EC2B3 Topic 4: Nominal Rigidity

Question 1

What is nominal rigidity?

Answer 1

Nominal rigidity refers to the slow adjustment of nominal variables, like wages and prices, in response to changes in the economy.

It implies that these nominal variables do not change instantly or proportionately to real economic changes.

Question 2

What are the implications of nominal rigidity in economics?

Answer 2

Nominal rigidity can lead to unemployment and economic inefficiencies during downturns because wages do not adjust downward.

This rigidity can prolong recessions and slow down recovery.

Question 3

How does nominal rigidity affect monetary policy?

Answer 3

Nominal rigidity can limit the effectiveness of monetary policy, as changes in interest rates may not lead to immediate adjustments in wages and prices.

This can result in delayed responses to economic stimuli.

Question 4

Fill in the blank: Nominal rigidity primarily involves the slow adjustment of _______ and _______.

Answer 4

wages and prices

These adjustments are crucial for balancing supply and demand in the economy.

Question 5

True or False: Nominal rigidity allows for instant adjustments in wages and prices to economic changes.

Answer 5

False

Nominal rigidity is characterized by slow adjustments.

Question 6

What can cause nominal rigidity?

Answer 6

Nominal rigidity can be caused by contracts, menu costs, and psychological factors.

Contracts may lock in wages, while menu costs refer to the costs of changing prices.

Question 7

List three factors contributing to nominal rigidity.

Answer 7

• Contracts
• Menu costs
• Psychological factors

These factors hinder the flexibility of wages and prices in the economy.

Question 8

How does nominal rigidity relate to unemployment?

Answer 8

Nominal rigidity can lead to higher unemployment during economic downturns as firms are unable to reduce wages.

This can create a mismatch between labor supply and demand.

Question 9

Fill in the blank: Nominal rigidity can prolong _______ and slow down _______.

Answer 9

recessions; recovery

The inability to adjust nominal variables can hinder economic growth.

Question 10

What role does nominal rigidity play in economic models?

Answer 10

Nominal rigidity is a key assumption in many economic models, particularly in explaining short-run fluctuations.

It helps economists understand the dynamics of business cycles.

Question 11

Why would prices be sticky

Answer 11

menu costs
cost of maaking pricing decisions
relationship with customers

Question 12

How do keynsian models account for nominal rigidity

Answer 12

• Failure of market clearing owing to this nominal rigidity
• Price stickiness assumes prices set by firms not markets –> imperfectly competitive goods market
• Pricess eventually adjust so long term clearing

Question 13

diff between nominal and real rates

Answer 13

nominal; cost of borrowing in money markets
CB controls it

Real; IR is one affecting AD
Market clearing rate with flexible prices

Question 14

What is transmision mechanism w sticky prices

Answer 14

Inflation slow to adjust so nominal rate affects real rates

MM IR are short term rates, while real rates that matter most for AD are long-term rates

Question 15

link between nominal and real rates is ____

q

Answer 15

The Fischer Equation

Question 16

What is the fischer equation (and approx. form)

Answer 16

1 + r = (1+i) / (1+π’)

r = i - π’ when (r * π ‘ is small)

Question 17

How are wages and labour decided with sticky prices

Answer 17

Labour demand perfectly wage inelastic (at andd past the sale point) and shifts with the aggreagte demand for goods

Question 18

draw the labour market diagram with sticky prices

Answer 18

Question 19

With sticky prices what does labour demand depend on

Answer 19

Depends on aggregate demand: firms do not make an independent decision on how much to sell

–> no Ys curve: supply of output passively responds to AD

AD determined by output demand curve (C + I + G)

Question 20

What does stickiness of prices suggest about inflation

Answer 20

implies zero inflation (π=0)

thus due to fischer ( i = r + π’e) and r = i

Question 22

What does sticky prices imply about Monetary Policy

How do you represent this on a graph

Answer 22

Monetary Policy sets the real interest rate (r) as r = 1 as π = 0

CB choice of nominal rate (i) is represented by MM line (‘Money and Monetary Policy’); assumed to be flat or upward sloping’)

Intersection between Y Demand curve and MM Line determined real interest rate (r) and output Y

Question 23

Draw the goods market with sticky prices and the MM line

Answer 23

excess supply iff Y to left of Ys

Question 24

Draw tehe effect of a cut in nominal rates with sticky prices, in the goods market

Answer 24

inflation does not adjust due to sticky prices

Shifts MM line downward as the real IR falls –> economy moves along the output demand curve

Question 25

source off -ve demanad shocks in new keynsian model

Answer 25

- Decline in C or I from low confidence or perception to greater risk - Worsening of credit-market frictionsn - Lower G spending New Keynesian model emphasis demand shocks and unexpected fallls in AD as the main cause of business cycles

Question 26

Describe and draw the effects of negative demand shocks (fall in confidence) to goods, labour and production

Answer 26

**1. Goods:** * Leftward shift of Ys from fall in AD **2. Labour:** * N(d) shift to left from a lower Y * Causes a lower employment --> lower w * But N(S) shifts to right from -ve wealth effect but higher avg. labour productivity (Y/N) due to diminishing returns **3. Production**: Move along production function curve to Y2

Question 27

How does the model prediction match up with the empirial evidence

Answer 27

Matches obserbed cyclicality of macro variables except prooductivity and real IR Avg. labour producitivity may be mis measured owing to 'labour hoarding' If MM line upward sloping, real IR is procylical; same as recent decades

Question 28

What is labour hoarding and draw the effect

Answer 28

If adjusting employment is costly for firms, not want to dismiss workers following a temporary demand shock 'Hoard' labour in recession --> actuala labour input falls more than measured labour input in recession. Measasured productivity can fall; making it procyclical

Question 29

What represents a firms profit margin

Answer 29

The gap between MPn and real wage w is firm's profit margin as p>MC MRPn is also below MPn

Question 29

Draw the labour and goods market with flexible pricess in the New Keynesian model

Answer 29

MRPn is scaled down MPn curve Nd behaves in same way as with per

Question 30

What is r * in the new Keynesian model

Answer 30

market clearing interest rate if prices are flexible Hypothetical equilibriuim real interest rate if no nominal rigidities in the economy also for output and labour

Question 31

What is the output gap

Answer 31

gap between actual GDP Y and its natural level Y *

Question 32

How is efficiency of the economy judged in new Keynesian

Answer 32

Comparing MPn to households' marginal rate of substitution between leisure and consumption MPn: produced if people were able to work more MRS (l,c): What value (measured in goods) people put on their time inefficiiently low if MPn > MRS (l,c)

Question 33

Thus how is efficiency judged on the goods market diagram

Answer 33

* Looking at hypotheticcal perfect competition output supply curve Y (s) on which MPn = MRS (l,c) so MPn = MRS l,c = w *

Question 34

two reasons why output is inefficiently low in new keynesian model

Answer 34

* Natural level of output Y * is already too low because imperfect competition * Sticky prices --> -ve demand shocks push GDP below Y *

Question 35

What is the optimal stabilisation policy in response to a decline in confidence about the future

Answer 35

MP Response: CB lowers rates --> move along Y(D) curve raising real Y To close output gap between Y and Y * , CB sshould set i and r equal to natural rate of interest r * --> positions MM line so it intersects Y(D) Fiscal policy could also provide a demand stimulus

Question 36

Draw the optimal stabilisation polixy and the steps

Answer 36

Question 37

Problems with opitmal stabilisation policy?

Answer 37

* Best policy achieves same outcome as if pricees flexiible * Need to know R * * Must be possible to adjust the nominal interest rate *i* * Not sustainable to reach natural rate

Question 38

Draw efficiency wages diagram - incorporating wage rigidity into the New Keynesian model

Answer 38

Question 39

What is the cylicality of the unemplyoment rate relative to the movement of real GDP

Answer 39