Sections+V+and+VI--Summary - Sections V and VISUMMARY 1....

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Sections V and VI—SUMMARY 1. The New Keynesian model—a second story of how money might have real effects in the short-run. The crucial new assumptions in this theory are (i) many firms have at least some monopoly power and can set prices—marking them up above the marginal cost of production and (ii) there are some adjustment costs associated with changing prices that prevent them from being changed immediately in response to demand shocks. So, here is how an increase in nominal demand (possibly caused by an increase in the money supply) can increase real production. Firms see the increased demand, but because of the adjustment cost they hesitate to increase price right away. The fact that prices do not increase implies that the extra nominal spending can afford to purchase more actual goods. However, will the firms be willing to sell more goods to meet the demand? Yes, because the initial prices were set above marginal costs, the firms could expand production and still make a profit. Thus, they sell off their inventory at a faster rate and demand greater employment in order to expand production to restore the inventory to normal levels. 2. The New Keynesian model fits the business cycle facts better than the Price Misperception theory. Initially prices remain constant as output rises, and then gradually adjust upward, causing the purchasing power of the increased nominal demand to fall back down to original levels. Prices are rising while output is falling over this latter stage of the cycle—so over the full cycle there should at least be a weak countercyclical correlation between prices and real output, more consistent with the data than the Misperception theory.
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This note was uploaded on 02/19/2011 for the course ECON 251 taught by Professor Blanchard during the Spring '08 term at Purdue.

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Sections+V+and+VI--Summary - Sections V and VISUMMARY 1....

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