REED ECONOMICS 314 - Imperfect Competition and Real and Nominal Price Rigidity

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Economics 314 Coursebook, 2009 Jeffrey Parker 11 IMPERFECT COMPETITION AND REAL AND NOMINAL PRICE RIGIDITY Chapter 11 Contents A. Topics and Tools ............................................................................ 1 B. What’s New and Keynesian about “New Keynesian” Economics ............... 3 Institutions of price setting ............................................................................................. 4 Market structure and price adjustment ............................................................................ 6 C. Understanding Romer’s Chapter 6, Part B ............................................ 6 Equilibrium with imperfect competition .......................................................................... 7 Nominal rigidities ...................................................................................................... 10 Mankiw’s menu-cost model ......................................................................................... 11 Nominal and real rigidities .......................................................................................... 12 Coordination failures .................................................................................................. 13 D. Works Cited in Text ....................................................................... 15 A. Topics and Tools The second and third sections of Romer’s Chapter 6 examine the “new Keyne-sian” response to the Lucas model. The microeconomic basis of Lucas’s model was reasonable and quite appealing, but Keynesians found the assumption of perfect market-clearing and the conclusions that resulted from it unreasonable. Thus ma-croeconomists who maintained Keynesian beliefs had strong incentives to develop a macroeconomic model that preserved desirable analytical features of Lucas’s model but incorporated wage or price stickiness and led to opposite conclusions about ma-croeconomic policy. The first models to be labeled as new Keynesian began from the assumption that (for whatever reason) firms and workers set labor contracts that specify the nominal wage in advance for more than one period. Stanley Fischer (1977) and John Taylor (1979) were able to show that one could derive a Keynesian policy result (i.e., that countercyclical monetary policy can improve welfare) while maintaining fairly solid microeconomic foundations and the assumption of rational expectations. The key11 – 2 assumption for Lucas’s policy-ineffectiveness result, it turned out, was the assump-tion of continuous market clearing via perfectly flexible wages and prices. The first wave of new Keynesian analysis was devoted to examining the implica-tions of different assumptions about how wages and prices are set. Since everyone agrees that wages and prices are unlikely to be perfectly flexible (for example, no one denies the existence of labor contracts in the union sector), these models were quite popular as alternatives to the Lucas imperfect-information framework. However, as Romer noted in Chapter 5 (pages 242 and 243), these wage-contract models predict a strongly counter-cyclical real wage, which is not consistent with actual observations. Part B of Chapter 6 lays out the basic microfoundations of the new Keynesian approach; Part C then applies these models in a macroeconomic context under sev-eral different assumptions about the frequency and nature of price changes. We focus in this Coursebook chapter on Part B, which is one of the most exciting sections of the course, but also one of the most challenging. On center stage are the concepts of nominal and real price rigidity. Both of these concepts have to do with re-sistance to price changes. As you might expect, nominal rigidity occurs when a firm exhibits reluctance to change its price in nominal (dollar) terms. Real rigidity is a sit-uation when a firm does not want to change its price relative to some other prices, for example when a firm wants to keep its price in line with those of other firms in the market. We begin in Section 6.4 by introducing a model in which firms are imperfectly competitive. Imperfect competition is necessary for models with price stickiness be-cause perfectly competitive firms always charge the market equilibrium price, elimi-nating any possibility for rigidity. Sections 6.5 and 6.6 explore the microeconomic implications of nominal and real rigidities. Romer demonstrates that nominal rigidi-ties of sufficient magnitude to explain price stickiness in the real world are implausi-ble. Real rigidities alone do not introduce non-neutral effects of monetary shocks; everyone will adjust together to the new market-clearing equilibrium. Only by com-bining nominal and real rigidities so that the latter amplify the non-neutral effects of the former are new Keynesians able to achieve a realistic depiction of non-neutral monetary effects. Section 6.7 discusses the possibility that real rigidities can lead to coordination failures in the macroeconomy. This literature employs game theory to examine inte-ractions between firms. Under certain circumstances, rigidities can lead to multiple equilibria in the macroeconomy. If there are two or more points of equilibrium, it is often possible to demonstrate that one is Pareto-superior to the other(s). In such a situation, the economy can become trapped at an inferior equilibrium where a change in policy could potentially push the economy to the best equilibrium.11 – 3 B. What’s New and Keynesian about “New Keynesian” Economics The label “new Keynesian economics” has been given to the broad class of mod-els that we are studying in the last two sections of Romer’s Chapter 6. Two natural questions to ask before we study their details are “In what ways are these models Keynesian?” and “In what ways do these models differ from ‘old Keynesian’ mod-els?” As noted in the overview above, the first new Keynesian models evolved as a reaction to the “neoclassical revolution” represented by Lucas (1972), Sargent and Wallace (1975), and Barro (1976). Whereas the earlier intellectual skirmishes be-tween the post-war Keynesian and monetarists had been fought on the turf of aggre-gate models such as IS/LM, Lucas and his followers transformed the rules of play to require rigorous specification of the maximization decisions made by individual agents. Natural extension of the basic microeconomic theories of utility and profit


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