LSE Economics DepartmentKevin SheedyEC210 Macroeconomic Principles 2014/201532L.1.09, x5022Lent Term[email protected]Problem Set 6: The Sticky Price Model1.The New-Keynesian sticky price model:(a) Why, with sticky prices and imperfect competition, will the economy generallynot be on the output supply curve?

(b) Suppose that monetary policy fixes the nominal interest rate. Show the effect ofa temporary increase in government spending on current output, consumption,employment, investment, the price level, the real wage and the real interestrate. Treat the wealth effect of the shock as negligible.1The marginal cost is, by definition, the cost of producing one more unit of output. One unit of labourproducesMPNunits of output so 1/MPNunits of labour are required to produce one unit of output.The nominal cost of hiring 1/MPNunits of labour isW/MPNso this is our marginal cost.

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Answer:As argued above, in the New Keynesian model theYscurve is irrelevant. The form of itsreplacement is determined by monetary policy.Here we assume that the central bank targets a particular nominal interest rateR. Fromthe approximate Fisher equationR=r+i. With sticky prices, in the short-runi= 0 soR=rand the real interest rate is determined by the central bank’s nominal interest ratetarget. In place of theYscurve there is aCBcurve which is horizontal at the centralbank’s target interest rate.The direct effects of the shock are:•An increase in G increases output demand shiftingYdto the right.•