10 Money and Business Cycles: Sticky Prices

Topic video: video 1

10.1 Perfect competition

Under perfect competition, every firm produces the same good and must sell at the same price.

1. What will be $$P(j)/P$$ under perfect competition?

2. What will be the optimal markup under perfect competition?

3. Suppose prices are sticky. If aggregate demand increases, will aggregate supply increase?

10.2 New Keynesian Model.

IS-LM model with neo-classical synthesis. Under imperfect competition,

1. What are the reasons that aggregate demand creates aggregate supply?

2. Is there a limit that aggregate demand can create aggregate supply?

3. (IS curve) If aggregate demand determines output, what does that mean for our output market equilibrium graph where Y-axis is the real interest rate and X-axis is the real output? Do we need to consider $$Y^{s}$$ curve?

When aggregate demand determines aggregate output, we need another condition to determine the equilibrium real interest rate and output.

1. If price is sticky, does our money equilibrium condition determine the price level? If not, what should happen when the supplied money stock $$M>PL(Y,i)$$?

2. For any given M, in the short run when price level P is fixed, there is a combination of output and interest rates that can ensure money equilibrium condition. If we trace out that combination on the graph where the Y-axis is the interest rate and the X-axis is the real output, what will the graph look like? Economists call this curve the LM curve.

3. In the short run when price is fixed for a while, the interest rate in money equilibrium condition refers to the nominal interest rate or the real interest rate?

10.3 Liquidity trap

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.”

1. Why is monetary policy ineffective when interest rates fail to decrease?

Suppose the interest rate for bonds is zero percent now. Consider that government continues asset purchasing from the public so that households hold more money than bonds now. For example, households used to have a portfolio of 30% money and 70% bonds. Now they have 50% money and 50% bonds.

1. If other than bonds, money is the only other financial asset available for the households. Will they feel unhappy about this new portfolio in terms of its rate of return?

2. In the short run we assume that P is fixed. Given that M increases but i and Y do not change, won’t such a change make M>PL(Y,i) ? Assume L(Y,i) represents the need of money for final output transaction purpose only. Then the extra money printed that is in the hands of the public must serve for other purposes. What purpose can you think of? (This tells you why people are willing to hold so much money, or that people will self create some purpose for holding money.)

3. Under liquidity trap, what kind of policy would you recommend to stimulate output in the short run?

10.4 Quantitative Easing

QE is special because of its mass purchase of the assets, such as the long-term bonds, other than short-term government bonds.

1. Do you think that it will avoid the liquidity trap in the sense that people use the extra money for final output demand?

2. What are the main purposes of QE? What are the drawbacks of it?

3. What are the factors that determine the effectiveness of QE?

10.5 Short-run AD management

The effectiveness of short-run AD management policies depends on two things: First, how much will AD respond to the policies? Secondly, how much does supply react to the demand increase?

1. For the following situations, do you think the policy will be effective at stimulating AD.

1. QE under close-to-zero interest rate.

2. Central bank leads an interest rate drop in the mist of future business pessimism.

3. Massive increase in government purchase with a promise of future government purchase to balance the intertemporal government budget.

4. Increase transfer payment to households, such as distributing consumption vouchers, through government deficit finance.

5. Increase transfer payment to poor households, such as distributing consumption vouchers, through taxing more on rich households.

2. For the following situations, do you think that supply will react to the demand increase significantly?

1. Higher portion of firms adjust their prices in each period.

2. Most of our firms are in a highly competitive market.

3. Labor law makes it difficult for firms to laid-off full-time employees.

4. Government increases the minimum wage rate.