Chapter 16 However The Imperfect Competition Assumption Necessary The

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Chapter 16: Money and Business Cycles II: Sticky

Prices and Nominal Wage Rates

Chapter Summary:

The original Keynesian model of recession and unemployment was based on

“sticky wages”. This produced countercyclical movements in the real wage and

procyclical movements in the price level, just as the monetary misperceptions model.

Empirical evidence since 1950 has not supported that idea, and economists working

in the Keynesian tradition developed a “sticky price” model that predicts a

procyclical real wage. Although the chapter reviews the sticky wage theory, the

In this theory, open-market operations produce real effects on the economy,

and the central bank conducts monetary policy in order to influence nominal interest

rates and aggregate demand. The discussion of Federal Reserve policy beginning on

page 401 demonstrates how economic theory impacts “real world” policies. Students

Chapter Outline:

I. The New Keynesian Model

A. Price Setting Under Imperfect Competition

B. Short-Rum Responses to a Monetary Shock

II. Money and Nominal Interest Rates

II. The Keynesian Model-Sticky Nominal Wage Rates

III. Long-Term Contracts and Sticky Nominal Wage Rates

Teaching Tips:

1. The Great Depression was the key event in the development of modern

macroeconomics. Students should be encouraged to think about the development of

economic that results from historical experience. The “back to reality” should be

2. Prior to his being appointed to serve as the Chairman of the Federal Reserve

Board, Ben Bernanke advocated an approach he called “constrained discretion.”

Here is his definition of that approach:

“ The approach to monetary policy that I call constrained discretion can be defined by two simple and

parsimonious principles.

3. Table 16.1, showing the differences in the predictions of the various models

Answers to review questions, pg. 412

1. Involuntary unemployment occurs when qualified job seekers are willing to work

at the market wage rate, but cannot do so because of the lack of job offers. In the

2. For a given level of money demand, an increase in the supply of money will create

a disequilibrium in the money market; people will have higher money balances than

they wish to hold. In that case, people will seek to adjust their portfolios by

B. Problems for discussion, pg. 412-413

3. a. The new Keynesian model assumes that prices and nominal wages are slow to

respond to changes in market conditions; and that technology is fixed, and it is

shocks in aggregate demand rather than supply which cause cyclical fluctuations in

GDP.

b. In the new Keynesian model, a change in M has real effects on the economy.

Increases in the money supply lead to increases in aggregate demand which translate

c. There are two explanations provided in the text- imperfect competition and

menu costs.

d. The model with sticky prices generates a pro cyclical real wage rate, which is

e. Money-supply shocks are not the only source of shocks in the model: any

unanticipated change in demand can have a similar impact. This could arise from an

f. The new Keynesian model represents an advance over the old in the sense that

it incorporates more micro-economic foundations and is consistent with much of the

empirical evidence of business cycles. The exception is the countercyclical prediction

money supply would have any real effects on the economy.

4. a. The reduction in aggregate demand reduces real output and employment.

b. In the one hand savings will increase relative to consumption, due to the higher

savings rate. Although it is theoretically possible that savings could fall in the

aggregate, this would require that real GDP falls by a multiple of the original change

5. The multiplier is based on the assumption that initial changes in demand reduce

real output rather than prices. The reduction in real output results in low levels of

spending, generating additional reductions in real output, and so on.

5a. If the price level adjusts, then the change in nominal spending will not have as

much effect on real output; the multiplier is reduced.

6. In the new Keynesian model, the increase in expected wealth will cause people to

increase consumption and aggregate demand. In the sticky price model, businesses

will respond to the increase in demand by increasing employment and output. The

7. Sticky wages generate similar effects on GDP as sticky prices, but the impact on

real wages differs in the two models. The sticky wage model predicts countercyclical