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Unformatted text preview: Disclaimer: These notes were prepared based on lectures of Prof Sala-i-Martins 2008 Fall Course of Intermediate Macro-W3213. Contents of these notes might not match completely with the current teachings in class. 8.1 Keynesian View So far in the Classical Model: (i)We saw that IF CONSUMERS AND FIRMS ARE RATIONAL AND OPTIMIZE, AND IF PRICES AND INTEREST RATES MOVE TO CLEAR ALL THE MARKETS at ALL POINTS IN TIME, then MONEY IS NEUTRAL. (ii)We also saw that all movements in output, consumption, and investment are the result of movement in the equilibrium position of the economy. One of the main tenants of Keynesian economics is that MONEY IS NOT NEUTRAL. Another is that RECESSIONS are episodes of DISEQUILIBRIUM. Journalists, Keynesian researchers, Yale Professors, they all think that when the FED INCREASES money supply they cause real changes at least in the short run. Let us take a quick look at what the real world has to say about the effectiveness of monetary policy: In 1980, Paul Volker said that inflation was too large and that he was going to cut money supply to lower the price level, even if that created a recession. Two years later, the United States was experiencing the largest recession of postwar history. After the Stock Market crash of 1929, there was a period of BANK FAILURES that reduced the money supply of the economy. It is true that (as the classical model predicts, the price level moved lower). Do you really think that the GREAT DEPRESSION was a moment of equilibrium (people optimally took leisure)? The same crash happens in 1987, but this time the FED (which did not exist as we know it in 1929) increased M and nothing happened (Monetary policy saved the day). At this juncture when the economy is facing another recession we see that the Fed is taking various monetary policies to stave off the recession. This action would have been meaningless if money were neutral and had no effect on the real variables. Why do classical economists think that money is neutral? Because they assume PRICES adjust IMMEDIATELY! But we go to the hairdresser and prices are the same for two years! We read Victoriass Secret Catalog and I see that they say that the price will be fixed for the whole season (they do not say that if the Fed increases M s by 10% this pink wonderbra will increase its price by 10%!). My CONTRACT with Columbia says that my wage is 600 dollars a year, not that it will increase by 5% when the Fed increases M s by 5%. The price of the New York Times has remained constant for 10 years in a row. Price level changes but slowly, they do not change overnight KEY ASSUMPTIONS OF THE KEYNESIAN MODEL Hence, the classical assumption of FLEXIBLE prices makes no sense. We will change it here....
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- Spring '11