Week 6 Introduction to the New Keynesian model Flashcards

1
Q

Is money neutral in the New Keynesian Model?

A

No, as we allow for sticky prices

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2
Q

What is the effect of the non-neutrality of money?

A

It allows for monetary policy to have real effects- providing scope for fiscal and monetary policy to stabilise the economy.

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3
Q

What are sticky price models sometimes called?

A

Menu cost models

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4
Q

What are sticky prices?

A

Sticky prices, also known as price stickiness refers to pricing that is resistant to changing market conditions.

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5
Q

Are prices fixed in the New Keynesian model and is this realistic?

A

Prices are fixed but this isn’t realistic

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6
Q

What is the liquidity trap?

A

A liquidity trap is a situation, described in Keynesian economics, in which, “after the rate of interest has fallen to a certain level, liquidity preference may become virtually absolute in the sense that almost everyone prefers holding cash rather than holding a debt which yields so low a rate of interest

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7
Q

What is our first assumption in a New Keynesian Model?

A

We need to assume monopolistic competition.

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8
Q

How do New Keynesian models modify the RBC model?

A

They assume that firms have some control over the
prices of their own goods. However, this modification would not make sense in a perfect
competition environment.

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9
Q

What do firms do in monopolistic competition?

A

Given the demand for their product, they set the price as a mark-up over marginal cost

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10
Q

If the only modification to the RBC model was monopolistic competition, what would be the only difference?

A

Output would be inefficiently low, but everything else would remain largely unchanged.

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11
Q

In a New Keynesian model do we assume flexible prices?

A

No, we assume that it is costly for firms to re-set prices (the stick price assumption)

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12
Q

Assuming sticky prices, if a shock affects the demand for their good after they have already set the prices, what will the firm do?

A

The firm will simply satisfy that demand.

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13
Q

Is the sticky priced assumption fixed or temporary?

A

The sticky price assumption is temporary- firms will be able to adjust prices in the future.

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14
Q

How do households and the government behave in a New Keynesian Model?

A

The behaviour of households and governments is identical to that in an RBC model.

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15
Q

In the New Keynesian Model, is the monetary policy neutral in the short run?

A

In the short run, monetary policy is not neutral.

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16
Q

In the New Keynesian Model, who do we assume sets the money supply?

A

In our models we have assumed that the money supply

(currency) is set by the central bank as its monopoly supplier.

17
Q

In the New Keynesian Model, assuming no inflation, who controls the real interest rate in the short term?

A

The central bank

18
Q

In the New Keynesian Model, assuming no inflation, what is the easiest way to think of the money supply?

A

It is easiest to think of the money supply as being horizontal.

19
Q

In the New Keynesian Model, assuming no inflation, which schedule are households always on?

A

Households are always on their labour schedule

20
Q

In the New Keynesian Model, assuming no inflation, having set prices and satisfying demand, which schedules will firms be on?

A

The firm will be on neither their labour demand or output supply schedule.

21
Q

In the New Keynesian Model, starting from equilibrium, if the central bank implements a
contractionary monetary policy, what does this mean for interest rates

A

A contractionary monetary policy → ↑ interest rates

22
Q

In the New Keynesian Model, starting from equilibrium, if the central bank implements a
contractionary monetary policy, what does this mean for the output demand schedule?

A

A contractionary monetary policy → a movement along the output supply schedule.

23
Q

In the New Keynesian Model, starting from equilibrium, if the central bank implements a
contractionary monetary policy, what does this mean for the out and labour supply and what are the effects of this on wages and employment?

A

As output supply is passive, output contracts while labour supply rises due to the increase in interest rates.
∴ wages↓ and employment ↓.

24
Q

In the New Keynesian Model, starting from equilibrium, if the central bank implements a
contractionary monetary policy, what does this mean for the money demand levels, and how does the central bank react to this?

A

Money demand contracts: the central bank matches this in order to ensure its chosen interest rate target

25
Q

In the New Keynesian Model, starting from equilibrium, if the central bank implements a
contractionary monetary policy, what would be the effect on the labour supply curve

A

A contractionary monetary policy → ↑interest rates → ↑labour supply → rightwards shift in labour supply curve.

26
Q

In the New Keynesian Model, starting from equilibrium, what does increasing government spending do to output demand and labour supply?

A

↑G → ↑Yd & ↑ Ns

27
Q

In the New Keynesian Model, starting from equilibrium, what does increasing government spending do to employment and wages?

A

↑G → ↑N & ↑ w

28
Q

In the New Keynesian Model, starting from equilibrium, what does increasing government spending do to themoney supply?

A

↑G → ↑Y
↑G → no change in interest rates
∴ ↑G → ↑Md
∴ ↑G → ↑Ms

29
Q

In the New Keynesian Model, how could a central bank fully offset any expansionary fiscal policy?

A

By increasing interest rates by the appropriate level to reduce Y back to what it previously was (ie keep output stable)

30
Q

In the New Keynesian Model, starting from equilibrium, what does an increase in current and future technology do to the money supply?

A
↑z → ↑Production Function
↑z' → ↑MPK' → ↑ Investment → ↑Yd
↑z → no change in interest rates
∴ ↑z → ↑Md
∴ ↑z → ↑Ms
31
Q

Under a liquidity trap, what two things are perfect subsitutes?

A

Money and bonds

32
Q

What becomes more important to policy makers during a liquidity trap and why?

A

Fiscal policy becomes much more important as the central bank cannot lower interest rates any further.

33
Q

How does Williamson define the output gap?

A

Ym − Y∗

ie current output under a shock - flexible output.

34
Q

What is the output gap?

A

Price rigidities mean that prices and quantities in the NK model differ from those that would prevail under flexible prices (the RBC equivalent)
For example, current output Y∗ may be high due to a monetary policy shock but had prices been flexible output would have been equal to Ym.

35
Q

What do optimal macroeconomic policies do?

A

We can think of optimal policy as policies that aim to minimise the output gap as well as to equate the actual and the natural rates of interest

36
Q

What is the output gap in the RBC model?

A

0

37
Q

What does the Taylor rule tell us?

A

Taylor’s rule makes the recommendation that the Federal Reserve should raise interest rates when inflation is high or when employment exceeds full employment levels. Conversely, when inflation and employment levels are low, the Taylor rule implies that interest rates should be decreased.

38
Q

What is the Taylor rule formula to work out the target rate for interest rates?

A

Target Rate in short term = Current short term interest rate + 0.5*(expected GDP growth - long term GDP growth) + 0.5 * (expected inflation-target inflation).