New Keynesian Model

Question 1

Under a liquidity trap in the New Keynesian model, what policy is ineffective?

Answer 1

Monetary policy. Both the real interest rate and inflation rate are essentially 0 - implementing a MP to change one has no effect on the other - potential to worsen the situation

Question 2

Why does the real interest rate remain fixed when G use expansionary FP?

Answer 2

Because r is controlled by CB. G have no control over r.

Question 3

How does the NK model differ from the RBC model?

Answer 3

NK assumes money is not neutral; thus MP has real effects. NK also assumes that pricing is sticky (takes time to adjust) but firms do have some control over market prices. Thus NK operates within monopolistic competition.

Question 4

What does contractionary MP imply?

Answer 4

Implies that CB aims to stabilise high inflation, thus the real interest rate will increase. The main aim is to reduce money expansion to fight high inflation. i

Question 5

What does expansionary FP imply?

Answer 5

G want to boost economic growth via improved AD. FP implies tax cuts/increased G. This leads to greater C, I. G crowds out private C.

Question 6

What would be an optimal policy?

Answer 6

An Optimal Policy would be one that aims to minimise the output gap (ye-yt) as well as to equate the actual and the natural rates of interest.