1. The Friedman model assumes that workers do not accurately perceive changes in the price level. Therefore the workers perceive a rise in the nominal wage to represent a rise in the real wage and they increase their supply of labor. Employers correctly understand that the increase in the price level exceeds that of the higher wage they have offered their workers. That decrease in the real wage leads to an increase in their demand for labor. The change in the nominal wage must be enough so that the quantity of labor supplied at the misperceived real wage equals the quantity of labor demanded at the correctly perceived real wage.
There are a couple of Phelps models. In one, firms and workers see the price of their products increasing, and not realizing that other firms are experiencing similar price increases, offer to hire more labor and workers accept those offers of employment. In the other model, it is workers who don¡¦t realize that all firms are offering the same wage increase as their employer. Therefore, some workers who would normally quit their jobs to seek work at other firms don¡¦t stay with their current firms. As a result, turnover unemployment declines.
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2. According to Friedman, expansionary monetary policy would lead to an increase in prices. Assuming imperfect knowledge by workers, the price rise would lead to increased employment and output in the short run. In the Lucas model, people are aware that monetary expansion has led to higher prices in the past. Therefore, the announcement of expansionary monetary policy will lead workers to increase their expected price levels. Thus, they cannot be ¡§fooled¡¨ as in the Friedman model. Therefore, according to the Lucas model, output would not rise, even in the short run, in response to the monetary expansion.
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3. Both the
Keynesian model and the Friedman model use the same labor demand curve; thus, a
countercyclical movement in the real wage occurs. Also, in both it is possible
for expansionary fiscal or monetary policy to increase price and output
in the short run. The major difference is that the Keynesian model is a non
market-clearing model. This implies that the labor market is out of equilibrium
in the short run. The Friedman model, on the other hand, is a market‑clearing
model. This suggests that the labor market is in equilibrium in the short run.
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4. Both the Friedman model and the Lucas model share the assumptions of continuous market clearing and imperfect information. Also, in each model expansionary fiscal or monetary policy causes an increase in price and output. The conditions under which this occurs are different, however. In the Friedman model, workers form their expectations ¡§adaptively¡¨ based on past information. Also, workers are ¡§fooled¡¨ into supplying more labor when their perceived real wage is greater than the actual real wage. In the Lucas model, workers form their expectations ¡§rationally¡¨ based on all past and current information available. Output can only deviate from the natural level if workers are ¡§surprised¡¨ or incorrectly guess the price level. The errors in price expectations are related to each other in the Friedman model. They are totally random and independent of each other in the Lucas model.
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5. A price surprise occurs when the actual price level differs from the expected price level. In the Lucas model, for there to be a business cycle, firms must judge changes in the general price level to vary significantly from unique local price movements. Only if a firm¡¦s price fluctuates independently of prices in the rest of the economy would the firm respond by altering production. In this case, the supply curve would have a relatively high value of ¡§h.¡¨ That is, the coefficient that measures the supply response to changes in the difference between P and Pe would be relatively high. The assumption of localized price surprises helps explain why the amplitude of business cycles varies among countries. Countries with historically low rates of inflation, such as the U.S., have relatively large fluctuations in real output. Countries that have had rapid inflation, such as Brazil and Argentina, experience relatively small changes in real output. With high rates of inflation, most firms in the economy experience the same movements in the general price level. These are so large as to swamp changes in an individual firm¡¦s unique price movements.
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6. In deciding whether to hire temporary or permanent employees to produce the additional output caused by expanding sales, the firm must estimate how long the expansion will last. If it lasts long enough, then the cost saving resulting from paying permanent workers a lower wage offsets the severance costs that it would have to pay if it had to lay off a permanent worker. Therefore the firm must look at how soon it expects the Fed will raise interest rates enough to reduce its sales. Its expectations of how soon the Fed would apply a Taylor rule to change interest rates depend on where the inflation rate and the output ratio are relative to the Fed¡¦s targets.
If the economy is just coming out of a recession, then the firm knows that the Fed is not likely to be worried about inflation. Therefore the firm can expect that the Fed will allow the economy to expand for some time. That would tip the firm¡¦s decision towards hiring permanent workers. On the other hand, if the economy has been expanding for a number of years, then the firm would have to evaluate where it sees inflation and output heading in the future in order to decide whether to hire temporary or permanent workers. These evaluations would have to be done relative to what the firm thinks are the Fed¡¦s goal for the inflation rate and where the Fed thinks real output is relative to natural real GDP.
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7. The
policymaker wants to adopt monetary policies that stabilize the economy. The
policy ineffectiveness proposition asserts that anticipated monetary policy
cannot change real GDP in a regular or predictable way; it does not assert that
monetary policy cannot affect real GDP. In particular, if monetary policy were
to change in a way that businesses and firms did not anticipate, then the price
level would diverge from what businesses and workers expected, resulting in a
change in output. Therefore the policymaker would want monetary policy to be
predictable so as to avoid such price surprises, resulting in a more stable
economy.
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8. The force driving the Freidman-Phelps-Lucas models is imperfect information. Markets will clear at natural real GDP and the natural rate of unemployment as soon as workers and firms are able to correctly estimate how money wages have changed relative to the price level. There are three reasons why misperceptions do not last long enough to explain the fluctuations in the output ratio that have occurred in modern economies. First, consumers and business experience many price changes continuously, and it does not take them long to understand the difference between changes in some price relative to others and a change in the general price level. Second, not only does the government produce a lot of data concerning economic conditions, but the development of the Internet, the expansion of business sections of newspapers, and the existence of business channels on cable TV all mean that those data are more widely disseminated than ever. Finally, if it were the case that specific changes in prices were always associated with specific changes in economic conditions, then firms and workers would come to interpret one change in the economy to soon be followed by another change. An example would be that if there were no supply shocks and if real GDP and natural real GDP were equal, then business and workers would know that any increase in output beyond that point would be followed by rises in prices and wages.
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9. An adverse supply shock pivots the production function down because firms can now produce less with the same amount of labor. As a result, the slope of the production function flattens and the demand for labor shifts down.
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10. Real business cycle theories begin with the assumption of a fixed AD curve. Thus, an adverse supply shock causes an increase in the price level, a fall in employment, and a fall in the real wage. Real-world data on recessionary periods in U.S. history, however, are not consistent with this prediction. In particular, prices have fallen more often than they have risen during recessions. (The experience during the oil shocks of the 1970s was an exception.) Moreover, real wages have not shown any consistent pattern. For the most part, RBC theorists do not attempt to explain price movements. Rather, RBC theorists have contended that there is no distinction between Y and YN. They have attempted to explain why there is a business cycle in YN itself. Some RBC theorists have attempted to explain countercyclical real-wage movements. They suggest that monetary policy responds passively to technological shocks. This relaxes the assumption of a fixed AD curve. The AD curve would shift leftward by enough to offset the predicted rise in prices. Little historical evidence is available to support such a contention, however.
11. Intertemporal substitution refers to substitution that takes places over time, such as when a couple switches the days that they pick-up their kids from an after-school program. In the context of the labor market, intertemporal substitution occurs when changes in real wages rates cause workers to switch when they engage in non-worker related activities in order to work more or less as the real wage rate rises or falls, respectively.
For a real
business cycle model (RBC) to explain why the real wage rate does not vary much
over the business cycle, the labor supply curve must be relatively flat. This is
because technology or supply shocks, which are the driving force in a RBC model,
shift the demand for labor curve, causing a movement along the supply of labor
curve. If the labor supply curve were steep, then those shifts in the demand for
labor curve would result in large changes in the real wage rate, which is not
what the real-world data show. Finally, for a RBC model to explain the
procyclical movement in employment, the labor supply curve cannot be vertical.
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12. The real business cycle model shares with the Lucas model the assumptions of continuously clearing markets, continuous equilibrium, and rational expectations. The RBC model differs from the Lucas model primarily by emphasizing business cycles generated by ¡§technology¡¨ shocks that alter the level of real GDP (YN). Such technology shocks shift the aggregate production function and, therefore, the demand for labor. The new equilibrium is at the intersection of the new labor demand curve and the existing labor supply curve. The new level of employment determines the level of output along the new aggregate production function. Therefore, the labor supply curve¡¦s slope largely determines the extent of employment change. The RBC theory does not explain the persistence of business cycles; it merely assumes their existence.\
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13. In the original Keynesian model, nominal wages were assumed to be rigid downward. The new Keynesian approach abandons the arbitrary assumption of a fixed nominal wage. It explains the microeconomic foundations for the existence of sticky wages. Sticky wages are insufficient to explain why nominal prices do not fully adjust to movements in nominal demand. Hence, the new Keynesian model also provides explanations for barriers to fully flexible prices, including nominal rigidities and real rigidities. New Keynesian explanations for nominal rigidities include menu costs and long-term contracts. New Keynesian explanations for real rigidities include the theory of efficiency wages.
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14. Unlike the classical and new classical models, the non market-clearing model used in the new Keynesian approach does not insist that all markets clear continuously. Classical and new classical firms are assumed to operate within perfectly flexible auction markets where they are forced to be price-takers. Given the price established in the market, classical and new classical firms choose only the profit‑maximizing output level. New Keynesian explanations for firm behavior borrow the assumptions of rational behavior and profit maximization. They recognize, however, that many modern firms operate in imperfectly competitive markets. Consequently, new Keynesian models stress that firms are likely to be price-setters and quantity-takers.
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15. With long‑term, staggered contracts, the economy is not able to respond as quickly to changing conditions. For example, in response to a beneficial supply shock, wages cannot fall quickly. This is so because only part of the wage package can be negotiated under the new conditions. Wages adjust slowly, and with a longer lag, to shifts in aggregate demand and supply. Therefore, much of the adjustment to shocks takes the form of fluctuations in output and employment, rather than in prices and wages.
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16. A macroeconomic
externality occurs when the profit‑maximizing behavior of firms prevents prices
from fully adjusting to demand and supply shocks. This creates the social costs
of lost output, employment, and consumer surplus. With long‑term, staggered
contracts, the economy cannot respond as quickly to changing conditions. For
example, in response to a beneficial supply shock that would lower inflation
expectations, wages will not respond quickly. This is so because only part of
the wage package can be negotiated under the new conditions. Wages adjust
slowly, and with a long lag, to shifts in aggregate demand and supply. Hence,
much of the adjustment to shocks must take the form of fluctuations in output
and employment, rather than in prices and wages. The chapter identifies other
sources of macroeconomic externalities. They are menu costs, coordination
failures, and real rigidities in labor and product markets. Any factor that
prevents full adjustment of prices to changes in nominal GDP can cause
macroeconomic externalities.
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17. Both models use the concepts of disequilibrium and non‑clearing markets. Consequently, prices and wages do not change instantly in response to shifts in aggregate demand and supply. As a result, it is likely that there will be business cycles in output and employment in response to demand or supply shocks. The two models differ primarily in their explanation of why wages and prices are sticky and why markets do not continuously clear. Unlike the original model, which merely assumed the stickiness of nominal wages, the new Keynesian model explains the microeconomic foundation for slow adjustment. The new Keynesian model adopts both the rational behavior and profit-maximizing postulates of classical and new classical theory. The original Keynesian model used historical and institutional accounts to make the point. The new Keynesian model, unlike its predecessor, provides symmetrical explanations for both nominal and real rigidities in both wages and prices. It posits a microeconomic explanation for why firms and workers will be off their demand and supply curves. The new Keynesian model also explains why individual firms and workers would be reluctant to rely on indexing nominal prices to nominal aggregate demand. This explanation counters new classical claims, such as instantaneous adjustments.
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18. Nominal and real rigidities refer to factors that prevent complete and rapid adjustment of wages, prices, and costs to changes in aggregate demand and supply. Nominal rigidities inhibit the flexibility of the nominal price level. The nominal price level cannot adjust due to factors¡Xsuch as menu costs and long‑term, staggered contracts¡Xthat make it unprofitable for firms to change the nominal price or wage level. Real rigidities make firms and workers reluctant to alter either real or relative wages. That is, neither firms nor workers want to index wages to changes in nominal aggregate demand. Real rigidities result in part from the fact that not all local firms and workers can count on economy-wide changes that will leave them equally well off as before the change. Input‑output approaches also explain the unwillingness of firms and workers to take the risks associated with full indexing. The collection of goods and services used by a firm or worker is unlikely to be the same collection used for indexation purposes.
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19. It is possible that fluctuations in aggregate demand and supply could have their entire impact absorbed by price and wage fluctuations, rather than output fluctuations. Indeed, both the old and new classical models assert that this is the expected outcome of continuous market-clearing models of the economy. The new classical models assert that both firms and workers voluntarily cut back employment and production during recessions. It is this contention that is countered by new Keynesian economics.
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20. The basic insight derived from efficiency wage theory is that firms adjust workers¡¦ wages little, if at all, in response to changes in aggregate demand. As a result, the brunt of demand fluctuations falls on employment and output rather than on wages and prices. For example, firms fear that reducing wages in response to falling aggregate demand will lower worker productivity, morale, loyalty, and the quality of workers the firm can attract and increase employee turnover. To avoid these undesirable consequences, firms are likely to keep the wage structure unchanged and choose instead to lay off employees. Yes, the theory is consistent with new Keynesians¡¦ explanations. It highlights and provides a microeconomic explanation for a factor that slows the wage adjustment process; it also helps explain why firms¡¦ marginal costs will be slow to fall when demand declines and thus why they will be less likely to reduce their prices sufficiently to avoid a recession.
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21. The chief similarities among the three models are their assumptions that economic agents behave rationally and have rational expectations. There are a number of important differences among the models. Both the new classical and real business cycle models assume continuous market clearing, whereas the new Keynesian model assumes that markets are not in continuous equilibrium because firms and workers may find it in their best interest not to alter prices and wages when demand or supply changes occur. The new classical and real business cycle models assume that anticipated policy changes will be ineffective at changing output and employment because workers and firms will quickly adjust their expected price level. New Keynesians do not share this view because they believe that even if the expected price level changes quickly, actual prices and wages change only slowly, so that anticipated policy changes can lead to changes in output and employment. Another major difference is that the real business cycle model attributes all output and employment fluctuations to supply shocks that change the level of YN; the new Keynesians, on the other hand, believe that demand shocks also influence output and employment by causing Y to fluctuate around YN.
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22. The new Keynesian model argues that because undesirable fluctuations in output and employment impose costs on society (a macroeconomic externality) which individual decision-makers have no incentive or power to avoid (coordination failure), government stabilization policy can play a beneficial role. Stabilization policy presents an alternative solution to the problem of coordinating wage and price changes among firms so that shocks impact only prices and wages and not output and employment. New classicals disagree. In their market-clearing models, coordination failure problems are nonexistent, and in addition the policy ineffectiveness proposition renders predictable stabilization policies impotent to affect output and employment.
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23. The autonomous drop in net exports shifts the IS and AD curves to the left. In the classical model, rapid downward adjustment of wages and prices keeps output and employment stable, limiting the impact of the demand decline to the price level. In the Keynesian model with perfectly rigid nominal wages, there is no downward adjustment of wages or prices and the full brunt of the demand drop is felt in falling output and employment. This model has nothing to say about the economy¡¦s eventual adjustment to the drop in demand. In the Friedman fooling model, lower demand leads to falling prices and wages. Because workers sense the falling wages before they do the falling prices, they perceive a decline in their real wages and supply less labor. Thus, employment and output fall but subsequently recover as workers gradually adjust their expected price level downward. The Lucas model sees the possibility that firms will be temporarily fooled, in that they know their own price has fallen but are uncertain if the same holds for the general price level. If the actual price level is below their expected price level, firms will produce less and output will fall along with employment. However, given rational expectations, recollection of past episodes in which demand declines were followed by a falling price level would speed the downward adjustment of expectations. As the expected price level declines there are no obstacles to rapid downward adjustment of wages and prices, so output and employment quickly return to their long-run levels. The real business cycle view would be similar to the Lucas model, since there have been no supply shocks in this example. The new Keynesian model would predict longer-term adverse impacts on output and employment than the new classical models, for even with rational expectations the adjustment of wages and prices will be slowed by such impediments as menu costs, coordination failures, efficiency wages, and long and staggered labor contracts. Prices will decline in the short-run, but not enough to return the economy to its natural rate of output.
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