Week 6 Introduction to the New Keynesian model

Question 1

Is money neutral in the New Keynesian Model?

Answer 1

No, as we allow for sticky prices

Question 2

What is the effect of the non-neutrality of money?

Answer 2

It allows for monetary policy to have real effects- providing scope for fiscal and monetary policy to stabilise the economy.

Question 3

What are sticky price models sometimes called?

Answer 3

Menu cost models

Question 4

What are sticky prices?

Answer 4

Sticky prices, also known as price stickiness refers to pricing that is resistant to changing market conditions.

Question 5

Are prices fixed in the New Keynesian model and is this realistic?

Answer 5

Prices are fixed but this isn’t realistic

Question 6

What is the liquidity trap?

Answer 6

A liquidity trap is a situation, described in Keynesian economics, in which, “after the rate of interest has fallen to a certain level, liquidity preference may become virtually absolute in the sense that almost everyone prefers holding cash rather than holding a debt which yields so low a rate of interest

Question 7

What is our first assumption in a New Keynesian Model?

Answer 7

We need to assume monopolistic competition.

Question 8

How do New Keynesian models modify the RBC model?

Answer 8

They assume that firms have some control over the
prices of their own goods. However, this modification would not make sense in a perfect
competition environment.

Question 9

What do firms do in monopolistic competition?

Answer 9

Given the demand for their product, they set the price as a mark-up over marginal cost

Question 10

If the only modification to the RBC model was monopolistic competition, what would be the only difference?

Answer 10

Output would be inefficiently low, but everything else would remain largely unchanged.

Question 11

In a New Keynesian model do we assume flexible prices?

Answer 11

No, we assume that it is costly for firms to re-set prices (the stick price assumption)

Question 12

Assuming sticky prices, if a shock affects the demand for their good after they have already set the prices, what will the firm do?

Answer 12

The firm will simply satisfy that demand.

Question 13

Is the sticky priced assumption fixed or temporary?

Answer 13

The sticky price assumption is temporary- firms will be able to adjust prices in the future.

Question 14

How do households and the government behave in a New Keynesian Model?

Answer 14

The behaviour of households and governments is identical to that in an RBC model.

Question 15

In the New Keynesian Model, is the monetary policy neutral in the short run?

Answer 15

In the short run, monetary policy is not neutral.

Question 16

In the New Keynesian Model, who do we assume sets the money supply?

Answer 16

In our models we have assumed that the money supply

(currency) is set by the central bank as its monopoly supplier.

Question 17

In the New Keynesian Model, assuming no inflation, who controls the real interest rate in the short term?

Answer 17

The central bank

Question 18

In the New Keynesian Model, assuming no inflation, what is the easiest way to think of the money supply?

Answer 18

It is easiest to think of the money supply as being horizontal.

Question 19

In the New Keynesian Model, assuming no inflation, which schedule are households always on?

Answer 19

Households are always on their labour schedule

Question 20

In the New Keynesian Model, assuming no inflation, having set prices and satisfying demand, which schedules will firms be on?

Answer 20

The firm will be on neither their labour demand or output supply schedule.

Question 21

In the New Keynesian Model, starting from equilibrium, if the central bank implements a
contractionary monetary policy, what does this mean for interest rates

Answer 21

A contractionary monetary policy → ↑ interest rates

Question 22

In the New Keynesian Model, starting from equilibrium, if the central bank implements a
contractionary monetary policy, what does this mean for the output demand schedule?

Answer 22

A contractionary monetary policy → a movement along the output supply schedule.

Question 23

In the New Keynesian Model, starting from equilibrium, if the central bank implements a
contractionary monetary policy, what does this mean for the out and labour supply and what are the effects of this on wages and employment?

Answer 23

As output supply is passive, output contracts while labour supply rises due to the increase in interest rates.
∴ wages↓ and employment ↓.

Question 24

In the New Keynesian Model, starting from equilibrium, if the central bank implements a
contractionary monetary policy, what does this mean for the money demand levels, and how does the central bank react to this?

Answer 24

Money demand contracts: the central bank matches this in order to ensure its chosen interest rate target

Question 25

In the New Keynesian Model, starting from equilibrium, if the central bank implements a
contractionary monetary policy, what would be the effect on the labour supply curve

Answer 25

A contractionary monetary policy → ↑interest rates → ↑labour supply → rightwards shift in labour supply curve.

Question 26

In the New Keynesian Model, starting from equilibrium, what does increasing government spending do to output demand and labour supply?

Answer 26

↑G → ↑Yd & ↑ Ns

Question 27

In the New Keynesian Model, starting from equilibrium, what does increasing government spending do to employment and wages?

Answer 27

↑G → ↑N & ↑ w

Question 28

In the New Keynesian Model, starting from equilibrium, what does increasing government spending do to themoney supply?

Answer 28

↑G → ↑Y
↑G → no change in interest rates
∴ ↑G → ↑Md
∴ ↑G → ↑Ms

Question 29

In the New Keynesian Model, how could a central bank fully offset any expansionary fiscal policy?

Answer 29

By increasing interest rates by the appropriate level to reduce Y back to what it previously was (ie keep output stable)

Question 30

In the New Keynesian Model, starting from equilibrium, what does an increase in current and future technology do to the money supply?

Answer 30

↑z → ↑Production Function
↑z' → ↑MPK' → ↑ Investment → ↑Yd
↑z → no change in interest rates
∴ ↑z → ↑Md
∴ ↑z → ↑Ms

Question 31

Under a liquidity trap, what two things are perfect subsitutes?

Answer 31

Money and bonds

Question 32

What becomes more important to policy makers during a liquidity trap and why?

Answer 32

Fiscal policy becomes much more important as the central bank cannot lower interest rates any further.

Question 33

How does Williamson define the output gap?

Answer 33

Ym − Y∗

ie current output under a shock - flexible output.

Question 34

What is the output gap?

Answer 34

Price rigidities mean that prices and quantities in the NK model differ from those that would prevail under flexible prices (the RBC equivalent)
For example, current output Y∗ may be high due to a monetary policy shock but had prices been flexible output would have been equal to Ym.

Question 35

What do optimal macroeconomic policies do?

Answer 35

We can think of optimal policy as policies that aim to minimise the output gap as well as to equate the actual and the natural rates of interest

Question 36

What is the output gap in the RBC model?

Answer 36

0

Question 37

What does the Taylor rule tell us?

Answer 37

Taylor’s rule makes the recommendation that the Federal Reserve should raise interest rates when inflation is high or when employment exceeds full employment levels. Conversely, when inflation and employment levels are low, the Taylor rule implies that interest rates should be decreased.

Question 38

What is the Taylor rule formula to work out the target rate for interest rates?

Answer 38

Target Rate in short term = Current short term interest rate + 0.5*(expected GDP growth - long term GDP growth) + 0.5 * (expected inflation-target inflation).