Class Week 7

Some words because this is the first wiki (I hope that many will follow): Please feel free to _edit_ and/or _expand_ this summary! I don't claim that everything is right or important. Maybe I've also forgot some important parts. It would also be nice to start a discussion (see discuss-button at the end of the page) about the article, assumptions, results, implications, etc.

Question

"small (second-order) costs of changing prices may lead to large (first-order) changes in output and welfare in response to changes in nominal money" (Blanchard and Kiyotaki, 1987, p.647)

Please come to the class prepared to present your explanation of the above statement.

Reading

Blanchard, Olivier and Stanley Fischer (1989), Lectures on Macroeconomics, Cambridge: MIT Press. Ch. 8.1 ("Price-setting under monopolistic competition").
Blanchard, Olivier and Nobu Kiyotaki (1987), "Monopolistic competition and the effects of aggregate demand", American Economic Review, 77 (4), 647-66.

Please feel free to refer to other sources of information related to the Blanchard-Kiyotaki model or to the statement.

I would recommend reading (at some point - not necessarily before the Class) the following papers which also relate to the idea in the statement:

Akerlof, George A and Janet L Yellen (1985) “Can small deviations from rationality make significant differences to economic equilibria?”, American Economic Review, 75 (4), 708-20.
Mankiw, N Gregory (1985), "Small menu costs and large business cycles: a macroeconomic model of monopoly”, Quarterly Journal of Economics, May 1985, 100 (2), 529-37.

Links

http://www2.warwick.ac.uk/fac/soc/economics/pg/modules/ec9012/details/#SemWk7

Summary

Assumptions

• Households and firms with separate labour and goods markets which are monopolistically competitive —> many firms each producing a differentiated good and many households each supplying a different labour skill
• Choice: buying good or holding money (avoid Say’s Law)
• CES in utility and consumption
• No dynamics

Firms

• Maximises profit s.t. production function taking wages and prices of the other goods as given (possible because large number of firms and households)

Households

• Maximises utility (derived from leisure, consumption and real money balances) s.t. budget constraint taking goods prices and other wages as given (possible because large number of firms and households)
• Two steps:
  1. Solve for allocation wealth » (consumption, leisure, money)
  2. Solve for level of labour supply and nominal wage (wage rule)

Model Mechanics

• Relation between real money balances and aggregate demand:
  • Desired real money balances are proportional to consumption expenditures
• Demand for goods
  • Function of the ratio of its nominal price to the nominal price index (Pi/P)
• Demand for labour
  • Function of the ratio of its nominal wage to the nominal wage level (Wi/W)
• Price Rule (firms set their prices accordingly)
  • Increase in W/P » marginal cost curve up » increase in relative price (Pi/P)
• Wage Rule (households set their wages accordingly)
  • Increase in W/P (real aggregate wage) » increase labour supply

• The real wage consistent with household’s behaviour (firm’s behaviour) is an increasing (decreasing) function of output. » find equilibrium there where both function cross

• Comparing to perfect competition: The equilibrium level of real money balances is lower in the monopolistic case; the price level is higher. Employment and output are lower. Effect on real wage not clear (depends on the degree of monopolistic competition in the two sectors; e.g. perfect competition labour market, monopolistic competition goods market » real wages lower as under perfect competition)

Aggregate Demand Externalities

• Monopolistic competition » amount of produced goods too low » possible alternative explanation: aggregate demand externality
• In monopolistic equilibrium no firm (worker) has an incentive do decrease prices (wages) and therewith to increase output
  • Decrease in all prices simultaneously: increases real money (M/P) and aggregate demand » demand increase reduces the initial distortion of underproduction and underemployment and increases social welfare

Menu Costs and Real Effects of Nominal Money

• Small costs of setting prices
• Small change in nominal money, dM, as a shock » changes in aggregate demand Y=K(M/P)
  • Firms would like to increase prices because of higher demand
  • Worker would like to increase wages because of higher demand of the firms (derived demand for labour increases through higher output demand)
  • Menu costs could lead to no price or wage changes if the change in M is small enough » prices and wages remain at the old level
  • The implication is that all nominal prices and wages remain unchanged, and that the increase in nominal money implies a proportional increase in real money balances (M/P)
  • Increase in real money balances has positive first-order effects on welfare

See Figure 3:

• decrease in prices lead to higher profits (E to E’). But no firm has an incentive to decrease prices given all others prices.
• increase in nominal money lead to the same movement (E to E’). Without menu costs the firms increase prices until they are back in E’ because of the increased demand.
• With menu costs they remain at E’ (because to changes in prices) and earn higher profits.

Larger changes in nominal money

• Large changes in nominal maybe overcome the small menu costs. It turns out that the effects than depends on the parameter of the model.
• The main conclusion however is that very small menu costs, say less than 0.08% of revenues, may be sufficient to prevent adjustment of prices.
• Welfare effects are very complex and depend on the model parameter and on the size of the change in nominal money.