the real interest rate r would be approximately:
r β i - Οβ = 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.
Assumptions of New Keynesian Model
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 firmsβ labor demand and the implied level of output supply.
What shifts firmβs labor demand in imperfect competition
the firmβs labor demand shifts with changes in the demand for its product, rather than directly with the real wage. Labor demand is perfectly wage inelastic
Why is there no Y2 curve with sticky prices
With sticky prices, labor demand depends on aggregate demand:
firms do not make an independent decision about how much to sell
* No ππ curve: supply of output passively responds to aggregate demand
What is inflation when prices are sticky. Relate it to the Fisher equation. Who then sets the real interest rate ?
When prices are completely sticky, inflation is zero (π = 0).
According to the Fisher equation π = π + πβ²π, this means that the real interest rate π equals the nominal interest rate π.
With sticky prices, monetary policy effectively sets the real interest rate π, which determines a point on the labor demand curve (ππ).
What does the interaction between the labor demand curve and the MM line tell us
The intersection between the labor demand curve (ππ) and the MM line determines the real interest rate π and the output level.
What happens to the Yd and MM line with negative demand shock from decreased confidence
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.
What happens if its costly for firms to adjust their workforce
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 workersβ true productivity has not changed. The rigidity in employment adjustments is the key driver of this effect.
4 causes of Negative demand shock
Potential sources of negative demand shocks include:
- Decreases in consumption (πΆπ) or investment (πΌπ) 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 (ππ) 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 (ππ β π) between interest rates when credit-market frictions worsen. Investment demand depends on ππ, so declines in investment (πΌπ) occur when the spread rises.
- Lower government spending (πΊ) can also act as a demand shock.
expand on what happens with decline in householdsβ and firmsβ confidence
This implies lower consumption (πΆπ) and investment (πΌπ).
The aggregate demand curve (ππ) shifts to the left.
Assuming no response from monetary policy (horizontal MM line), the interest rate π remains unchanged.
GDP (π) decreases.
Lower GDP reduces labor demand, shifting the labor demand curve (ππ) to the left.
This results in lower employment (π) and a lower real wage (π€).
However, average labor productivity (π/π) increases due to diminishing returns.
The negative wealth effect shifts the labor supply curve (ππ ) to the right, causing a further decline in output.
For a firm that can adjust itsβ price what is labor determined by
- 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 firmβs desired profit margin.
when are demand-management policies to address economic fluctuations needed for sticky prices
When prices are sticky, shocks to the economy can lead to deviations of actual GDP π from the supply curve ππ .
The difference between actual GDP π and its natural level πβ is termed the βoutput gap.β
Deviations from the natural level of output πβ suggest a potential role for demand-management policies to address economic fluctuations.
How is efficiency determined with sticky prices
Efficiency is determined by comparing what can be produced (πππ) to what people value their time (ππ
ππ,πΆ).
If πππ is greater than ππ
ππ,πΆ, it means production and employment are lower than they could be.
2 main reasons for inefficieny
Imperfect competition leads firms to lower output to boost profits even when itβs not optimal.
Sticky prices, combined with negative demand shocks, push GDP below its natural level, exacerbating the inefficiency.
What should the CB get r* to to close the output gap
To close the output gap between π and πβ
, the central bank should set π (and π) equal to the natural rate of interest πβ
what is the efficiency wage?
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.
