Chapter 17
New Classical Macro Confronts New Keynesian Macro
187
Section 17-10 discusses the efficiency wage model. This is a theory explaining real wage rigidities that
has received much attention. It establishes a relationship between the real wages paid to workers and their
efficiency. Implications of this theory include that firms pay a wage rate that is above the market clearing
level and that they will be reluctant to cut their wage rate in the face of declining demand, choosing
instead to adjust their employment level.
Section 17-11 concludes the chapter with some criticisms of the new Keynesian model. There is also a
discussion of the differing implications of the new Keynesian theory and the other models. Remind
students that the new Keynesian model uses microeconomics to explicitly explain why wages and prices
are slow to adjust. It assumes non-market-clearing for both workers and firms. It also overcomes many
criticisms brought against other theories of the business cycle. A criticism of the new Keynesian model
is its inability to explain the existence of business cycles before the era of union contracts. Also, the
existence of long-term staggered labor contracts need not always imply slow adjustment of wages and
prices. In countries where policymakers are expected to pursue inflationary policies, for example, full
indexation may avoid the slow adjustment of wages and prices implied by overlapping-staggered labor
contracts.
„
Changes in the Eleventh Edition
The structure and content of Chapter 17 are moderately changed from the 10th edition. Major changes
have occurred in Sections 17-2 and 17-3. In Section 17-2, Subsection 17-2(a), “Distinctive Features:
Market Clearing and Imperfect Information,” has been modified completely. Gordon has replaced the
major part of the discussion from the 10th edition with a new explanation and dropped the Figure 17-1
where “A Business Cycle in the Fooling Model” was explained.
In Section 17-3, he deleted Subsection 17-3(b), “The Friedman-Phelps-Lucas Supply Functions and the
Price Surprises,” along with the Figure 17-2. He modified and expanded the discussion about the topic
“The Assumption of Rational Expectation,” in Subsection 17-3(a) in greater detail to incorporate the
major idea from the deleted Subsection 17-3(b). The rest of the chapter has remained mostly unchanged.
As Figures 17-1 and 17-2 from the 10th edition have been deleted, the rest of the figures have been
renumbered accordingly in the 11th edition. The IP Box in Section 17-5 on productivity fluctuations in
the United States and Japan has been updated through year 2006.
„
Answers to Questions in Textbook
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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Gordon • Macroeconomics, Eleventh Edition
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.
3. Both the Keynesian model and the Friedman model use the same labor demand curve; thus, a
counter-cyclical 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.
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.
5. 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.
6. 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.
Chapter 17
New Classical Macro Confronts New Keynesian Macro
189
7. 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.
8. 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.
9. 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. Realworld 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 Y N. They have
attempted to explain why there is a business cycle in Y N itself. Some RBC theorists have attempted
to explain counter-cyclical 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.
10. 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 pro-cyclical movement in
employment, the labor supply curve cannot be vertical.
11. 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 (Y N ). 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
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Gordon • Macroeconomics, Eleventh Edition
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.
12. Input growth varied much more in the United States than it did in Japan over the entire period. Input
growth in Japan rose through the late 1960s, then fell until the mid-1970s, after which it stabilized
until the early 1990s. Inputs have grown very slowly in Japan since the early 1990’s; in fact, they fell
in 1999 and 2001–02.
Output growth in both the United States and Japan were similar to input growth in the two countries
in that first, output growth varied more in the U.S. than it did in Japan over the entire period, and
second, output growth in both countries tended to vary more than input growth did. That meant that
in both countries, multifactor productivity rose when output growth accelerated and fell when output
growth declined. However, multifactor productivity growth was even more pro-cyclical in Japan
because input growth was more stable in Japan than in the United States.
There are some other differences between the growth rates of input, output, and multifactor
productivity between the United States and Japan. First, unlike the U.S., where output declined
during the recessions of 1974–75, the early 1980s, and 1991, output in Japan never fell prior to 1998.
Second, while multifactor productivity growth was higher on average from 1975 through 1991 in
Japan than it was in the United States, since 1992 the average multifactor productivity growth rate
has been negative in Japan, whereas in the United States, the average multifactor productivity growth
rate from 1992–2006 was twice as high as it had been in the period 1975–91. Thus, during a time
when Japan was experiencing a multifactor productivity growth slowdown, the United States was
seeing a revival of multifactor productivity growth.
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.
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.
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.
Chapter 17
New Classical Macro Confronts New Keynesian Macro
191
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. As explained in question # 15, 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.
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.
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—such as
menu costs and long-term, staggered contracts—that 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. Inputoutput 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.
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.
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
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Gordon • Macroeconomics, Eleventh Edition
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.
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 Y N; the new Keynesians, on the other hand,
believe that demand shocks also influence output and employment by causing Y to fluctuate
around Y N.
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.
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.
Chapter 17
New Classical Macro Confronts New Keynesian Macro
„
Answers to Problems in Textbook
1.
a.
193
The differences between the actual price level and each person’s forecast are given in the table
below.
Period
Person A’s forecast error
Person B’s forecast error
1
2
3
4
5
6
7
8
9
10
0
−1
0
1
1
1
1
−2
2
0
1
−1
1
0
1
2
3
−1
1
2
b. Rational expectations assume that people use all the information available to them when making
a forecast and that their forecasting errors be random and not display any consistent pattern.
Since we do not know what information the two people had when making their forecasts of the
price level or even the forecasting technique that they used to construct their forecasts, all we
can do in trying to judge whether their forecasts were formed by rational expectations is to
examine each person’s forecast errors.
Person A’s forecast errors are either zero or positive numbers. These errors indicate that
Person A consistently underestimated the price level. That consistent pattern of underestimating
the price level would seem to indicate that the person did not use rational expectations to
construct forecasts of the price level. On the other hand, like Person A, Person B twice correctly
estimated the price level, but on the eight occasions, half of the time the forecasts of the price
level were too low and the other half of the time, the forecasts were too high. It is more likely
that Person B’s forecasts were formed by rational expectations. Still that conclusion must be
tentative because we do not know what information Person B had at the time of the forecast and
we do know what method Person B used to construct the forecasts.
2.
The equation for the aggregate demand curve is Y = 9,000 + 3,000/P, given that the nominal
money supply is initially 3,000. If the price level equals 0.8, the point on the aggregate demand
curve is Y = 9,000 + 3,000/0.8 = 9,000 + 3,750 = 12,750. The same calculation shows that the
following points are on the aggregate demand curve: (12,000, 1.0), (11,500, 1.2), (11,400, 1.25),
and (11,000, 1.5).
b. The long-run equilibrium values of real GDP and the price level are where aggregate demand
and long-run aggregate supply are equal. Long-run equilibrium also requires the price level to
equal the expected price level or equivalently that the price surprise is zero. Since the long-run
aggregate supply curve is vertical at natural real GDP and since natural real GDP equals 12,000,
the long-run equilibrium values of real GDP and the price level are also 12,000 and 1.0, given
that the expected price level is initially 1.0.
c. The decrease in the real exchange results in an increase in aggregate demand so that the new
equation for the aggregate demand curve is Y = 9,600 + 3,000/P, given the initial value of the
nominal money supply. Therefore, if the price level equals 0.8, the point on the new aggregate
demand curve is Y = 9,600 + 3,000/0.8 = 9,600 + 3,750 = 13,350. The same calculation shows
that the following points are on the new aggregate demand curve: (12,600, 1.0), (12,100, 1.2),
(12,000, 1.25), and (11,600, 1.5).
a.
The new level of aggregate demand and short-run aggregate supply are equal at real GDP equal
to 12,100 and a price surprise equal to .2. Therefore, the new equilibrium price level equals 1.2
in the short run.
Gordon • Macroeconomics, Eleventh Edition
194
d. If monetary policymakers respond to the decline in the real exchange rate by doing nothing and
leaving the nominal money supply at its current level of 3,000, then the long-run equilibrium
price level is 1.25, since that is where aggregate demand and the long-run aggregate supply are
equal at the natural real GDP level of 12,000.
If monetary policymakers change the money supply so as to return the price level to 1.0,
which is what it was equal to in Part b, then the nominal money supply, M s, must be such that
12,000 = 9,600 + M s/1.0 or M s = 12,000 − 9,600 = 2,400. That is, monetary policymakers must
reduce the nominal money supply to 2,400 for the price level and the expected price level to be
equal at P = 1.0.
If monetary policy changes the money supply so as to keep the price level equal to 1.2, which is
what it was in Part c, then the nominal money supply, M s, must be such that 12,000 = 9,600 +
M s/1.2 or M s/1.2 = 12,000 − 9,600 = 2,400. Therefore, M s = 1.2(2,400) = 2,880. That is,
monetary policymakers must reduce the nominal money supply to 2,880 for the price level
and the expected price level to be equal at P = 1.2.
3.
a.
If the decline in the real exchange rate is only temporary, so that the aggregate demand curve
returns to its original level, then given no change in the nominal money supply, the economy is
long-run equilibrium when the expected price level and the actual price level at 1.0.
On the other hand, if monetary policymakers change the nominal money supply so as to
maintain a price level equal to 1.2 when aggregate demand returns to its original level, then they
must change the nominal money supply to M s′so that 12,000 = 9,000 + M s′/1.2 or M s′/1.2 =
12,000 − 9,000 or M s′ = 1.20(3,000) = 3,600. That is, monetary policymakers would have to
increase the nominal money supply to 3,600 to keep the price level and expected price level
equal to 1.2.
b. If monetary policymakers do nothing in the sense of not changing the nominal money supply,
then expected and actual price level rise if the decline in the real exchange rate persists. The
reason both price levels rise is that firms and workers know it takes a higher price level to offset
the increase in aggregate demand caused by the decline in the real exchange rate, given that they
expect monetary policymakers to take no steps to offset that increase in aggregate demand. On
the other hand, if firms and workers know that the decline in the real exchange rate is only
temporary, then they understand that the increase in aggregate demand is also only temporary.
So if they expect that monetary policymakers are not going to take any steps to respond to the
temporary changes in the real exchange rate and aggregate demand, then they also know that the
price level returns to 1.0, so that is the price level they expect.
Note, however, that if the decline in the real exchange rate is expected to persist, so that the
increase in aggregate demand is also expected to persist and firms and workers also expect
monetary policymakers to take actions to reduce the price level to 1.0 in the face of that increase
in aggregate demand, then monetary policymakers must reduce the nominal money supply
enough to shift the aggregate demand curve back to its original level.
Finally, if firms and workers expect that monetary policy makers will maintain the price
level at 1.2, then when the decline in the real exchange rate is expected to persist, monetary
policymakers must take action so as to reduce aggregate demand so that aggregate demand and
long-run aggregate supply are equal to 12,000 at a price level of 1.2. That reduction in aggregate
demand would require a decrease in the nominal money supply. On the other hand, if the decline
in the real exchange is only temporary and so also is the increase in aggregate demand, then
monetary policymakers would have to increase aggregate demand so as to keep aggregate
demand and long-run aggregate supply equal to 12,000 at a price level of 1.2. That would
require an increase in the nominal money supply.
Chapter 17
c.
New Classical Macro Confronts New Keynesian Macro
195
Policymakers, workers, and firms would look to data from the foreign exchange markets and
economic conditions in the rest of the world in an attempt to determine if there were changes in
any of these areas that would cause the decline in the real exchange rate to either persist or only
be temporary in nature.
If monetary policymakers have always responded to changes in aggregate demand by not doing
anything, then there is nothing that they can do to signal to workers and firms whether the
change in the real exchange rate is going to persist or is only temporary. On the other hand, if
monetary policymakers have responded to changes in aggregate demand so as to either maintain
the price level at its pre- or post-surprise level, then what they do to the nominal money supply
signals to firms and workers what they have discovered concerning the nature of change in the
real exchange rate. For example, if workers and firms expect that monetary policymakers act so
as to maintain the price level equal to 1.0, its pre-surprise level, then monetary policymakers
can signal to workers and firms that the decline in the real exchange is only temporary by
maintaining the nominal money supply at its pre-surprise level. On the other hand, if monetary
policy makers discover that the decline in the real exchange rate is going to persist, then they
can signal that to workers and firms by reducing the nominal money supply. Finally, you should
be able to figure out how monetary policymakers can signal to firms and workers what they
know about the change in the real exchange rate via a change in the nominal money supply if
workers and firms expect monetary policymakers to maintain the price level at 1.2.
4.
If the price level equals 0.75, the point on the aggregate demand curve is Y = 7,000 + 2,400/
0.75 = 7,000 + 3,200 = 10,200. The same calculation shows that the following points are on
the aggregate demand curve: (10,000, 0.80), (9,400, 1.00), (9,000, 1.20), (8,920, 1.25), and
(8,600, 1.50).
b. The aggregate supply curve is vertical at natural real GDP in a real business cycle model.
Therefore, in any period, real GDP equals natural real GDP, and the price level is where the
vertical aggregate supply curve intersects the aggregate demand curve. In period one,
the technology shock equals −400, so that natural real GDP and real GDP equal 8,600. The
price level in period one equals 1.50. In period two, the technology shock equals −80, so that
natural real GDP and real GDP equal 8,920. The price level in period two equals 1.25. In period
three, the technology shock equals 0, so that natural real GDP and real GDP equal 9,000. The
price level in period three equals 1.20. In period four, the technology shock equals 1,000, so that
natural real GDP and real GDP equal 10,000. The price level in period four equals 0.80. In
period five, the technology shock equals 400, so that natural real GDP and real GDP equal
9,400. The price level in period five equals 1.00. In period six, the technology shock equals 0,
so that natural real GDP and real GDP equal 9,000. The price level in period six equals 1.20.
a.
Real GDP rises from period one through period four as technology shocks become larger. The
price level falls over that same time. Then, real GDP declines in the last two periods as the size
of the technology shocks decrease. The price level rises during periods five and six.
5.
a. MR0 = 10 − 0.2 Y.
b. Set MC0 = MR0 and solve for Y: 3 = 10 − 0.2 Y ⇒ Y = 35. Substitute Y = 35 into the demand
curve and solve for P: P = 10 − 0.1(35) = 6.50.
c. Total Revenue = 6.50(35) = 227.50. Total cost = 3.00(35) = 105. Profit = TR − TC = 227.50 −
105.00 = 122.50.
d. Consumer surplus = (0.5)(3.50)(35) = 61.25.
Gordon • Macroeconomics, Eleventh Edition
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6.
a.
MR1 = 8 − 0.16 Y.
b. Marginal cost must fall. MCrequired = MR1 at Y = 35 = 8 − 0.16(35) = 2.40.
c. P1 = 8 − 0.08(35) = 5.20.
d. The firm will maximize profits when MC0 = MR1 . Thus, given 3 = 8 − 0.16 Y, profit-maximizing
Y = 31.25. Profit-maximizing price = 8 − 0.8(31.25) = 5.50. This assumes there are no menu
costs.
e. Given P0 = 6.50, we have: 6.50 = 8 − 0.08 Y. Thus, Y1 = 1.5/0.08 = 18.75.
f. Profit lost = Area A = (P0 − P1 )Y1 = (6.5 − 5.2)(18.75) = 24.375. Profits gained = Area B =
(Y0 − Y1 )(P1 − MC1 ) = (35 − 18.75)(5.2 − 2.4) = 45.50.
g. There is a maximal value for menu costs at which this firm would not change output. That value
cannot exceed the difference between A and B: 45.50 − 24.375 = 21.125.
h. No. The foregone profits are less than the menu costs incurred in achieving them. Menu costs
less than $22.00 may prevent the profit-maximizing firm from choosing the price and output
combination where MC0 = MR1 .