2 Imperfect competition Monetary policy affects nominal variables even with

2 imperfect competition monetary policy affects

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2. Imperfect competition Monetary policy affects nominal variables even with perfect competition and flexible prices. Understanding the real effects of monetary policy requires understanding why prices might fail to adjust fully (nominal rigidities). With perfect competition, firms do not have the power to set market prices. They face a horizontal (perfectly elastic) demand curve. Any firm with a price above the market price receives zero demand; undercutting the market leads to an arbitrarily large surge in demand. Firms would make no profits or large losses by deviating from the market price, so they would never choose to do so. With imperfect competition, firms are producing products that are imperfect substitutes. They have some pricing power: the demand curves they face are downward sloping. With imperfect competition, firms may choose to leave prices unchanged. Hence, imperfect competition is necessary for money non-neutrality. However, in the absence of any cost of adjustment (e.g. menu cost), so long as there is a positive benefit, firms would still always make a price change, and output would be equal to its natural level, which is independent of monetary policy. Thus, imperfect competition is not a sufficient condition for money non-neutrality.
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4 3. Inflation and expectations about future monetary policy a. The New Keynesian Phillips curve at time t is: 𝜋 𝑡 = β𝐸 𝑡 [𝜋 𝑡+1 ] + κ? 𝑡 and at time t + 1 is: 𝜋 𝑡+1 = β𝐸 𝑡+1 [𝜋 𝑡+2 ] + κ? 𝑡+1 This gives inflation at time t +1, which can be used to explain inflation expectations at time t if agents form expectations rationally. Substitute for 𝜋 𝑡+1 in the time t Phillips curve: 𝜋 𝑡 = β𝐸 𝑡 [β𝐸 𝑡+1 [𝜋 𝑡+2 ] + κ? 𝑡+1 ] + κ? 𝑡 = κ(? 𝑡 + β𝐸 𝑡 [? 𝑡+1 ]) + β 2 𝐸 𝑡 [𝐸 𝑡+1 [𝜋 𝑡+2 ]] We now need to know 𝐸 𝑡 [𝐸 𝑡+1 [𝜋 𝑡+2 ]] , that is, time t expectations of what time t + 1 expectations of inflation at time t +2 will be. But if agents are rational then there will never be a difference between what they expect π t +2 to be as of time t , and what they expect now that they will expect π t +2 to be in the future (otherwise they could improve their expectation using the information available at time t ).
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