sticky prices and inflation

Question 1

what keeps firms from adjusting prices in the short term?

Answer 1

• “menu costs”: fixed costs of changing prices, such as printing new menus or chaing price tags.
• “long-term contracts: prices or wages are fixed for a given time, say a year.
• imperfect information: it is difficult or costly to always observe all infromation

Question 1

what is the main mechanism determining inflation?

the formula shown here is aggregate inflation

Answer 1

inflation today, depends on expected price changes tomorrow (inflation tomorrow) plus a termin the difference between marginal cost times markup and the equilibrium relative price (1).

Question 2

linearized price setting equation
interpretation

Answer 2

• when expected inflation rises, firms begin raising their prices today to avoid paying higher marginal price adjustment costs next period.
• when marginal costs (wt-At) rise, all firms raise their prices in order to stay close to their desired relative price.
• the coefficient (η - 1)/ψ tells us how strongly inflation responds to changes in real marginal costs.
• It depends on the elasticity of good demands to prices, it reflects how strong the strategic feedback is between firms when setting prices. the higher η, the stronger firms react to cost changes.
• the scaling factor of the price adjustment cost, which makes a given marginal price change more costly for each firm.

Question 3

interpretation: New Keynesian Philipps Curve

Answer 3

• inflation depends on expected inflation and the output gap, which is the difference between the actual level of output and the natural level of outut,.

Question 4

interpretation: New Keynesian IS curve

Answer 4

• shows that output depends positevly on expected output (because of consumption smoothing) and negatively on the gap between the real interest rate and the long-run rate ρ.