ch20 - CHAPTER 20 ADVANCED TOPICS Solutions to the Problems...

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ADVANCED TOPICS Solutions to the Problems in the Textbook : Conceptual Problems: 1. Some of the aspects of the theories discussed in this chapter complement each other, but there are also major disagreements. The real business cycle theory is an outgrowth of the rational expectations theory and the random walk of GDP theory, while the new Keynesian models respond to the rational expectations theory by showing why prices may still be sticky even under the assumption of rational expectations. In both the real business cycle theory and the new Keynesian models, expectations are formed rationally, but only the real business cycle theory assumes that markets clear very rapidly. These theories therefore disagree on the speed of the price adjustment. They also disagree on the sources of shocks to the economy. The question of whether output follows a random walk has also been an important point of disagreement. If output shocks are important they must come from the supply side and they must have permanent effects. 2. Rational expectations differ from perfect foresight in that expectations are imperfect. While rational people will make efficient use of all information available, they may still make incorrect forecasts. However, when expectations are rational, no systematic errors are made. The best guess for the forecast error term is zero. Under perfect foresight, monetary policy is always neutral, that is, the effect of monetary policy on real output is zero even in the short run. Under rational expectations, monetary policy has a short-run effect on output if the policy change is unanticipated, but it is neutral in the long run. 3. The propagation mechanism is the process by which a disturbance spreads through the economy. The concept of intertemporal substitution of leisure is most often used to describe why people work more in some periods than in others. Assume, for example, that there is a negative shock to technology such that the marginal product of labor (and therefore the real wage rate) drops temporarily until the market clears. Workers realize that, for the near future the real wage rate is lower than usual. Therefore they may choose to take some time off or work fewer hours than usual, intending to make up for it later when the wage rate has increased again. In this way, a small change in wages (resulting from a shock in technology) can create a large change in output, even though labor supply is fairly insensitive to wage rate changes in the long run. 4. The models by Mankiw and Lucas both assume rational expectations. However, in Mankiw's menu- cost model of aggregate supply, firms have enough market power to set their own prices. Prices are sticky, since firms are reluctant to change them due to the perceived loss of market share or profit or the costs of doing so (the menu cost). In Lucas' imperfect-information model of aggregate supply, firms are assumed to be price takers and prices adjust immediately to clear markets. Mankiw's model
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This note was uploaded on 12/18/2010 for the course SOES 2003 taught by Professor Jian during the Fall '10 term at Uni. Southampton.

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ch20 - CHAPTER 20 ADVANCED TOPICS Solutions to the Problems...

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