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#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.
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Oct 14, 2020EXPERT
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