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[solution] » Need help with this question. Graphs are essential.  #3. (40 POINTS TOTAL) The Fed'


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Need help with this question. Graphs are essential. 


#3. (40 POINTS TOTAL) The Fed's FRB/US is a New Keynesian model (Click Here for article). Below

 

is an excerpt from the article:

 

"An aspect of FRB/US that is closely related to slow market adjustment is the behavior of inflation. In the

 

model, firms seek to pay workers the value of their marginal

 

product and to price their output as a markup over trend unit labor and energy costs. However, labor

 

contracts and other factors create frictions that slow the speed at which wages

 

and prices adjust to shifts in demand and supply. (Commodity prices are an exception to this behavior

 

because they adjust quickly on world spot markets). Such ??sticky-price?? behavior is incorporated into the

 

equations of FRB/US that govern the response of inflation to changes in economic conditions. An

 

important implication of this view of the inflation process is that policy-directed changes in short-term

 

nominal interest rates have a temporary influence on the real rate of interest."

 

a) (20 points) Begin with discussing why the New Keynesians believe that prices are sticky in as much

 

detail as possible. Then use the efficiency wage theory/model to buttress (support) your argument (i.e.,

 

why does the efficiency wage theory play a critical role in explaining why firms are willing to

 

produce more output at the same price?) Draw two graphs, one showing the effort curve and the

 

efficiency wage (be sure to explain how firms pick the efficiency wage) and the other being a labor

 

supply- labor demand diagram with the assumption that the efficiency wage (w*) is above the market

 

clearing (classical) wage (wclass). Why is this model so attractive in dealing with the empirical reality in

 

labor markets that the classical school has such a hard time with and what is the empirical reality we are

 

referring to? Please apply your answer to the recent experience in US labor markets.

 

New Keynesians believe that prices are sticky because they believe there to be menu costs to the change

 

in prices which in many instances cost more than the additional revenue derived from changes in prices.

 

In the case of demand shocks, firms are not sure if those shocks are temporary or permanent, in addition

 

they are unsure about the business decisions of competing firms, so the firm seeks to keep prices at the

 

same level. So in determining whether the shock is temporary or permanent, firms will wait until more

 

information is available and then determine their decision. (raise if permanent, keep the same if

 

temporary). Essentially, if the marginal costs of menu costs are greater than the marginal benefit of

 

changes in prices, then prices will remain the same.

 

In the Great Recession, jobs became uncertain and there are people who are involuntarily unemployed ?

 

this emphasizes the difference between classicals and Keynesians, in that the classicals cannot illustrate

 

involuntary unemployment in their model. What a firm can do to produce more output without changing

 

prices is to hire more workers at the same wage. Workers are willing to work harder at any given wage

 

and are willing to put more effort since jobs are uncertain. Doing so will increase MR to be greater than

 

Mc. The firm can now produce more until MR = MC, which is profit maximizing condition. In

 

conclusion, the firm can hire the involuntary unemployed for the same wage to produce more at the same

 

price. They are willing to do this because they are increasing profits and they will make profit until MR =

 

MC. The real wage necessary to obtain any specific level of effort will be lower during recessions, hence

 

the efficiency wage paid in recessions will also be lower. This assists the efficiency wage model match

 

the business cycle fact that real wages are lower in recessions than I booms.

 

b) (20 points) Now draw two more diagrams depicting what is happening in the product markets

 

(demand, marginal revenue, marginal cost and profits) and why firms are willing to change output at

 

the given price level (short run), given a positive shock to (aggregate) demand? Begin at point A with the

 

initial conditions and then let the positive demand shock occur. Label the new profit maximizing price,

 

quantity, and profits as point B on both diagrams. Now locate points C on both diagrams assuming that

 

the firm did not immediately change prices and thus, kept prices fixed, consistent with the ??sticky-price?? behavior alluded to in the excerpt above. Please be very clear as to why exactly firms are willing to act

 

like a 'vending machine' in the short run (be willing to increase output at the same price). Is this firm

 

behavior, being willing to increase output at the same price, consistent with the firm?s profit maximizing

 

objective? Why or why not? In the short run you will be able to make more total revenue in the short run at the same price then

 

you were able to make before the demand shock ? total revenue increases as a result of either raising

 

prices or quantity (assuming the other is kept constant). By merely keeping prices constant, similar to

 

a vending machine, you can keep the potential customers you would lose as a result of increasing

 

prices. In addition, if the firm were to keep prices constant as they determine whether the demand shock is

 

temporary or permanent, they ensure that they do not lose market share to competitors. Lastly, so long as the firm charges a price above the marginal cost of production, they will see their

 

profits rise, even if they may not be maximizing them in the short run. (We see this in point A vs.

 

point C)

 


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