V.A. - MPL(j)). (iv) Firms do not respond immediately to a...

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V. The New Keynesian Model 1. New Assumptions (i) We will consider an environment where goods prices do not respond to nominal spending shocks in the short-run . For this to be true prices must be “set” by firms and not taken (determined by the market). (ii) Firms can set their prices if they have monopoly power. For this reason we now assume imperfect competition . (iii) If you remember from micro when firms have monopoly power, they set prices above marginal costs and produce less than in the competitive case. So for each firm j, P (j) > MC (j) (For simplicity, we assume that the only way to vary production in the short-run is to vary employment (no capital utilization choice). In this case, the marginal cost per unit production is the wage paid to a worker divided by the number of units of output that worker produced—i.e. w/
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Unformatted text preview: MPL(j)). (iv) Firms do not respond immediately to a demand shock because there are adjustment costs that are first required (manager/owners must meet to decide on new pricing strategy and then physically change the price at the store and in advertising) 2. Effect of a Money Shock (i) an increase in the money supply causes an increase in dollar spending as before (ii) Now firms do not change prices in response. Will they change production? Yes, remember even if P (j) is fixed it is above MC (j), so profit can be earned by expanding production even if MC (j) is increasing in output. (iii) Since all firms will be expanding employment, there will be an increased demand for labor and a higher real wage rate. 3. Comparison to Other Theories Barro Ch.16 PP1...
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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 University-West Lafayette.

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V.A. - MPL(j)). (iv) Firms do not respond immediately to a...

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