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slides08 - 1 Real Effects of Monetary Policy Macroeconomics...

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1 [Money and Interest Rates - P.1] Real Effects of Monetary Policy Macroeconomics with Sticky Prices • Why do monetary changes have real effects in the short run? • Classical Premise: Prices and wages are perfectly flexible. - If the Fed increases M, consumer prices rise immediately and proportionally. - Implicit: An unchanged real wage requires a proportional increase in nominal wages. • Observation: Consumer prices and nominal wages do not change very often. Several theories of pricing frictions – often called "sticky prices” - Old Keynesian : Money illusion – people are not always rational. On labor markets: inflexible wages. On goods markets: inflexible prices. - New Keynesian : People economize on information cost => Provides rational explanations for sticky prices, incentives to enter long-term nominal contracts. - New Classical : Sellers misinterpret buyers willingness to pay more for their goods as shift in relative demand, even if more money has raised aggregate demand. Here apply simplified New-Keynesian logic. Ignore labor; focus on prices and output. You are not responsible for theoretical foundations of sticky prices, but for the practical implications.
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2 [Money and Interest Rates - P.2] Three Main Implications of Sticky Prices (Outline of Items to Be Discussed) 1. The Liquidity Effect: Impact on nominal and real interest rates • Instantaneous. Asset allocation issue. 2. The Income Effect: Impact on real output and incomes. • Short-run macro issue. Fades away in the longer run. 3. A Price Adjustment Process: Describes dynamics of consumer prices. • Classical answers are always correct in the long run. Gradual adjustment. • Expected inflation also adjusts; matches actual inflation in the long run. Natural Rate Hypothesis as “anchor” for long-run output (Friedman/Phelps): - Prices adjust eventually => Sticky-price effects must vanish. - Historical motivation: “Natural rate of unemployment” = Unemployment rate implied by normal search behavior. Actual unemployment may deviate due to sticky wages. - Famous assertion by Milton Friedman & Ed Phelps: Economy always returns to the natural rate. => Implies a natural rate level of output Y n = Output level derived in the classical model. - Related: NAIRU = Non-accelerating inflation rate of unemployment. Same idea because Y>Y n triggers rising prices and wages, whereas Y<Y n discourages price increases.
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3 [Money and Interest Rates - P.3] The Liquidity Effect • Financial market implication of sticky prices: - Suppose M increases. Consider the market for money: M = f ( i , Y ) P or equivalently M V ( i ) = Y P - If P is fixed, either i must decline (so V declines) or Y must increase. • Consider the very short run: Output cannot reasonably change. (say, within minutes of the open market operation) => The immediate effect of higher money supply is to reduce interest rates.
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slides08 - 1 Real Effects of Monetary Policy Macroeconomics...

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