Week 9 New keynesian theory of flucatiations

Question 1

What did we say about money last week?

Answer 1

Money is neutral in the full intertemporal model as we make the assumption that prices adjust immediately to any shock they face.

Any monetary policy action that the central bank will do will just increase the level of prices, will not have an effect on output or the labour market.

Question 2

What did we say about the nominal interest rates last week?

Answer 2

Having a 0 lower bound will lead to a liquidity trap, if the central bank uses open market operations to increase the money supply. ( this is where the fiscal authority, govt, buy short term maturity bonds from banks, meaning the banks can have liqudity, and increase money supply, but this will not increase, as the return on bonds is 0, so it will decrease by the same amount, the increase in money supply)

Question 3

Is the zero lower bound the lowest bound to the real interest rate?

Answer 3

Nope, we can go a bit negative, this is because there is storage costs, when i get money from the bank i have to store it somewhere or security for it. Depending on the storage cost, will take you how much negative it would be.

Question 4

So with an effective lower bound ( a lit bit negative) will you make a profit?

Answer 4

You will not make a profit, because of these stroage costs, as you take out money, pay a little less than the loan, but pay the stroage cost, so no profit.

Question 5

Will the demand for loans at the negative or effective lower bound be infinite, are we sure about what the effective lower bound even is?

Answer 5

No they will not be infinite, as not everyoen will try to borrow as much as possible.

So we are not sure what the effective lower bound is

Question 6

Other than menu costs, what is another cost of inflation?

Answer 6

Relative price distoritions

Question 7

What do we mean about relative price distortions?

Answer 7

Well firms only change their price after inflation, if the additional profits of an increase in price is more than cost of changing price. Some companies, may not change price and some may do, meaning some prices are cheaper than the other, causing relative price disortions.

Question 8

Why is relative price distortion bad for scarce resources?

Answer 8

if a good is less scarce then the allocation of goods is going to be inefficient, as you will tend to buy more of it, if price is lower even though this is not meant to happen, sending the wrong signals

Question 9

What is an additioanl cost of unexpected inflation?

Answer 9

Arbitary redistruntion of purchasing power

Question 10

What is a benefit of inflation?

Answer 10

Stay away from deflation, stay away from zero lower bound

Question 11

What are costs of deflation?

Answer 11

Consumers postpone purchases of durable goods( if prices going down e.g. a car, you will delay your purchases, as in the next period you know prices are going down.)

Menu costs

Question 12

From our evidence are prices fully flexible?

Answer 12

Probably not, firms seem to change price on average 6-10 months, depending on sector. ( More compeitition then the firm changes it more frequently)

Question 13

What do new keynesian models show?

Answer 13

Money is not neutral, and prices do not adjust immediately, meaning that some markets are not in equilbrium.

Question 14

Why might firms be infrrequent in changing prices?

Answer 14

Menu costs, competition presurres.

Question 15

What are we going to assume about new keynesian models 3 assumptions?

Answer 15

1) Prices are constant in the first period and cannot be changed in the first period
2) Central bank has a target interest rate r* and use money supply to hit it( nominal and real interest rate the same)
3) Output is determined by output demand ( firms will produce to satisfy output demand at the current prices)

Question 16

What is an output gap?

Answer 16

Output gap is the difference between equibrium output(if prices were flexible) and actual output deterimined by output demand.

Question 17

What is the natural rate of interest?

Answer 17

Is the equibirum rate of intererst if prices were flexible.

Question 18

Is the target interest rate always in disequilbrium?

Answer 18

No it is not always in disequibrium, it can be at equibrium.

Question 19

How would the new keynesian model look like on our 3 way model?

Answer 19

Question 20

Describe this New keynesian model?

Answer 20

1) The price level is p*, which has been set and we cannot change this in the current period. Firms cannot change price in the current period.
2) The monetary policy has a target interest rate r*
3) The central bank will manipulate the money supply, so that the target real interest rate is hit.
4) This target interest rate is where output demand and supply are not equal because of our assumption.
5) This target interest rate is very high if we want to reach an efficient allocation of output ym and efficient real interest rate is rm.
6) As output is determined by output demand we see that we have y* and r* which are plugged in the money demand formula to give PL(Y*,r*)
7) The central bank sets the money supply so that it is exacly matching the money demand at the price level which is fixed.
8) If there is a change in the target interest rate, that will effect money demand, and if the central bank wants to hit that specific interest target, it will have to change the money supply to match it.
9) In the labour market we dont have equiibrium, as we dont produce at Ym, we dont need so much workers working for you.
10) so in short the central bank has a target and it will keep manipulating the money supply to hit that target interest rate( for the fixed prices)

Question 21

There are 3 ways in orfer to reduce the output gap and get close or competely reduce the output gap which are what?

Answer 21

Monetary policy not being neutral

Do nothing

Monetary policy

Fiscal policy

Question 22

How can we use monetary policy to reduce the output gap? Show that the monetary policy is not neutral?

Answer 22

1) Lets say we start from a situation in theh economy where the target interest rate is r1, which is higher than the natural rate of interest, thus we are at an inefficient situation, thus an output gap.
2) What the central bank can do to reduce the target interest rate to r2, meaning we produce an amount y2.
3) This will affect the money demand which shifts to the right( as output is higher and real interest rate is lower)
4) The central bank has to hit thisi target interest rate and keep prices fixed, so they will increase the money supply.
5) thus we are closing the output gap getting closer and closer to the efficent allocation of resources.
6) But monetary policy is not neutral, we get closer and closer.
7) In the labour market, interest rates have gone down leading to the intertemporal subsitution of lesiure, fuutre lesiure is more expensive, so you work less today, this corresponds to a wage w2, but not in equibrium.

Question 23

How can we improve allocation of resources by not doing anything?

Answer 23

1) In the current period firms cannot adjust prices but in the long run they can.
2) lets say the interest target rate is r1 and we are producing y1, which is the inefficient
3) we cannot do anything about this, we are stuck.
4) in next period firms can reduce prices a little bit, meaning consumers want to buy more, so we move along the output demand , meaning real interest rates fall and if the central bank doesnt do anything.
5) this leads to the natural rate of interest and y2, which means that the money demand will shift to the right and prices will stop going down untill we reach y2. Thus we can achieve an efficient allocation in the long run.

Question 24

What is the argument against a do nothing response to improve allocation of resources?

Answer 24

This is not a good idea as it is going to take a long time to reach this level after a shock has hit the economy

Question 25

Quick question why are firms in rquibrium in the first place?

Answer 25

Because there is a shock that happens.

Question 26

So how do we make sure we hit an efficient equibrium immediately, even with constant prices?

Answer 26

Reduce the target interest rate the monetary policy has set by the central bank.

Question 27

How would Reducing the target interest rate ( monetary policy) to reach an effcient competitive equibrium immediately?

Answer 27

1) If i reduce the target interest rate from, r1 to r2, the output gap would reduce, as we move along the output demand curve, as consumers are buying more goods, This means an increase in output and a decreaase in interest rate, this means that the money demand will increase.
2) As there is a shift in money demand, i will have to increase the money to hit the money demand at that fixed price, as interest rate is lower and output is higher.
3) In the labour market, interest rate goes down meaning that the intertemporal subsitution of lesiure means, future lesiure is more expensive, meaning you work less today, meaning labour supply shifts to the left and we reach a new equibrium.

Question 28

So we can also use fiscal policy ( increase governement spending) to improve the allocation of resources, how?

Answer 28

If we increase government spending, and assume the monetary authority keeps the interest rate target r1.

If i increase government spending then output demand will move to the right by quite a lot)

If i keep the same interest rate target r1, ( we assume output is determined by output demand, i will produce at y2. .

This means money demand will shift to the right as the interest rate didnt change but output is higher

Labour supply also shifts to the right as higher governemnt spending means higher taxes, so for the same level of the interest rate, i want to work more, as lifetime wealth is lower to get the same wage,

The output supply will also shift to the right.

GDP has increased quite a bit