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Lecture Note on Real Effects of Monetary Policy
Econ 135 - Prof. Bohn
This note summarizes the effects of monetary policy in a sticky-price model, and more broadly, the
essentials of Keynesian macroeconomics. A key assumption is that prices and wages are “sticky” and
change only gradually—more slowly than in the Classical model. Monetary policy then has an impact
on real variables, notably on real output and on the real interest rate.
This note has a two related objectives. One is to understand the macroeconomic effects of monetary
policy changes—to add more precision to Mishkin’s ch.5. It turns out that the economic tools we need
to answer monetary questions also provide answers about the effects of other macroeconomic
disturbances. Knowing the effects of other disturbances is important, because the Fed often responds
to other disturbances. Indeed, the Fed almost never changes monetary policy without a reason, That is,
monetary policy changes are almost always an effort to mitigate the effects of some other disturbances,
to stabilize output, interest rates, and/or inflation. A second objective of this note is therefore to
understand the impact of other economic disturbances, and how the Fed can respond and modify their
impact.
Section 1 introduces sticky prices. Sections 2-4 combine frictions in the “short run” with flexible
prices in the “long run” to explain the empirically observed, time-varying effects of monetary changes
on all the relevant variables—output, prices, inflation, and interest rates. Section 5 shows how the
presentation here relates to the liquidity, income, price and expected inflation effects discussed in
Mishkin ch.5. Section 6 comments on optimal monetary policy.
1. Sticky Nominal Prices and Wages
There are several theories of why money has real effects. The leading ones are sticky prices and
misperceptions about relative versus absolute price changes. Both provide a link between money and
real output. Once this link is established, we will see that money also influences real interest rates and
other real variables.
Keynesian theory maintains that suppliers of goods and/or labor don’t adjust nominal prices and wages
as quickly as the Classical model assumes. This may be because of stupidity (politely called
irrationality), or because people find it convenient—perhaps quite rationally—to sign long-term
employment or supply contracts in the nominal unit of account. Either way,
if M increases and P does
not change in proportion, money must have real effects
. If prices and wages are “too low” relative to
the normal market-clearing level, buyers of goods and labor have an incentive to increase their
purchases, shifting out along their demand curves. If sellers satisfy the extra demand—and this is a key