Problem Set 7 - Solutions

The Keynesian Model

The four main assumptions in the Keynesian Model are: Prices are sticky. That is, they are not exible as in the classical model. This is one of the most important assumptions. The fact that prices are sticky introduces an important role for monetary policy: now the Fed can induce booms and recessions when they change the amount of money supply in the economy. This assumption is quite realistic; it is difcult that prices change instantaneously after a monetary policy shock. Empirical evidence suggests that it takes between 6 to 8 months for prices to adjust. There are various reasons: menu costs, competitive pressures, prices set in advance... The money market is always in equilibrium: this assumption is again quite realistic. The money market can change very fast. At least, faster than the output market: it is easier to change nominal interest rates (they can even change daily in the bank system) than to change production. Output is demand determined: this assumption might be the most controversial one. If demand determines output, this implies that during a boom, rms are producing more than they would like. In a classical economy, this would be impossible, since rms would make losses. In the Keynesian model, in order to support this assumption, we need to introduce monopolies (or monopolistic competition). However, it is true that in many sectors of the economy, there is no perfect competition (as in the classical world). So the introduction of monopolistic competition is realistic. Prices adjust at the following rate, P = (Y d Y s ). The interpretation is straightforward: when the demand is bigger than the supply, there is a friction in the economy, and rms would like to increase the price level.

Economics 3213 Answers to Problem Set 9: Beauty and the Beast

Prof. Xavier Sala-i-Martin
1. Beast
a. When the Fed prints more money, money supply increases, so that there is more money available in the economy. The Keynesian model assumes that (a) money market always clears; and (b) prices cannot adjust instantaneously. If this is the case, the only way the money market can clear is by increasing the money demand for the fixed level of prices (Diagram 1). If people choose to hold more money, interest rates must go down, so that alternative interest-bearing assets are less attractive. If prices are fixed in the short-run, nominal and real interest rates are equal: R = r. Hence, both nominal and real interest rates must go down as a result of monetary expansion. By the same token, real and nominal interest rates must go up if money supply is decreased.

b. Remember the formula for the money demand:

. If prices are fixed in the

short run, we can replace the nominal interest rate with the real interest rate: . Now we can express r as a function of Y and plot this expression in Diagram 2 with Y and r on the axes: . This liquidity-money (LM) curve represents all combinations of output and real interest rate that clear the money market. When the Fed increases the money supply and the price level is fixed in the short run, real interest rate decreases (Diagram 2). The LM curve shifts clockwise (Diagram 3). We assume that output is determined by demand in the short run. If firms are monopolistically competitive, i.e. there are many of them in each industry, but each product is slightly different from others, each firm optimally charges a price higher than its marginal cost. If the demand increases a little, each firm is still willing to supply this greater quantity because price is still above marginal cost. Therefore, the short run equilibrium is found at the intersection of the LM curve and the aggregate demand curve. In the short run, output is higher; real interest rate is lower; prices are fixed.

In the medium run, people demand more than firms are willing to sell at the lower interest rate. Prices start to go up (Diagram 2). The LM curve starts shifting back because people want to carry more nominal money when prices are rising (Diagram 3). In the medium run, output is declining; real interest rates are rising; prices are rising. In the long run, output and the real interest rate revert to the classical equilibrium at the intersection of aggregate supply and aggregate demand. Only prices are higher. c. The result in (b) is clearly different from the classical model. The key assumptions are the flexibility of prices in the classical model and price stickiness in the Keynesian model. When prices are flexible, everyone realizes that there is more money in the economy but the same amount of real goods. Hence, prices go up instantaneously, and there are no real changes. However, if prices are sticky in the short run, people can buy more for a while. Hence, real interest rates fall and real output increases. Money is neutral in the classical model and not neutral in the Keynesian model.

2. Lumiere
i. When the money supply decreases, the LM curve shifts counterclockwise (Diagram 4). Remember that the LM curve is given by . When M decreases, r increases for any value of Y. If output is supply-determined, both real interest rate and real output increase. In the medium run, output supplied is greater than output demanded at the higher interest rate. Prices start falling, and the LM curve starts shifting back. The initial equilibrium is reached in the long run.

ii. When money supply increases, the LM curve shifts clockwise. Both real interest rate and real output decrease. In the long run, they revert to the classical equilibrium, while the price level increases. iii. Changes in money supply affect real interest rate and real output; therefore, money is not neutral when prices are sticky and output is supply-determined. However, money affects output in the wrong direction. In this model, expansionary monetary policy decreases output, and contractionary policy increases output. This is clearly contradicted by empirical evidence. In reality, when the Fed increases the money supply (equivalently, when the Fed lowers the interest rate), real output usually increases for some time. When the Fed decreases the money supply (raises the interest rate), real output typically decreases.

3. Gaston
i. If output is determined by the short side of the market, then at any particular real interest rate, the minimum of aggregate supply and demand determine the actual output: Y = min{Y d, Y s} (solid lines in Diagram 5).

When money supply decreases, the LM curve shifts counterclockwise (Diagram 5). For r > r*, the short-run equilibrium is determined by the intersection of the LM curve and the aggregate demand curve. Real interest rate increases, and real output decreases in the short run. In the medium run, demand is less than supply; hence, prices go down. Real interest rate and real output return to the classical equilibrium; prices are lower in the long run. ii. When money supply increases, the LM curve shifts clockwise. For r < r*, the short-run equilibrium is determined by the intersection of the LM curve and the aggregate supply curve. Real interest rate decreases, and real output decreases as well in the short run. In the medium run, demand is greater than supply; hence, prices go up. Real interest rate and real output return to the classical equilibrium; prices are higher in the long run. iii. Money is still not neutral when prices are sticky and output is determined by the short side of the market. However, money affects output in the right direction only when money supply is decreased. In this model, both expansionary and contractionary policies decrease output. This is contradicted by empirical evidence because when the Fed increases the money supply (equivalently, when the Fed lowers the interest rate), real output usually increases for some time. To get consistent predictions in the Keynesian model, output must be demand-determined.

The cost of going to the bank

(a) In the Classical Model, a change in will only produce a change in the money market. Since the cost of going to the bank is smaller, people want to carry less money in their pockets. Then, the money demand curve will shift to the left in the money market, thus producing an increase in the price level. The equilibrium level of consumption, output and the real interest rate will remain unchanged. Changes in the money market are neutral in the output market. (b) In the Keynesian model, prices are xed in the short run. Then, if the money demand curve shifts to the left, at the initial price P , there is an excess of money supply in the economy. People will exchange money for bonds, thus reducing the interest rate. In the real market, the LM curve will shift to the right, since for any level of income the interest rate is Y going to be lower (remember that the LM curve is given by r = 2( M/ P)2 . If output is demand determined, this will induce a boom in the economy in the short run, so that output and consumption go up, and the real interest rate is lower. However, in the medium run prices can change, and since demand is higher than supply, the prices should start to go up slowly. This will also shift the LM curve slowly to the left. In the long run, we go back to the initial classical equilibrium but with higher prices.