Another example can be taken of automatic dispensers like coffee machines or

Another example can be taken of automatic dispensers

This preview shows page 14 - 16 out of 19 pages.

Another example can be taken of automatic dispensers like coffee machines or telephones operating on coins. Certainly, with these machines, the cost of adjusting every small change in price would involve a high cost. The firms would prefer not to change their prices to bear the cost. It is so because the cost of changing prices is more than the benefit expected from it. Mankiw model explains this idea of weighing the costs of changing prices against the benefits obtained from such a change. Mankiw Model of Nominal Rigidities: There are two reasons due to which firms do not change their prices frequently.
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competitive market in which a small deviation from the optimizing price will lead to fall in demand to zero and therefore, even if a perfectly competitive firm has equal menu cost as imperfectly competitive, the loss of profits by not changing the prices be big enough to outweigh the menu costs. A competitive firm is not a price- maker. But in case of a imperfectly competitive firm, Mankiw showed that the profits that the firm expects to get from increased prices could be much less especially when elasticity of demand for the product of the firm is less than unity i.e. the monopoly power of the firm is more and if the deviation of the actual price from the profit optimizing price is small. In this case, the menu cost of increasing price could be higher than the potential profits and therefore, being rational, the firm does not change its price. Same applies to all firm sin the industry and therefore, nominal price level remains unchanged. It can be used to explain the Keynesian conclusion of an increase in money supply on output rather than on prices is based on it. Prices remaining same, an increase in money supply leads to increase in real money supply which in turn increases real aggregate output either through a decrease in rate of interest or through a real balanced effect. In classical model, there would have been no effect on output if prices were flexible. Therefore, it established a major difference between classical and Keynesian models. One infinitely-lived household the maximizes intertemporal utility. The household receives wage income in exchanges for its labour services and interest income for its accumulated assets. Population growth rate is constant (equal to n ) and at time t = 0 there is only one individual in the economy (i.e. L 0 = 1), so that total population any time t is given by L t = e nt Budget constraint (The change in assets the sum of labour and interest income less consumption): B g = w t L t + r 1 B t C t B t : assets w t : wages rate and r t : interest rate In per capita terms: b g = w t + r t b t – nb t – c t where b t = B C . L L t t t t t c One important constraint: Households cannot borrow unlimited amounts to finance arbitrarily high levels of consumption.
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