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PIIBP2_LEC2_mau - Part IIB Paper 2 Business Cycle Theory...

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Part IIB Paper 2: Business Cycle Theory LECTURE 2: New Keynesian Economics Mauricio Prado University of Cambridge 24 and 25 February 2011 Mauricio Prado (University of Cambridge) Part IIB P2 - Business Cycles - Lecture 2 24 and 25 Feb 2011 1 / 41
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Outline of lecture New Keynesian Economics The role of imperfect competition in macroeconomics A static model of imperfect competition Empirical evidence about imperfect competition Nominal rigidities in Keynesian vs. New Keynesian models A model of imperfect competition with menu costs Empirical evidence about nominal rigidities Mauricio Prado (University of Cambridge) Part IIB P2 - Business Cycles - Lecture 2 24 and 25 Feb 2011 2 / 41
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New Keynesian Economics Two general hypotheses: Market imperfections (imperfect competition, asymmetric information, ...) are central to economic fluctuations Nominal variables (e.g. the quantity of money) affect real quantities (e.g. output): money is non-neutral Ingredients: Imperfect competition Nominal rigidities Real rigidities Microfoundations of Keynesian results Mauricio Prado (University of Cambridge) Part IIB P2 - Business Cycles - Lecture 2 24 and 25 Feb 2011 3 / 41
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Imperfect competition in macroeconomics Basic ideas: Many markets are imperfectly competitive. This has potentially important macroeconomic implications: Suboptimality of free-market outcomes Keynesian multiplier effects Price-setting behaviour (in place of the ‘auctioneer’) Hart (1982), N.G. Mankiw (1988) Mauricio Prado (University of Cambridge) Part IIB P2 - Business Cycles - Lecture 2 24 and 25 Feb 2011 4 / 41
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A model of imperfect competition Y Q P w e L C Π π T G W N q i F , c Variable Aggregate expenditure (in £ ) Real output (in units of goods) Nominal price of goods Nominal wage Time endowment (in units of time) leisure (in units of time) consumption (in units of goods) aggregate profits (in £ ) individual firm profits (in £ ) Taxes (in £ ) Government spending (in £ ) Government lending (in £ ) Number of firms output of firm i constants Mauricio Prado (University of Cambridge) Part IIB P2 - Business Cycles - Lecture 2 24 and 25 Feb 2011 5 / 41
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Household(s) Objective max [ α log C + ( 1 - α ) log L ] , α ( 0, 1 ) st : PC = w ( e - L ) + Π - T Lagrangian function L = α log C + ( 1 - α ) log L + λ w ( e - L ) + Π - T P - C FOC α C = λ 1 - α L = λ w P Substitute into BC PC = α ( we + Π - T ) Consumption function ( α = MPC) Mauricio Prado (University of Cambridge) Part IIB P2 - Business Cycles - Lecture 2 24 and 25 Feb 2011 6 / 41
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Government Gvt budget (in £ ) T = G + W Total expenditure (in £ ) Y = PC + G = α ( we + Π - T ) + G Equilibrium Y = PQ Mauricio Prado (University of Cambridge) Part IIB P2 - Business Cycles - Lecture 2 24 and 25 Feb 2011 7 / 41
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Firms There are N Cournot oligopolists Cost function for firm i : C ( q ) = F + cq Total output Q = N j = 1 q j = j 6 = i q j + q i Firms know that their production affects P , they maximise profit accordingly Cournot oligopoly they take aggregate expenditure, Y , and the production of others, j 6 = i q j = ¯ θ , as given Inverse demand function P ( q i ) = Y Q = Y ¯ θ + q i = P ( q i ) q i < 0 Mauricio Prado (University of Cambridge) Part IIB P2 - Business Cycles - Lecture 2 24 and 25 Feb 2011 8 / 41
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Firms
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