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The New Keynesian ModelECON 30020: Intermediate Macroeconomics
Prof. Eric Sims
University of Notre Dame
Fall 2016
1 / 38
New Keynesian Models
I At risk of oversimplification, New Keynesian models are theleading alternative to the neoclassical / RBC model
I βNewβ Keynesian: neoclassical backbone to these models.Just a twist on neoclassical model, not a fundamentallydifferent framework. In the βmedium runβ/βlong runβ modelsare the same
I Basic difference: nominal rigidities. Wages and/or prices areimperfectly flexible
I Means:
1. Money is non-neutral2. Demand shocks matter3. Equilibrium of the model is inefficient4. There is therefore scope for policy to improve outcomes in
short run
2 / 38
Demand and Supply
I The demand side of the neoclassical and New Keynesianmodels are the same
I Differences arise on the supply side
I Two basic variants (or mixture of the two): wage stickinessand/or price stickiness
I Mathematically, what we are going to assume is that eitherthe nominal wage or price level are predetermined (i.e.exogenous)
I This will require some change in the labor market β either thefirm (price stickiness) or household (wage stickiness) is off itsdemand or supply schedule
I Because it works out to be a bit simpler, we will focus on thesticky price model in class, though book covers both
3 / 38
Review: Neoclassical Model:I Equilibrium conditions:
Ct = Cd (Yt β Gt ,Yt+1 β Gt , rt)
Nt = Ns(wt , ΞΈt)
Nt = Nd (wt ,At ,Kt)
It = Id (rt ,At+1, qt ,Kt)
Yt = AtF (Kt ,Nt)
Yt = Ct + It + Gt
Mt = PtMd (it ,Yt)
rt = it β Οet+1
I Pt is endogenousI Nominal wage, Wt , is Wt = wtPt , and is also therefore
endogenous
4 / 38
New Keynesian Model
I Sticky price model:I Pt = PΜt is now exogenous, rather than endogenousI Extreme form of price stickiness: price level completely
pre-determinedI Replace labor demand curve with Pt = PΜt . Firm (which sets
price), has to hire labor to meet demand at PΜt rather than tomaximize its value
I Sticky wage model:I Wt = WΜt is now exogenous, rather than endogenousI Extreme form of wage stickiness: wage set βin advance,β
worker has to supply as much labor as is demanded at thiswage
I This means that we replace the labor supply curve with thecondition wt = WΜt/Pt
5 / 38
Graphing the EquilibriumI We will use the AD (aggregate demand) and AS (aggregate
supply) curves to summarize the equilibriumI AD: stands for aggregate demand. Summarizes the following
conditions:
Ct = Cd (Yt β Gt ,Yt+1 β Gt , rt)
It = Id (rt ,At+1, qt ,Kt)
Yt = Ct + It + Gt
Mt = PtMd (it ,Yt)
rt = it β Οet+1
I Differently than before, AD curve summarizes both realdemand (the first three equations) and nominal demand (thelast two)
I Classical dichotomy will no longer hold, so cannot separatelyanalyze real and nominal sides of the economy
6 / 38
The IS and LM Curves
I The IS curve is identical to before: set of (rt ,Yt) pairs wherethe first three of the conditions hold
I LM curve (liquidity = money) plots combinations of (rt ,Yt)where last two equations hold
I LM curve is upward-sloping in (rt ,Yt) space. Basic idea:holding Mt and Pt fixed, if rt goes up, Yt must go up formoney demand to equal money supply
I Go through graphical derivation
I LM curve will shift if Mt , Pt , or Οet+1 change
I Rule of thumb: LM curve shifts in the same direction as realbalances, MtPt
7 / 38
Deriving the LM Curve
πππ‘π‘ πππ‘π‘
πππ‘π‘ πππ‘π‘
ππ0,π‘π‘
ππ0,π‘π‘ ππ0,π‘π‘
ππ0,π‘π‘
πππ π πΏπΏππ
πππ‘π‘πππποΏ½ππ0,π‘π‘ + πππ‘π‘+1ππ ,ππ0,π‘π‘οΏ½ = πππποΏ½ππ1,π‘π‘ + πππ‘π‘+1ππ ,ππ1,π‘π‘οΏ½
ππ1,π‘π‘
πππ‘π‘ππππ(ππ0,π‘π‘ + πππ‘π‘+1ππ ,ππ1,π‘π‘)
ππ1,π‘π‘
8 / 38
The AD Curve
I The AD curve is the set of (Pt ,Yt) pairs where the economyis on both the IS and LM curves
I Basic idea: Pt determines position of LM curve, whichdetermines a Yt where the LM curve intersects the IS curve.A higher Pt means the LM curve shifts in, which results in alower Yt
I Hence, the AD curve is downward-sloping
I Go through graphical derivation
9 / 38
Deriving the AD Curve
πππ‘π‘
πππ‘π‘
πππ‘π‘
πππ‘π‘
πΌπΌπΌπΌ
πΏπΏπΏπΏ(ππ0,π‘π‘,πΏπΏ0,π‘π‘)
πΏπΏπΏπΏ(ππ1,π‘π‘,πΏπΏ0,π‘π‘)
πΏπΏπΏπΏ(ππ2,π‘π‘,πΏπΏ0,π‘π‘)
ππ0,π‘π‘
ππ1,π‘π‘
ππ2,π‘π‘
ππ0,π‘π‘
ππ1,π‘π‘
ππ2,π‘π‘
π΄π΄π΄π΄
10 / 38
Shifts of the AD Curve
I The AD curve will shift if either the IS or LM curves shift (forreason other than Pt)
I This means that the AD curve will shift right if:I At+1, qt , or Gt increase (IS shifts); Mt or Ο
et+1 increase (LM
shifts)I Gt+1 decreases (IS shift)
I Note: we could use the AD curve to summarize the demandside of the neoclassical model as well
I Was just convenient to not since this emphasized classicaldichotomy in the neoclassical model
11 / 38
The Supply Side
I Generically, the AS curve is the set of (Pt ,Yt) pairs (i)consistent with the production function, (ii) some notion oflabor market equilibrium, and (iii) any exogenous restrictionon nominal price or wage adjustment
I Can use the AS curve to summarize the neoclassical model aswell as the New Keynesian model:
Nt = Ns(wt , ΞΈt)
Nt = Nd (wt ,At ,Kt)
Yt = AtF (Kt ,Nt)
I Since Pt does not appear in these equations, the AS curvewould be vertical in the neoclassical model
12 / 38
The Neoclassical AS Curve
π€π€π‘π‘ πππ‘π‘
πππ‘π‘ πππ‘π‘
πππ‘π‘
πππ‘π‘
πππ‘π‘
πππ‘π‘
π΄π΄π΄π΄
π€π€π‘π‘
ππ0,π‘π‘ ππ0,π‘π‘
ππππ(π€π€π‘π‘,π΄π΄π‘π‘ ,πΎπΎπ‘π‘)
π΄π΄π‘π‘πΉπΉ(πΎπΎπ‘π‘,πππ‘π‘)
πππ‘π‘ = πππ‘π‘
ππ0,π‘π‘
πππ π (π€π€π‘π‘ ,πππ‘π‘)
ππ1,π‘π‘
ππ2,π‘π‘
13 / 38
Neoclassical IS-LM-AD-AS Equilibrium
π€π€π‘π‘ πππ‘π‘
πππ‘π‘ πππ‘π‘
πππ‘π‘
πππ‘π‘
πππ‘π‘
πππ‘π‘
πππ‘π‘
π΄π΄π΄π΄
πΌπΌπ΄π΄
π€π€π‘π‘
ππ0,π‘π‘
ππ0,π‘π‘ ππ0,π‘π‘
ππππ(π€π€π‘π‘,π΄π΄π‘π‘ ,πΎπΎπ‘π‘)
πΏπΏπΏπΏ(πΏπΏπ‘π‘ ,ππ0,π‘π‘)
π΄π΄π‘π‘πΉπΉ(πΎπΎπ‘π‘,πππ‘π‘)
πππ‘π‘ = πππ‘π‘
πππ‘π‘
π΄π΄π΄π΄
ππ0,π‘π‘
πππ π (π€π€π‘π‘ ,πππ‘π‘)
14 / 38
Sticky Price Model
I In sticky price model, assume that Pt = PΜt is predeterminedand hence exogenous (think something like menu costs)
I Replace labor demand with this condition: firm has to meetdemand at Pt , cannot optimally choose labor conditional onthis
I Conditions:
Nt = Ns(wt , ΞΈt)
Pt = PΜt
Yt = AtF (Kt ,Nt)
I The AS curve will just be horizontal at PΜt . Can only shift ifPΜt changes exogenously
15 / 38
The Sticky Price AS Curve
πππ‘π‘
πππ‘π‘
πππ‘π‘
πππ‘π‘
πππ‘π‘
πππ‘π‘
π€π€π‘π‘ πππ‘π‘
πποΏ½π‘π‘
πππ‘π‘ = πππ‘π‘
πππ‘π‘ = π΄π΄π‘π‘πΉπΉ(πΎπΎπ‘π‘ ,πππ‘π‘)
πππ π (π€π€π‘π‘,πππ‘π‘)
π΄π΄π΄π΄
16 / 38
Sticky Price IS-LM-AD-AS Equilibrium
π€π€π‘π‘ πππ‘π‘
πππ‘π‘ πππ‘π‘
πππ‘π‘
πππ‘π‘
πππ‘π‘
πππ‘π‘
πππ‘π‘
π΄π΄π΄π΄
πΌπΌπ΄π΄
ππ0,π‘π‘
ππ0,π‘π‘ ππ0,π‘π‘
πππ π (π€π€π‘π‘ ,πππ‘π‘)
πΏπΏπΏπΏ(πΏπΏπ‘π‘ ,ππ0,π‘π‘)
π΄π΄π‘π‘πΉπΉ(πΎπΎπ‘π‘,πππ‘π‘)
πππ‘π‘ = πππ‘π‘
πππ‘π‘
π΄π΄π΄π΄
πποΏ½0,π‘π‘ π€π€0,π‘π‘
17 / 38
Increase in Mt
I Whereas in the neoclassical model Yt is supply determined, inthe New Keynesian model output is demand determined
I First, figure out what Yt is, and then figure out what Nt mustbe to support that
I In an increase in Mt shifts the LM curve to the right, andhence the AD curve to the right as well
I With a horizontal (as opposed to vertical) AS curve, thisresults in a higher Yt and lower rt
I The lower rt stimulates It ; lower rt plus higher Yt means Ct ishigher
I To support higher Yt , Nt must rise
I To induce workers to work more, wt must rise
18 / 38
Increase in Mt : Graphically
π€π€π‘π‘
πππ‘π‘
πππ‘π‘ πππ‘π‘
πππ‘π‘
πππ‘π‘
πππ‘π‘
πππ‘π‘
πππ‘π‘
π΄π΄π΄π΄
πΌπΌπ΄π΄
ππ0,π‘π‘
ππ0,π‘π‘ ππ0,π‘π‘
πππ π (π€π€π‘π‘ ,πππ‘π‘)
πΏπΏπΏπΏ(πΏπΏ0,π‘π‘,ππ0,π‘π‘)
π΄π΄π‘π‘πΉπΉ(πΎπΎπ‘π‘,πππ‘π‘) πππ‘π‘ = πππ‘π‘
πππ‘π‘
π΄π΄π΄π΄
πποΏ½0,π‘π‘ π€π€0,π‘π‘
πΏπΏπΏπΏ(πΏπΏ1,π‘π‘,ππ0,π‘π‘)
ππ1,π‘π‘
π€π€1,π‘π‘
ππ1,π‘π‘
π΄π΄π΄π΄β²
ππ1,π‘π‘
0 subscript: original
1 subscript: post-shock
Original
Post-shock
19 / 38
Increase in Mt : Graphically in Neoclassical Model
π€π€π‘π‘ πππ‘π‘
πππ‘π‘ πππ‘π‘
πππ‘π‘
πππ‘π‘
πππ‘π‘
πππ‘π‘
πππ‘π‘
π΄π΄π΄π΄
πΌπΌπ΄π΄
π€π€π‘π‘
ππ0,π‘π‘
ππ0,π‘π‘ ππ0,π‘π‘
ππππ(π€π€π‘π‘,π΄π΄π‘π‘ ,πΎπΎπ‘π‘)
πΏπΏπΏπΏοΏ½πΏπΏ0,π‘π‘,ππ0,π‘π‘οΏ½ = πΏπΏπΏπΏ(πΏπΏ1,π‘π‘,ππ1,π‘π‘)
π΄π΄π‘π‘πΉπΉ(πΎπΎπ‘π‘,πππ‘π‘)
πππ‘π‘ = πππ‘π‘
πππ‘π‘
π΄π΄π΄π΄
ππ0,π‘π‘
πππ π (π€π€π‘π‘ ,πππ‘π‘)
πΏπΏπΏπΏ(πΏπΏ1,π‘π‘,ππ0,π‘π‘)
π΄π΄π΄π΄β²
ππ1,π‘π‘
Original
Post-shock
Post-shock, indirect effect of πππ‘π‘ on LM
0 subscript: original
1 subscript: post-shock
20 / 38
IS Shock
I Increase in qt , At+1, Gt , or decrease in Gt+1: shifts IS curveto the right
I Results in AD curve shifting to the right, which means higherYt
I Higher Yt means that Nt must rise
I Again, compare results to neoclassical model
21 / 38
Sticky Price Model: IS Shock
π€π€π‘π‘
πππ‘π‘
πππ‘π‘ πππ‘π‘
πππ‘π‘
πππ‘π‘
πππ‘π‘
πππ‘π‘
πππ‘π‘
π΄π΄π΄π΄
πΌπΌπ΄π΄
ππ0,π‘π‘
ππ0,π‘π‘ ππ0,π‘π‘
πππ π (π€π€π‘π‘ ,πππ‘π‘)
πΏπΏπΏπΏ(πΏπΏπ‘π‘ ,ππ0,π‘π‘)
π΄π΄π‘π‘πΉπΉ(πΎπΎπ‘π‘,πππ‘π‘) πππ‘π‘ = πππ‘π‘
πππ‘π‘
π΄π΄π΄π΄
πποΏ½0,π‘π‘ π€π€0,π‘π‘
π΄π΄π΄π΄β²
ππ1,π‘π‘
ππ1,π‘π‘
π€π€1,π‘π‘
ππ1,π‘π‘
πΌπΌπ΄π΄β² 0 subscript: original
1 subscript: post-shock
Original
Post-shock
22 / 38
Increase in At
I Since PΜt doesnβt change, in the sticky price model an increasein At has no effect on Yt
I Mechanically, this means that Nt must fall
23 / 38
Increase in At : Graphically
π€π€π‘π‘ πππ‘π‘
πππ‘π‘ πππ‘π‘
πππ‘π‘
πππ‘π‘
πππ‘π‘
πππ‘π‘
πππ‘π‘
π΄π΄π΄π΄
πΌπΌπ΄π΄
ππ0,π‘π‘
ππ0,π‘π‘ ππ0,π‘π‘
πππ π (π€π€π‘π‘ ,πππ‘π‘)
πΏπΏπΏπΏ(πΏπΏπ‘π‘ ,ππ0,π‘π‘)
π΄π΄0,π‘π‘πΉπΉ(πΎπΎπ‘π‘,πππ‘π‘)
πππ‘π‘ = πππ‘π‘
πππ‘π‘
π΄π΄π΄π΄
πποΏ½0,π‘π‘ π€π€0,π‘π‘
π€π€1,π‘π‘
ππ1,π‘π‘
π΄π΄1,π‘π‘πΉπΉ(πΎπΎπ‘π‘,πππ‘π‘)
0 subscript: original
1 subscript: post-shock
Original
Post-shock
24 / 38
Comparing Neoclassical and New Keynesian Models
I Useful rule of thumb: demand shocks have bigger effects inNew Keynesian model and supply shocks smaller effectsrelative to neoclassical model
I For productivity shock in particular, it is βcontractionaryβ insense of lowering hours worked
I Some empirical debate on this:I Gali (1999) and Basu, Fernald, and Kimball (2006): positive
productivity shock lowers hours in the short run (i.e. the NewKeynesian model) and raises hours in the medium run (i.e. theneoclassical model)
I Nevertheless, there is some debate about these empiricalfindings
25 / 38
Increase in PΜt
I This is the only exogenous variable which will shift the AScurve in the sticky price model
I Real world interpretation: increase in prices of intermediateinputs (e.g. price of oil)
I Results in AS shifting up, Yt falling, and Pt rising. Sometimescalled βstagflationβ β prices (inflation) rising and output(employment) declining
26 / 38
Graphical Effects: Increase in PΜt
π€π€π‘π‘ πππ‘π‘
πππ‘π‘ πππ‘π‘
πππ‘π‘
πππ‘π‘
πππ‘π‘
πππ‘π‘
πππ‘π‘
π΄π΄π΄π΄
πΌπΌπ΄π΄
ππ0,π‘π‘
ππ0,π‘π‘ ππ0,π‘π‘
πππ π (π€π€π‘π‘ ,πππ‘π‘)
πΏπΏπΏπΏ(πΏπΏπ‘π‘ ,ππ0,π‘π‘)
π΄π΄π‘π‘πΉπΉ(πΎπΎπ‘π‘,πππ‘π‘)
πππ‘π‘ = πππ‘π‘
πππ‘π‘
π΄π΄π΄π΄
πποΏ½0,π‘π‘ π€π€0,π‘π‘
π΄π΄π΄π΄β² πποΏ½1,π‘π‘
ππ1,π‘π‘ ππ1,π‘π‘
π€π€1,π‘π‘
ππ1,π‘π‘
πΏπΏπΏπΏ(πΏπΏπ‘π‘ ,ππ1,π‘π‘)
0 subscript: original
1 subscript: post-shock
Original
Post-shock
Post-shock, indirect effect of πππ‘π‘ on LM
27 / 38
Summarizing Qualitative Effects in the Sticky Price Model
Exogenous ShockVariable β Mt β IS curve β At β ΞΈt β PΜtYt + + 0 0 -
Nt + + - 0 -
wt + + - + -
rt - + 0 0 +
it - + 0 0 +
Pt 0 0 0 0 +
28 / 38
Dynamics
I The New Keynesian model is a special case of the neoclassicalmodel β we simply swap labor demand with a fixed nominalprice
I Call Y ft the βflexible priceβ level of output β the level ofoutput which would emerge in the neoclassical model
I If firm could adjust price, it would do so that it is on its labordemand curve, which would entail Yt = Y ft
I Refer to Yt β Y ft as the output gap β the gap between actualoutput and what it would be in the absence of price stickiness
I To see this graphically, draw in a hypothetical AS curve forthe neoclassical model β call this AS f
29 / 38
A Negative Output Gap
π€π€π‘π‘ πππ‘π‘
πππ‘π‘ πππ‘π‘
πππ‘π‘
πππ‘π‘
πππ‘π‘
πππ‘π‘
πππ‘π‘
π΄π΄π΄π΄
πΌπΌπ΄π΄
ππ0,π‘π‘
ππ0,π‘π‘ ππ0,π‘π‘
πππ π (π€π€π‘π‘ ,πππ‘π‘)
πΏπΏπΏπΏ(πΏπΏπ‘π‘ ,ππ0,π‘π‘)
π΄π΄π‘π‘πΉπΉ(πΎπΎπ‘π‘,πππ‘π‘)
πππ‘π‘ = πππ‘π‘
πππ‘π‘
π΄π΄π΄π΄
πποΏ½0,π‘π‘ π€π€0,π‘π‘
ππ0,π‘π‘ππ ππ0,π‘π‘
ππ
ππππ(π€π€π‘π‘,π΄π΄π‘π‘ ,πΎπΎπ‘π‘)
π΄π΄π΄π΄ππ
π€π€0,π‘π‘ππ
Sticky price model
Hypothetical flexible price model
ππ0,π‘π‘ππ
0 subscript: equilibrium value
f superscript: hypothetical flexible price equilibrium
πΏπΏπΏπΏ(πΏπΏπ‘π‘ ,ππ0,π‘π‘ππ )
ππ0,π‘π‘ππ
30 / 38
Transition from Short Run to Medium Run
I If the firm is producing less than it would like, it will facepressure to lower its price
I Hence, as we transition from short run (price fixed) tomedium run (price flexible), the firm will lower its price, PΜt
I This will cause the AS curve to shift down, and output to rise
I This pressure will persist until βthe gap is closedβ
31 / 38
Closing the Gap
π€π€π‘π‘ πππ‘π‘
πππ‘π‘ πππ‘π‘
πππ‘π‘
πππ‘π‘
πππ‘π‘
πππ‘π‘
πππ‘π‘
π΄π΄π΄π΄
πΌπΌπ΄π΄
ππ0,π‘π‘
ππ0,π‘π‘ ππ0,π‘π‘
πππ π (π€π€π‘π‘ ,πππ‘π‘)
πΏπΏπΏπΏ(πΏπΏπ‘π‘ ,ππ0,π‘π‘)
π΄π΄π‘π‘πΉπΉ(πΎπΎπ‘π‘,πππ‘π‘)
πππ‘π‘ = πππ‘π‘
πππ‘π‘
π΄π΄π΄π΄
πποΏ½0,π‘π‘ π€π€0,π‘π‘
ππ1,π‘π‘= ππ0,π‘π‘
ππ ππ1,π‘π‘= ππ0,π‘π‘
ππ
ππππ(π€π€π‘π‘,π΄π΄π‘π‘ ,πΎπΎπ‘π‘)
π΄π΄π΄π΄ππ
π€π€1,π‘π‘ = π€π€0,π‘π‘ππ
Sticky price model
Hypothetical flexible price model
πποΏ½1,π‘π‘ = ππ0,π‘π‘ππ
0 subscript: equilibrium value
f superscript: hypothetical flexible price equilibrium
1 subscript: equilibrium value after price adjustment
πΏπΏπΏπΏοΏ½πΏπΏπ‘π‘ ,ππ0,π‘π‘ππ οΏ½
= πΏπΏπΏπΏ(πΏπΏπ‘π‘ ,ππ1,π‘π‘)
ππ1,π‘π‘ = ππ0,π‘π‘ππ
π΄π΄π΄π΄β²
Sticky price model, post price adjustment
32 / 38
Dynamic Response to Shocks
I Can use this approach to think about effects of shocks in bothshort run and medium run
I In short run, AS curve is fixed, and we determine endogenousvariables with that fixed AS curve
I In the medium run, the AS curve adjusts to βclose the gap.βCan graphically do this by thinking about a hypotheticalvertical βmedium runβ AS curve (AS f ).
33 / 38
Phillips Curve
I This analysis suggests that there ought to exist a positiverelationship between the output gap, Yt β Y ft , and theinflation rate, Οt (the change in prices)
I Positive output gaps put upward pressure on prices, andnegative gaps downward pressure on prices
I The Phillips Curve formalizes this idea. Something like:
Οt = Ξ³(Yt β Y ft ), Ξ³ > 0
34 / 38
Empirical Relationship Between Inflation and the OutputGap
-2
0
2
4
6
8
10
12
14
-.08 -.06 -.04 -.02 .00 .02 .04 .06
Output Gap
Infla
tion
Inflation - Output Gap Scatter Plot1960 - 2016
I Masks sub-sample differencesI Ambiguity about how to measure Y ft empirically
35 / 38
Can Monetary Policy Permanently Engineer HigherOutput?
I No
I Can temporarily raise output by increasing Mt , but in mediumrun this puts upward pressure on prices and the effect goesaway
I Continually trying to raise output will only result in moreinflation
I Further, it may cause the firm to anticipate the change in Mt ,which could cause the AS curve to shift simultaneously withthe AD shift, resulting in no effect of monetary expansion onoutput
I It is really only unanticipated monetary expansion that canstimulate output, and even then only for a while
36 / 38
Fully Anticipated Increase in Mt , so that PΜt also rises
π€π€π‘π‘ πππ‘π‘
πππ‘π‘ πππ‘π‘
πππ‘π‘
πππ‘π‘
πππ‘π‘
πππ‘π‘
πππ‘π‘
π΄π΄π΄π΄
πΌπΌπ΄π΄
ππ0,π‘π‘ = ππ1,π‘π‘
ππ0,π‘π‘= ππ1,π‘π‘
ππ0,π‘π‘= ππ1,π‘π‘
πππ π (π€π€π‘π‘ ,πππ‘π‘)
πΏπΏπΏπΏοΏ½πΏπΏ0,π‘π‘,ππ0,π‘π‘οΏ½ =
πΏπΏπΏπΏοΏ½πΏπΏ1,π‘π‘,ππ1,π‘π‘οΏ½
π΄π΄π‘π‘πΉπΉ(πΎπΎπ‘π‘,πππ‘π‘)
πππ‘π‘ = πππ‘π‘
πππ‘π‘
π΄π΄π΄π΄
πποΏ½0,π‘π‘ π€π€0,π‘π‘ = π€π€1,π‘π‘
πΏπΏπΏπΏ(πΏπΏ1,π‘π‘,ππ0,π‘π‘)
π΄π΄π΄π΄β²
π΄π΄π΄π΄β² πποΏ½1,π‘π‘
0 subscript: initial equilibrium
1 subscript: post-shock equilibrium where πΏπΏπ‘π‘ increases but this is anticipated and reflected in πποΏ½π‘π‘
Original
Post-shock
Indirect of price on position of LM
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Costless Disinflation
I Can central bank lower prices (disinflation) without incurringan output loss?
I Conventional wisdom for 1980-1982 recession was that it wascaused by Fed trying to get inflation under control (negativemonetary shock)
I Suppose that the Fed announces in advance that it is going toreduce Mt . If firms believe this, they may adjust prices downin anticipation, causing AS curve to shift down at same timethe AD shifts in
I In principle, this allows for a reduction in Pt with no change inYt β i.e. costless disinflation
I Underscores importance of central bank credibility andcommunication: for this to work, people must believe thecentral bank, and the central bank must clearly communicateits objectives
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