Macroeconomics-II-English-Version-munotes

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1Chapter 1: Imperfectly Flexible Prices - I
Module 1
1 IMPERFECTLY FLEXIBLE PRICES - I
Unit Structure
1.0 Objectives
1.1 Introduction
1.2 Imperfectly Flexible Prices (Sticky Price)
1.3 Price -Setting under Imperfect Competition
1.4 Menu Cost
1.5 Summary
1.6 Questions
1.0 Objectives
• To know the Concept of Imperfectly Flexible Prices
• To know the reasons of imperfectly flexible prices
• To know how to price setting under imperfect competition
• To understand the concept of Menu cost
1.1 Introduction
Various economists have observed that fluctuations in the aggregate demand during
short run causes deviations in the output and employment from the potential GDP.
The classical and new classical economists advocated the view that it was because
of wage -price flexibility that changes in the aggregate demand leads to an
appropriate changes in the wages and prices, in such a manner that aggregate output
and employment level remains unchanged. Contrary to this Keynes and his earlier
followers assumed wages and prices to be rigid or sticky, because of this any
fluctuation in the aggregate demand did not affect wages and prices in the short run
but on the contrary this caused changes in the levels of output and employment.
The new classical economics is based on r ational expectations and raised doubts
on the validity of the assumption of price rigidity or stickiness of the traditional munotes.in

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2 MACROECONOMICS - II
Keynesian model and pointed out that it was not based on the firm foundations of
microeconomics which was based on the rational of p rofit maximizing principle.
The main element in the Keynesian model is that both the money wages as well as
the prices are sticky or slow to adjust to the changes in the economic conditions.
Now, here the question arises why are the prices sticky or slow t o adjust to the
changes in the economic conditions? With the help of microeconomic theory the
new Keynesians tried to explain the short run price stickiness and thus putting it on
firmer theoretical foundations. A number of models tried to explain the pri ce
stickiness which were based on the microeconomic principles and did make some
improvement over the traditional Keynesian model but they too fell within
framework of the earlier Keynesian model and are thus called New Keynesian
Economics or Models.
A maj or difference between the New Keynesian economics and the traditional
Keynesian model is that the New Keynesian economics is based on the imperfect
competition whereas the traditional Keynesian model assumes perfect competition
where the firm faces a horiz ontal demand curve. A horizontal demand curve in
perfect competition showed that the firm can sell as much quantity it likes to sell at
the prevailing price which is determined by the forces of demand and supply for
that commodity. However, a downward slop ing demand curve of an imperfectly
competitive firm implies that any price cut by the firm will lead to some increase
in its sales but rival firms will too follow the suit and are likely to cut their prices
too, so it may not be a profitable idea to change or adjust prices. The new Keynesian
models are based on the optimal behaviour of firms working rationally.
1.2 Imperfectly Flexible Prices (Sticky Price) The major feature which distinguishes neoclassical macroeconomics from Keynesian macroeconomics is th e assumed speed of price adjustment. The neoclassical models assume that the prices are perfectly flexible and instantaneously adjust to clear goods, labour and money markets. On the other hand
Keynesian macroeconomics models assume that the prices are sti cky or even fixed,
and as a result at best, they adjust to clear markets only slowly or at worst they fail
to clear markets at all, leaving either permanent excess demand (shortages) or
excess supply (unemployment).
New Keynesian economists along with Prof. Mankiw went on to explain that under
imperfect competition in the product market for example Oligopoly, Monopolistic
Competition etc. When there is a decrease in the aggregate demand the firms try
to keep their pr ices constant i.e. sticky. Firms face a downward sloping demand munotes.in

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3Chapter 1: Imperfectly Flexible Prices - I
curve under imperfect competition. If there is a fall in the aggregate demands in the
economy which can be due to a contraction in t he money supply in the economy,
then also the firms under i mperfect competition would not reduce their prices in
the process it may lose some of its clients or customers but not all of them. For
example when there is a decrease in the aggregate demand which result in a decline
in the demand for Tata automobiles, t hen the Tata Motors company can still
continue to sell its cars at the previously high prices and may not lower the prices of the same, that is prices may remain sticky in the face of decrease in demand. Elaborating on this point Richard Froyen ( Macroecon omics, 6th edition, 1999, p.
62) writes “Monopolistic competitors and oligopolies have some control over the
price of their products. In fact, the incentive to lower prices may be fairly weak for
those types of firms. If they hold to their initial price wh en demand falls, they will
lose sales, but the sales they retain will still be at the relatively high initial price.
Also, if all firms hold to the initial price, no individual firm will lose sale”.
However, it may be noted here that even under imperfect competition market
conditions, that when the demand for a product decreases, a firm gains or benefits
from lowering the prices. As the firms under imperfectly competitive market face
a downward sloping demand curve, a reduction in the price by the firm wil l increase
the quantity demanded of the product, this is turn may lead to some gain in profits.
This gives rise to a big question that why don’t the firms lower their price when
there is a decline in the aggregate demand?
1.2.1 Reasons for Imperfectly flex ible prices or Sticky Prices
The two important reasons have been given for sticky prices by the new Keynesian
economists. They are
1. The price paid by the firm or the cost borne by the firm for not adjusting
prices is the potential loss of consumer’s goodwill. The consumer’s goodwill
is also lost when the firm raises its prices. The customers don’t mind or rather
understand when the pri ces raised by the firms are mainly due to rising cost.
However, customers don’t like the change in the price made by the firm due
to change in the demand for their product. It is mainly because of this reason
that the firms prefer to keep the prices sticky .
2. The other aspect of perceived cost of price cutting during recession it that it may lead to higher price cuts by the rival companies and which may ultimately leads to a price war which harms every firm. These price cutting
responses become more relevant in case of oligopolistic markets where the
rival firms keep an eye on the pricing decisions of their rival firms. munotes.in

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The price stickiness will depend upon the cost of price adjustment, if the price
adjustment costs are high enough , then the price stickiness w ill be there. This
implies that the price will not adjust or response to changes in aggregate demand,
or to the fluctuations in demand causing business cycles, whether it is recession or
boom in the economy.
1.2.2 Imperfectly Flexible Price Model in Mathematical Form
Here, it is assumed that an economy has large number of firms, each having some monopoly power, like firms working under monopolistic competition and oligopoly have some monopoly power over its product. Here let Y i represe nt the
demand of each firm, P i is the relative price of the product of a firm to the overall
price level (P) and Y is the aggregate demand for the product. The demand function
for each firm’s product can be written as
Yi = (P i / P) – e Y e > 1 …………. (1)
The above equation ( 1) shows that the demand for the firm’s product depends on
its relative prices (Pi/P) price elasticity of demand (e)
and the aggregate demand (Y).
In order to simplify the model Mankiw has assumed that the real aggregate demand
(Y) is determined by the real money supply, that is, Y = M / P. Substituting M / P
for Y in equation (1) we have
Yi = (P i / P) – e. M / P …………. (2)
The equation (2) shows us that the demand situation which a firm faces depends on
its relative price to the overall price (Pi / P) and real money supply (M / P) which
determines aggregate demand. Besides this , the relative price of a firm also
determines its relative position on the given aggregat e demand for the product.
An imperfectly competitive firm fixes it price by adding a mark -up over its
marginal cost. Thus,
Pi = e W
e -1 MP L …………. (3)

Where, W / MP L is marginal cost and e / (e – 1) is the mark -up. A firm’s profit
which is represented by π can be obtained by multiplying the amount of output
demanded and sold by the difference between price and the marginal cost.

Profit (𝜋𝜋) = P i – (W / MP L) Y i …………….. (4) munotes.in

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5Chapter 1: Imperfectly Flexible Prices - ISuppose there is a decrease in the aggregate demand, which is due to decrease in the nominal money supply, with price Pi remaining the same. In terms of equation (2) with the fall in M, demand for output of each firm, Y 1 will decline which will
result in recession, price of each firm remaining unchanged.
The firms will have to reduce their prices in order to maintain output level when
there is fall in the demand. When the firm facing a downward -sloping downward
demand curve reduces its prices then it will lead to increase in sales and profits.
However, accord ing to Mankiw, price adjustment by a firm would yield only
second order gain and even small menu costs exceed it. Therefore, the firm will not
adjust i.e. cut prices. If the average price level does not get adjusted to the new
reduced demand conditions for output, the recession will occur in the economy.
With this reduced output (Y) of the firm, the profits as measured by equation (4)
will fall.
When Mankiw compares menu cost of price adjustment, potential gain fro m price
cutting will be very small, that i s, of second order under the following two
conditions:
1. The potential gain of making price adjustment is very small when the
difference between the existing price and profit maximizing i.e. optimal price
is small.
2. A firm dealing in a product having a low-price elasticity of demand, the
increase in profit is less sensitive to adjusting price to the exactly new profit -
maximizing level.
Here, it may be highlighted again that the firms don’t adjust their prices when
they are facing changes in the demand because when they are taking pricing
decisions, they don’t take into account the external demand benefits of adjusting
prices. It is becau se of this, that the overall price level (P) and the relative prices
of the firms remain unchanged. Thus, the fall in the aggregate demand leads to a
reduction in the output i.e. recession.
Check Progress
1. What do you understand by imperfectly flexible prices?
2. What are the reasons of imperfectly flexible prices or sticky prices?
3. Explain imperfectly flexible price model in mathematical form .
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References: Macro Ec onomics by Dr. H. L. Ahuja
1.3 Price -Setting Under Imperfect Competition
Gregory Mankiw and some other Keynesian economists are of the opinion that not
adjusting prices in the time of a fall in the aggregate demand would lead to
recession. During recession, both output level and the employment level are quite
low, large number of factories don’t work or work below capacity. When a society
fails to attain its potential GDP and full employment level which is socially
desirable, it implies that the members of the society have failed to co -ordinate
among themselves in some way or th e other. This co -ordination problem is relevant
and important in the explanation of stickiness of the prices of the firms which is set
them anticipating the actions of rivals. While fixing the prices one firm anticipates
what price the other firm will set, but still their decisions are based on uncertainty
about what prices the other firms will charge.
Let us now see how the price stickiness leads to recession which is mainly due to
the failure of co -ordination between the rivals when the aggregate demand
decreases. We consider that in the economy there are two firms, firm A and firm B
which implies that there is an oligopoly market. When there is decrease in the
aggregate demand which let’s say is due to fall in the money supply, now each firm
will have to take a decision whether it should cut its price to achieve profit
maximization, or should it keep its price at the existing high level. However, it is
worth noting out here that firm’s profit depends not only on its own price decision
but also on the prici ng decision of the other firms. We can explain this with the
help of the following table which represents pay -off matrix of two firms of various
combinations of pricing decisions of the two firms.
Table No. 1.1 Pay off Matrix
(In Crores) Firm A Firm B Cut Price Keeping Price high Cut Price Firm A’s Profit: 50 Firm B’s Profit: 50 Firm A’s Profit: 10 Firm B’s Profit: 25 Keeping Price high Firm A’s Profit: 25 Firm B’s Profit: 10 Firm A’s Profit: 20 Firm B’s Profit: 20
It can be seen here that both the firms decide to keep the prices at the current high
level where each of the firms will make a profit of Rs.20 cr. (see right hand side munotes.in

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7Chapter 1: Imperfectly Flexible Prices - I
bottom box) without anyone of them opting for price cutting. In such a situation
becaus e of price stickiness there will be a fall in the output as well as the
employment level in the economy which will ultimately lead to recession. If on the
other hand, if both the firms decide to cut their prices, then each firm will make a
profit of Rs.50 cr. This will not only increase the profits of the two firms
individually but will also lead to social optimum. This will happen because as the
prices are reduced by both the firms it will lead to fall in the overall price level
which will ultimately stimulate aggregate demand. So in such a case recession
would not occur.
Further, if firm A cuts its price, while the firm B keeps its price at the existing high
level, firm A’s profits are Rs. 10 crores while firm B’s profit are 25 crores. (See
right -hand side upper box of the table). When firm B does not cut its price in
recession firm A’s profits are much lower, one because of lower output and
secondly due to lower price. Similarly, if firm B cuts its price but firm A Keeps its
price at the existing high level, firm A’s profits are 25 crores and firm B’s profits
are Rs. 10 cr ores (see bottom box of left -side of payoff matrix of the table). None
of the firms would prefer recession, but to avoid recession, both of them need act
together. A decision taken by one firm will affect the earning opportunities
available to the other fi rm. When the firm reduces its price, it is beneficial for others
also this happens because of beneficial aggregate demand externality (due to higher
profits) earned by it . As both the firms are ignoring this beneficial externality, this
will lead them to r ecession as there is no co -ordination between them.
It is obvious, that each firm will expect the other firm to reduce its price, so both
firms will reduce their prices which will be desirable not only from individual point
of view but from the point of v iew of the society as well, as these reduction in prices
by the firms will lead to reduction in the overall price level which will enable them
to avoid recession in terms of both employment and output. On the other hand, if
each firm expects that the other will keep its price at the present high level both
will keep prices unchanged at the present relatively high level. This ultimately leads
to recession, which is neither good for the individual firms no r for the society as a
whole . Anyone of the two results can be true however; the new Keynesian
economists think that the second inferior outcome, that is, no reduction or
adjustment in prices which will lead to recession has more chances because of
coordin ation failure. Thus, Gregory writes (Gregory Mankiw, Macroeconomics, 6th
edition, p.512.) , “If the two firms could coordinate, they would both cut their price
and reach the preferred outcome. ” However, in the real life situation co -ordinated
effort is diff icult as the number of firms setting the prices is very large. From this munotes.in

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we can conclude that prices are sticky mainly because of people’s expectations,
although stickiness is not good for anyone.
1.4 Menu Costs
It has been argued by the New Keynesian economists that menu costs are the reason
for price stickiness. Business cycles can result due to price stickiness, the sub -
optimal adjustment of prices in response to demand shocks. Gregory Mankiw in
his article “Small Menu Costs and Large Busin ess Cycles: A Macroeconomic
Model of Monopoly ” in 1985 presented that sticky price can be both individually
effective but ineffective when it comes to public . It has been pointed out by Mankiw
that, even small menu costs can cause large welfare losses.
One of the main reasons according to Mankiw and other Keynesian economists that
the firms do not want to alter their prices when there is change in the demand for
their products is that they have to incur costs for making adjustment in prices when
demand for their products changes is that they have to incur costs for making
adjustment in prices. To change prices, a firm has to print a new catalogue and send
it to its customers, distribute new price list among its sale staff. Such costs of
making price adjustme nts are called Menu Cost. This term came into existence
from the practice of restaurants. When restaurants alter their prices, they will have
to print new menus and incur cost on it.
According to New Keynesian economists and Mankiw the firm will only change
its price when the advantages or gains by changing the prices over weigh the costs.
However, there were some economists who were doubtful about this point of view
kept forward by the new Keynesian economists. The new Keynesian economists
have pointe d out that menu costs are quite trivial and therefore they cannot explain
stickiness of price in the face of decrease in aggregate demand. They questioned
how recession which occurred due to price -stickiness and proved very costly for
the entire economy wa s explained by small menu costs. But Mankiw ( N. Gregory,
Macroeconomics, Worth Publishers 6th edition, 2003, p.510 ) has argued that “small
does not mean inconsequential, even though menu costs are small, they can have
large effects on the economy as a whol e”.
A static model of a monopoly firm’s pricing decision was used by Mankiw, which
sets its price in advance and changes it ex post, by paying a small menu cost. A
monopoly firm faces an inverse demand function and a constant cost function.
C = kqN
Where,
C = T otal nominal cost of production
q = Q uantity produced munotes.in

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9Chapter 1: Imperfectly Flexible Prices - I
k = C onstant
P = f(q)N
Where,
P = N ominal price
Nominal scale variable is represented by N, which represents the exogenous level
of aggregate demand. It can be believed to be an overall price level. C and P both
increase proportionally to N that is the level of nominal demand.
Now, let C = C/N and P = P/N which turns the firm’s problem independent of the
aggregate demand.
C= kq
P = f(q)
The figure below represents the producer’s surplus (profit earned by the firm)
which is equal to the rectangle between point K and Pm. While on the other hand,
the excess utility enjoyed by the consumer over the price paid represents the
consumer’s surplus, which is represented by the triangle above. The s um of both
consumers’ surplus and producers’ surplus represents the total surplus.
The firm needs to set its price one period ahead based on expectations about future
aggregate demand, being this price P mNe. If expectations are correct ex - post, the
observ ed price p 0 is p m. Otherwise; the observed price is P m (Ne/N).
Figure No. 1.1

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1.4.1 First scenario
The first case Mankiw examines is when aggregate demand N is lower than
expected, and therefore p 0 is higher than P m, as shown in the figure below. The
producer surplus is lowered by B -A (since profits as seen before were equal to
rectangle B plus the rectangle to its left), which is positive because P m is by
definition the profit -maximising price. Social welfare (or total surplus) is reduced
by B + C, an d therefore the reduction in welfare due to the contraction in aggregate
demand is larger than the loss in the surplus of the firm.
Figure No. 1.2


Now, let’s suppose that the firm is capable of changing its price ex -post, at a menu
cost of z. The firm can then reduce its price from P 0 to P m and obtain additional
profits of B - A, which the firm will do if B - A > z. However, from the point of
view of a social planner, the firm should lower its price if and only if B + C > z.
Let’s see Mankiw’s prop ositions on different outcomes:
• Proposition 1. If the firm reduces its price after a contraction in demand then
doing so is social optimal (if it reduces the price, is because B – A > z and
therefore B + C > z + A + C > z)
• Proposition 2. If even after a contraction in demand if the firm does not
reduce its price to P m then B + C > z > B + A, even though it is socially
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11Chapter 1: Imperfectly Flexible Prices - Ioptimal (the ineffectiveness results which is because printing new menu results in an external benefit of C + A)
• Proposition 3. As the aggregate demand contract then there is reduction in
social welfare unambiguously, this is shown b y the sum of the producer’s and
consumer’s surplus. If the price is reduced by the producer , then the
contraction only has the menu cost z. If the firm does not cut its price, then
the contraction has the cost of B + C (probably much larger than z).
1.4.2 Second scenario
The second case Mankiw analyses is an expansion in aggregate demand (N > Ne),
and therefore P 0 < P m. Firstly, let’s see what happens when P 0 > k (N/Ne < P m / k),
as shown in our third figure. In this case, producer surplus is reduced by D - F,
which is positive (P m maximises the firm’s profits) and social welfare increases by
E + F. A new price will be set by the firm if the increase in their profits is more
than the menu cost. In other words, the firm will change its price if D - F > z.
Figure No. 1.3

• Proposition 4. Social welfare will decrease by the menu cost , if there is an
expansion in demand and if the firm resets its price . If it doesn’t, total surplus
increases by E + F.
1.4.3 Third scenario
Now, let’s see what happens if N / Ne > P m / k, and therefore P 0 < k. Then, social
welfare decreases by a positive or negative amount of I - J, which makes for an
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uncertain welfare effect. The firm’s profits, which are now negative, have been
reduced by G + H + I. If G + H + I > z, then the f irm will reset its price to P m. Doing
so would be socially optimal if I - J > z.
Figure No. 1.4

• Proposition 5. Social welfare (total surplus) will decrease by the menu cost
z if the firm resets its price following the expansion in demand. Total surplus
does not decrease by more than the menu cost (if the firm doesn’t reset its
price is because G + H + I < z, whic h implies that I - J < z – J – G - H < z and
therefore the social welfare reduction I - J < z).
• Proposition 6. When there is an expansion in the aggregate demand it may
either lead to an increase in the welfare or may reduce it, but such an increase
or red uction will never be more than the menu cost. While a contraction in
the aggregate demand will decrease the welfare, this reduction in welfare will
be more than the menu cost.
In order to defend his point of view Mankiw took the help of aggregate demand
externality. He stressed the point that if there are beneficial externalities to price
adjustment by any firm then that needs to be recognized. When the price reduction
by one firm benefits the other firms as well it is called beneficial externality effect.
If a high price charging firm reduces its price, then this in turn will result in slightly
lower average price level which in turn will lead to an expansion in the aggregate
income by causing a rightward shift in the LM curve. As there is an expansion in
the aggregate income this will lead to the benefi t of other firms as it will have a
positive impact on the demand for their products. Since this benefit’s other firms
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13Chapter 1: Imperfectly Flexible Prices - I
too, it is called aggregate demand externality. However, according to Mankiw this
benefit is external to the firms hence they ignore it co mpletely while taking their
price making decision for their products. To quote Mankiw, “The firm makes
decision by comparing the benefit of a price cut – higher sales and profits – to the
cost of price adjustment. Yet because of the aggregate demand extern ality, the
benefits to society of the price cut would exceed the benefits to the firm. The firm
ignores this externality when making its decision, so it may decide not to pay the
menu cost and cut its price even though the price cut is socially desirable. Hence
sticky prices may be optimal for those setting prices, even though they are
undesirable for the economy as a whole”.
1.4.4 Conclusion
So all in all we see that Mankiw demonstrated that when aggregate demand expands
private incentives ensure high pric e adjustment however the adjustment is small
when there is a contraction in the aggregate a demand . Social planner presented
their view by pointing out that prices may be stuck too high, but never too low,
which points out the downward price stickiness, al though not into an upward
rigidity. However, Mankiw also pointed out to a more complete model (general
equilibrium) which according to him will probably show higher degrees of price
stickiness, since inter firm purchase will sharpen price rigidity. Therefo re, we can
conclude that small menu costs could mean large inefficiency effects which would
certainly remain in a general equilibrium.
As far as the economic policies are concerned there is a requirement to alleviate
these problems, Mankiw explains how an active monetary policy is required.
Especially , he makes a mention of policies that aim at the pricing mechanism, such
as tax -based incomes policy and other supply -side policies.
Check Progress
1. What do you understand by price setting under imperfect competition?
2. Explain price setting under imperfect competition with the help of example.
3. What do you understand by Menu Cost?
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References: Macro Economics by N. Gregory Mankiw munotes.in

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1.5 Summary
1. A downward sloping demand curve of an imperfectly competitive firm
implies that any price cut by the firm will lead to some increase in its sales ,
but rival firms will too follow the suit and are likely to cut their prices too, so
it may not be a profitable idea to change or adjust prices.
2. As the firms under imperfectly competitive market face a downward sloping
demand curve, a reduction in the price by the firm will increase the quantity
demanded of the product, this is turn may lead to some gain in profits.
3. The price paid by the firm or the cost borne by the firm for not adjusting
prices is the potential loss of consumer’s goodwill.
4. The other aspect of perceived cost of price cutting during recession i s that it
may lead to higher price cuts by the rival companies and which may
ultimately leads to a price war which harms every firm.
5. The price stickiness will depend upon the cost of price adjustment, if the price
adjustment costs are high enough, then the price stickiness will be there. This
implies that the price will not adjust or respon d to changes in aggregate
demand, or to the fluctuations in demand causing business cycles, whether it
is recession or boom in the economy.
6. A firm dealing in a product having a low price elasticity of demand, the
increase in profit is less sensitive to adjus ting price to the exactly new
profit -maximizing level.
7. The fall in the aggregate demand leads to a reduction in the output i.e.
recession.
8. The price stickiness leads to recession which is mainly due to the failure of
co-ordination between the rivals when t he aggregate demand decreases.
9. To change prices, a firm has to print a new catalogue and send it to its
customers, distribute new price list among its sale staff. Such costs of making
price adjustments are called Menu Cost.
10. The firm makes decision by compa ring the benefit of a price cut – higher
sales and profits – to the cost of price adjustment. Yet because of the
aggregate demand externality, the benefits to society of the price cut would
exceed the benefits to the firm.
11. Sticky prices may be optimal for those setting prices, even though they are
undesirable for the economy as a whole”. munotes.in

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15Chapter 1: Imperfectly Flexible Prices - I
1.6 Questions
Q1. Explain in detail about imperfectly flexible prices and what are the reasons
of sticky prices?
Q2. Explain imperfectly flexible price model in mathematical form.
Q3. Explain price -setting under imperfect competition.
Q4. Explain in detail the concept of menu cost.

™™™™™™™
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Module 1
2 IMPERFECTLY FLEXIBLE PRICES - II
Unit Structure
2.0 Objectives
2.1 Introduction
2.2 Real Rigidity
2.3 Quadratic Price Adjustment
2.4 Summary
2.5 Questions
2.0 Objectives
• To know the Concept of Real rigidity
• To know the quadratic price adjustment
2.1 Introduction
In macroeconomics, rigidities are real prices and wages that fail to handle to the
extent indicated by equilibrium or if something hold one price or wage fixed to a
relative value of another. Real rigidities are often distinguished from nominal
rigidities, rigidities that don't adjust because prices are often sticky and fail to vary
value whilst the underlying factors that determine prices fluctuate. Real rigidities,
alongside nominal, are a key a p art of new Keynesian economics. Economic models
with real rigidities cause nominal shocks (like changes in monetary policy) having
an outsized impact on the economy.
2.2 Real Rigidity
Large class of business cycle propagation mechanism are referred to as real
rigidities. Real rigidities are the essence to any successful explanation of business
cycles.
2.2.1 The definition of real rigidities
Let us suppose an economy that is at its flexible -price equilibrium, now suppose
the money supply is increased with prices unchanged, so that the aggregate output
increases. Now here, the question arises that how much a representative firm would munotes.in

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17Chapter 2: Imperfectly Flexible Prices - II
want to increase its price if it faces no barriers to nominal price adjustment? Going
by the definition , the firm would want to increase its price by a smaller amount in
response to a given increase in aggregate output, the greater is the degree of real
rigidity.
2.2.2 Diagrammatically Representation of Real Rigidity
Now the question a rises that whether small frictions can lead to nominal
disturbances which in turn can have large effects on aggregate economic activity
which depends on the incentives that the individual firms gets to change their prices
when aggregate output changes. For example, consider that there is an overall
decline in the output in the economy. Here, the challenge which the firm faces is
that when the demand for its product declines as a result of the fall in the aggregate
production is whether it should continue wi th its current prices and reduce its
output, or should it lower its price and thereby maintain its original level of output.
This issue can be analysed using the marginal revenue -marginal cost diagram in
Figure 2.1͘
Figure No. 2.1

In the beginning the economy is in the equilibrium, thus the firm’s production level
is at the point where its marginal cost is equal to its marginal revenue which is
represented by Point A in the diagram. With a contraction in the output of the whole
economy, th e output shifts the demand curve of the firm – at a given price, demand
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18 MACROECONOMICS - II
for the firm’s product is lower. Thus, marginal revenue shifts in. If on the other
hand, if the firm does not change its price, its output is determined by demand at
the existing price that is point B. Over here, marginal revenue is greater than the
marginal cost, so the firm has an incentive to reduce its price and increase its output.
Now, when the firm changes its price, it produces at a point where marginal cost is
equal to marginal revenue that is at point C. The additional profits to be gained
from reducing price and increasing quantity produced is represented by the area of
the shaded triangle in the diagram.
A crucial point is highlighted in the diagram that is the firm’s incenti ve to reduce
its price may be small even if it is greatly affected by the fall in the demand for its
product. The firm would certainly prefer to face the original and the higher demand
curve, but however, now it can only choose a point on the new demand cu rve. The
firm may find that the gains from reducing its price are small even though the shift
in its demand curve is large.
If the gains to the firm from cutting its price are indeed small, the behaviour of
many such firms facing small frictions in price adjustment can cause an aggregate
demand disturbance to have large real effects. Let us assume that the decline in the
money supply is causing the underlying disturbance or there is some other adverse
aggregate demand shift, and let us further assume that provisionally the firms do
not cut their prices in response to such disturbance. In this situation, aggregate real
output fal ls. The figure shows the situation faced by the representative firm. If the
representative firm's incentive to adjust its price is small and there are frictions in
price adjustment, then firms' conjectured behaviour of holding their prices fixed is
indeed equilibrium. However, if there is a huge incentive for price adjustment then
all the firms will cut their prices, and the final result will be negative aggregate
demand shock which will only result in lower prices.
An incentive of the firm to change its price in response to the decrease in demand —
the size of the triangle in Figure 1 —is determined by the responses of marginal
revenue and marginal cost to the downturn in aggregate demand. Take marginal
cost first. Since less output is being p roduced, less labour is demanded. With an
upward -sloping labour supply curve, this implies a decline in the real wage, and
hence in marginal cost. The cyclical behaviour of marginal cost also depends on
the degree of short -run diminishing returns to labour ; if the marginal product of
labour rises quickly as labour input declines , the marginal cost curve is sheer (steep)
even if the real wage is unchanged . The greater the marginal cost declines when
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19Chapter 2: Imperfectly Flexible Prices - II
Now consider marginal revenue. The greater the shift in marginal revenue curve to
the left, the smaller the firm's incentive to lower its price. The size of the shift of
the marginal revenue curve depends on the cyclical behavio ur of the elasticity of
demand. In the figure, the demand elasticity faced by the firm at its existing price
is assumed not to change when aggregate output changes. In this case, marginal
revenue at the existing price (which now corresponds to a lower level of output) is
not affected by the change in economy -wide output. If the elas ticity of demand at
the existing price decreases when aggregate output declines, the shift in marginal
revenue is larger; if the elasticity rises, the shift is smaller.
The framework set out in Figure 1 can be used to prove that simply adding
imperfect com petition and small barriers to price adjustment to the majority world
view of the 1950s and 1960s is not sufficient to deliver a microeconomic basis for
the view that aggregate demand shocks are central to economic fluctuations. The
source of the difficult y lies in the labour market. If labour supply is relatively
inelastic —surely the usual view 20 years ago, and probably the prevailing view
today —and if there are no departures from Walrasian assumptions aside from the
presence of small hurdles to nominal a djustment, then the decline in labour input
associated with the decline in production leads to a large fall in the real wage.
In this case, marginal cost declines significantly in recessions. As a result, unless
the elasticity of demand also falls substant ially, firms' incentives to reduce prices
are large. Back -of-the-envelope calculations for a simple model in which imperfect
competition is the only departure from Walrasian assumptions show that if labour
supply is relatively inelastic, firms' inducements to change their prices in the face
of aggregate demand movements of a few per cent swamp any plausible barriers to
nominal adjustment (Ball and Romer, 1990).
Thus, if the classical dichotomy is to fail, it must be that marginal cost does not fall
sharply in response to a demand -driven output contraction, or that marginal revenue
does fall sharply, or some co mbination of the two. At a more general level, the
incentive to change price in response to a change in economy -wide output can be
expressed as a funct ion of two factors: the impact of the change on the firm's profit -
maximizing real price, and the cost to the firm of a given departure of its real price
from the p rofit-maximizing level. For the incentive for adjustment in the face of
demand -driven fluctuations to be small, either profit -maximizing real price must
respond little to changes in aggregate output —in the terminology of Ball and
Romer (1990), the degree of "real rigidity" must be high —or considerable departure s from profit -maximizing prices must have only small costs. In the si mple
model discussed above, the large changes in real wages in response to a ggregate
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20 MACROECONOMICS - II
output —that is, real rigidity is low —and so the incen tive for adjustment is large.
Both a smaller cyclical sensitivity of marginal cost and a larger cyclical sensitivity
of marginal revenue increase real rigidity, and thus reduce firms' incent ives to
adjust their prices. In short, a complete model of large r eal effects o f nominal
disturbances requires both nominal frictions and real rigidities.
Thus, if the classical contradiction is to fail, it must be that marginal cost does not
fall sharply in response to a demand -driven output contraction, or that margina l
revenue does fall sharply, or some combination of the two. At a more general level,
the motivation to change price in response to a change in economy -wide output can
be expressed as a function of two factors: the influence of the change on the firm's
profit-maximizing real price, and the cost to the firm of a given withdrawal of its
real price from the profit -maximizing level. For the incentive for adjustment in the
face of demand -driven fluctuations to be small, either profit -maximizing real price
must r espond little to changes in aggregate output —in the terminology of Ball and
Romer describes the degree of "real rigidity" must be high or considerable
departures from profit -maximizing prices must have only small costs. The large
fluctuations in real wage s in response to aggregate output movements cause profit -
maximizing prices to be very responsive to output —that is, real rigidity is low —
and so the inducement for adjustment is large. Both a smaller cyclical sensitivity
of incremental cost and a bigger cyc lical sensitivity of marginal revenue increase
real rigidity, and thus reduce firms' incentives to regulate their prices. In short, a
complete model of great real effects of nominal disturbances requires both nominal
frictions and real rigidities.
2.3 Quad ratic Price Adjustment
2.3.1 Introduction
Higher competition among firms is mostly seen to put downward pressure on the
price level. But in the presence of resistances on nominal price adjustments, the
effects for short -run dynamics of inflation are unclear. Furthermore, the reaction of inflation and output to shocks may depend on the prevailing competitive environment. We uses the standard New Keynesian framework based on
optimising behaviour of monopolistica lly competitive firms which face constraints
on nominal price adjustments to examine these issues. It shows that expectations
about firms’ price -setting behaviour in the face of a structural change in competition determine the consequences for inflation dy namics and valuation of
‘cost -push’ or mark -up surprises .
In the New Keynesian context , the Dixit and Stiglitz (1977) elasticity of demand
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21Chapter 2: Imperfectly Flexible Prices - II
related to the preferred mark -up over cost that firms want to charge for their
product. A higher substitutability between goods involves a higher level of
competition among firms and a lower desired mark -up (a reduction in firms’ pricing
power). A structural increase in competition among firms relates to a one -off rise
in the elasticity.
We consider modelling price -setting behaviour that are commonly used as micro
foundations for the New Keynesian Phillips Curve (NKPC) within this framework.
A model is convenient ways to describe firms’ pr icing behaviour in the goods
market.
2.3.2 The Concept of Quadratic Price Adjustment Cost
The Rotemberg (1982) ‘quadratic price adjustment cost’ model (the R model) in
which firms compare the profit loss from letting the desired nominal price move
away from actual price with the cost of price adjustment. They choose the price in
a way that minimises the two costs.
Higher competition in the R model raises the slope of the Phillips curve. The
purpose is that in the occurrence of quadratic adjustment costs, each firm’s pricing
decision contains reducing profit loss from not charging the preferred price today
and in the future. As the elasticity of demand rises and the economy come closer to
perfect competition, not only does the level of preferred mark -up decrease but also
varying prices turn into moderately cheaper. The last happens due the size of
optimum price adjustment decreases . This effect encourages price elasticity in the
R model and raises the slope of the Phillips curve.
When modifying prices a firm may not want a big difference in its price comparative to the average price so as not to lose market share. This concern for
prospective market stake loss means that relative prices can be rigi d or ‘real
rigidity’ can prevail in the goods market as explained by Ball and Romer (1990)
and Kimball (1995). Market share loss is bigger when the elasticity of substitution
between goods is high, that is, when the degree of competition among firms is hig h.
A higher competition suggests greater real rigidity and increases inactivity in price
adjustments. This effect declines the slope of the Phillips curve. More clearly, for
understanding the concept of quadratic price Adjustment we can explain the new
Keynesian model and the Rotemberg (R) model.
(i) The New Keynesian model
Consider an economy with a representative household at time t that maximises a
discounted sum of expected utilities:
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(1)
Subject, to the standard budget constraint. The parameter ȕ is the subjective
discount factor
Dixit -Stiglitz constant -elasticity of -substitution consumption index, Ct(i)
represents consumption of the ith good, Ht (i) is the supply of type -i labour to the
production of good of variety i, ı!0 is the intertemporal elasticity of substitution
of aggregate expenditure, Ɏ is the disutility of labour. For our purpose, the relevant
utility -maximising condition is the intratemporal condition of the choice of labour
supply of types i:
(2)
Where
is the price index. Wƚ;ŝͿis the wage rate per unit labour of types ŝ.
On the supply side, firms operate in a monopolistically competitive market and are
uniformly distributed on the interval [0 ; 1]. Each firm i faces a demand curve, Yt(i),
(3)
Where,
LVDJJUHJDWHGHPDQG3WLLVWKHSULFHRIILUPL¶VJRRGDQG Ɏt is the time -varying
elasticity of demand for firm i that fluctuates around its steady -state level Ɏ. Firm
i produce output using a technology
Yt (i) = H t (i)Į, 0 < ܤ ” (4)
Where Ht (i) is the labour input and Į is the elasticity of output with respect to
ODERXU:HLPSOLFLWO\DVVXPHWKDWFDSLWDOVWRFNLVµILUP -VSHFLILF¶DQGFRQVWDQWRYHU
time.
(ii) The Rotemberg (R) model: quadratic cost of nominal price adjustment
Following Rotemberg (1982), each firm faces a quadratic cost of nominal price
adjustment, measured in terms of the final good and given by
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23Chapter 2: Imperfectly Flexible Prices - II
(5)
Where c 努 0 determines the magnitude of the price adjustment cost and ߨ 努 1 is
the gross steady -state inflation rate. Given (3), (4), (5), and wages in the labour
market, a firm chooses a sequence for Pt(i) to maximise the expected sum of future
discounted profits.

(6)
Where is the stochastic discount factor. In a symmetric
equilibrium the optimal price P t* is the same for all firms, P t*(i) = p t . In addition,
Ht(i) = Ht, Yt(i) = Yt, Wt(i) = Wtand the aggregate resource constraint is
(7)
Where ʌt = Pt / Pt-1 is the gross inflation rate. The first -order condition for (6) can
be written as

(8)
Where ̭t is the mark -up over the marginal cost,
In (8), there are two terms in the denominator of the mark -up, ̭t
The first term, øt / (øt -1), represents the mark -up and the second term

Represents the net cost associated with price adjustment. When there is no price
stickiness (c = 0), the mark -up is the same as the desired mark -up, ¡t / (øt - 1).
References: Advanced Macro Economics by David Romer
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24 MACROECONOMICS - II
2.4 Summary
1. Rigidities in real prices aren’t adequate to form rigidities in nominal prices
and real effects of nominal shocks.
2. Little frictions in nominal adjustment, like costs of changing, prices, create
only small non -neutralities.
3. However, substantial nominal ri gidity will arise from a mixture of real
rigidities and small nominal frictions.
4. The linking between real and nominal rigidity given the presence of nominal
frictions both in general and for several specific sources of real rigidity like
price of adjustin g real cost and wages efficiency .
5. The Rotenberg ‘quadratic price adjustment cost’ model (the R model) in
which firms compare the profit loss from letting the desired nominal price
move away from actual price with the cost of price adjustment. They choose
the price in a way that minimises the two costs.
2.5 Questions
Q1. Explain in deta il the concept of Real rigidity.
Q2. Explain Concept of quadratic price adjustment.

™™™™™™™
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25Chapter 3: New Classical Economics - I
Module 2
3 NEW CLASSICAL ECONOMICS - I
Unit Structure
2.0 Objectives
3.1 Introduction
3.2 Concept of the New Classical Economics
3.3 The New Classical Rational Expectation Model
3.4 Policy Implication of the new Classical Rational Expectation Model
3.5 Concept and Meaning of DSGE
3.6 Dynamic Stochastic General Equilibrium Models
3.7 Summary
3.8 Questions
3.9 References
3.0 Objectives
y To know the views of New Classical Macro Economics
y To know the principles and policy implication of new classical
Macroeconomics to relevance of current period
y To know the Concept of DSGE model
3.1 Introduction
In 1970s the new classical ideas were emerging and their concept of any cyclic
fluctuations in economic activity had to be consistent with the concept of market
clearing and optimizing behaviour by rational economic agents. This new statement
of the classi cal ideas became to be known as new classical macroeconomics. The
new classical macroeconomics has been developed by American economists and
in particular by Lucas and Sargent.
The new classical macroeconomics challenged the Keynesian proposition that
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26 MACROECONOMICS - II
classical macroeconomics pointed out the failures of the Keynesian theory as the
theory had failed mise rably in mid -1960s which led to stimulate a critical reappraisal of the micro foundation of Keynesian analysis. The new classical
macroeconomics explained the macroeconomic behaviour by forming a framework
characterized by (a) market clearing and (b) optim izing behaviour.
3.2 Concept of the New Classical Economics
The new classical macroeconomics challenged and changed a part of monetarist
and Keynesian views about the role that macroeconomic stabilization policy plays
in the light of the classical school of thought.
At one place where Keynesian theory is of the view that the demand management
policies both fiscal and monetary help in stabilizing the economy. The new
classical macroeconomics firmly believed in active interventionist fiscal and
monetary poli cies.
The new classical macroeconomics regarded both the policies as complementary
to each other. Their idea depended more on the expansionary fiscal policy which
controlled recession , existence of recession ultimately leads to rising unemployment with nea rly zero growth in the economy. On the other hand they
used deflationary fiscal policy with monetary policy to control inflation.
The monetarists believed that the economy with continue to be stable and when it
is disturbed by some changes in the basic con ditions it will quickly revert to its
long-run growth path. They criticized the idea of discretionary fiscal and monetary
policies.
The new classical macroeconomics policies involve long and variable time lags
which can make them ineffective and destabiliz ing, but still they advocate annual
fixed growth rate in money supply instead of discretion in monetary policy.
Friedman was of the view that fiscal policy only influences or affects behaviour of
money. Therefore, government can follow a sound monetary policy by not
interfering at all and thus giving total freedom to business and industry. This helps
create a healthy environment for investment and growth.
An important post – Keynesian development in macroeconomics is the rational
expectations mo del propounded by an American economist, Robert Lucas in the
70s. Since rational expectation model re -establishes many classical concepts and
policy prescriptions, it is also called “New Classical Economics”. The rational
expectation model was developed a gainst the background of both high inflation and
high unemployment that prevailed in the US economy in the 1970s. As the
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27Chapter 3: New Classical Economics - I
to contradict the Keynesian theory, there was a lot of dissatisfaction with its calling
for new explanation of the then prevailing situation of high inflation and high
unemployment.
3.3 The New Classical Rational Expectation Model
3.3.1 Rational Expectation: Meaning
New classical economics is based on the rat ional expectation hypothesis of Robert
Lucas. According to this hypothesis both the workers as well as the firms are not
sure about their future and hence their decisions are based on their future
expectations. The economic agents make use of all the avail able information to
make best possible forecast and thus make rational expectations of the future. Prior to this Philips curve model associated higher inflation with lower unemployment rate. However, Philips curve model assumed that workers and firms
did n ot use the available information to make forecast and therefore would make
the same mistake time and again. For example, in these previous theories higher
inflation was assumed to raise workers’ willingness to supply more labour as they
thought their higher money wages brought about by high inflation meant higher
real wages as a they did not realize that the prices of all the commodities would
also rise. This monetary stimulus mi ght cause a temporary boom. An important
aspect of rational expectations model is that it believes equilibrium in which
markets clear immediately.
3.3.2 Lucas Critique
They questioned the Keynesian and monetarist view that there will be slow
adjustment of price expectations and for analysis of the effects of policy these
expectations are assumed to remain constant in short run. The supporters of the
rational expectations said that such expectation formation was quite impractical
and was not p ossible in real world. Past behaviour of the prices cannot always be
the basis of firms and workers expectations, as there may be changes in the policy
which can prove them wrong.
Thus, the expectation to be rational the economic agents use all the inform ation
available to them in order to predict the price level according to the monetary policy
adopted. If the expectations are rational the policy changes by the government will
be well anticipated by the people. For example, if the Central Bank is known to
respond in a certain systematically to follow expansionary monetary policy when
the situation of unemployment of labour emerges, then people anticipate that the
Central Bank will expand the money supply to tackle the unemployment problem
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28 MACROECONOMICS - II
3.3.3 New Classical model of Rational Expectation
For understanding of New Classical model of rational expectations, it is necessary
to explain Lucas aggre gate supply function and aggregate demand function. 1. Aggregate Supply function
As per Lucas Aggregate Supply function, the real aggregate output represents the
functional relationship of difference between the actual price level (P) and expected
price lev el (Pe). Lucas supply function is written as:
Y = Y* + į (P - Pe)
Where,
Y = Actual Aggregate output in a given period
Y* = Potential output corresponding the level of natural unemployment
Į Constant value
P = Actual Price level
Pe = Expected price level
From the above Lucas supply function it is proved that if actual price level (P) >
expected price level (Pe), actual aggregate output in short run (Y) would be greater
than the potential Y*. The extent of Y will greater than Y * depend on the value of
ĮOn the other hand, if actual price level (P) < expected price level (Pe), actual
aggregate output in short run (Y) would be lesser than the potential Y*.
According to the Lucas approach in the short run, the actual price level of output is
variable and it responds to the changes in the aggregate demand. However, it differs
from the Keynesian theory as the wages here are not just given on the basis of the
last period’s equilibrium. Here, the wages are fixed in the beginning of the current
period at the market clearing level, given the expected price level as determined by
the anticipated demand conditions for the current period.
Price surprize is described as the difference between the actual price level and the
expected price level (P -Pe). The firm expects a certain price level at the beginning
of each period. However, if the actual price happens to be different then there will
be price surprize. For example, if actual price level is more than the average
expected price level, the firm will learn about it only slowly, since only after a
certain time lag it reali zes that all pri ces has risen. However, the firm knows quickly
that price of its own product has risen. Thus, the firm perceives, through incorrectly,
that the price of its product has risen relatively to others. Thus, the firms are ‘fooled’
in believing that their relati ve prices have risen. As a result of the rise in its relative
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29Chapter 3: New Classical Economics - I
Similarly, whenever there is a positive price surprize, the workers too are fooled
into believing that their price, that is their real wage has risen relative to other
prices. So, we can see when the price level is higher than the expected price level,
the economy will produce higher output and employ more labour than when the
price levels are at their expected level. 2. Aggregate Demand function
The second element in the rational expectation theory in the nature of aggregate
demand. It is fluctuations in aggregate demand that bring about change in price
level and output. In Lucas new classical approach aggregate demand is generally
considered in terms of quantity theory as given below:
AD: MV = PY
Where,
M = Money supply
V = Income velocity of money
P = Price level
Y = Real income or aggregate output
In term of g rowth of the variables the above quantity theory equation can be
written as;
¨ M = ¨P + ¨Y
M P Y
Note that velocity V is assumed to be constant, it disappear in the equation written
in terms of growth of these variables.
Rewriting the above equation we have
¨3 = ¨M - ¨Y
P M Y
¨Y / Y which measures growth rate of output is generally written as g. Doing so
we have
¨P = ¨M - g
P M
The expected inflation rate by the firms and workers will depend on the expected
JURZWKUDWHRIPRQH\VXSSO\¨00DQGWKHH[SHFWHGJURZWKUDWHRIRXWSXWJ
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30 MACROECONOMICS - II
Now for simplifying the new classical model we take expected price level (Pe) as
determined by expected money supply (Me) and expected output level (Ye) rather
than expected growth rates (ge) of these variables. 3. New Classical Rational Expectations Model
According to the New Classical Rational Expectations Model, expected price
depends on the expected levels of the various variables withi n the model that
actually determine the price level which in turn becomes the expected price level
by the workers and suppliers of the output. These price -determining variable on the
demand side are the expected level of money supply (Me), government expenditure
(ge), tax collected (tc) and the amount of autonomous investment (Ie).
On the supply side there are various important factors which determine the price
level of the output; these factors include oil price, excise duties, custom dutie s,
capital goods and the price of the raw material. In the new classical model the
position of labour supply curve and aggregate supply curve of output depends on
the expected values of these policy variables such as Me, ge, Ie, which determine
the price l evel.
The effect of full -anticipated expansion in the money supply, say from M 0 to M 1 is
explained by rational expectation model. In the figure given below money supply
M0, government expenditure g 0, tax collection t 0 and autonomous investment I 0
determin es the aggregate demand curve AD 0. The supply curve is represented by
SAS 0 which depends on the price level which is determined by money supply (M 0).
Figure No. 3.1

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31Chapter 3: New Classical Economics - I
Other determining variables remaining constant, the aggregate demand curve shifts
to AD 1 as the money supply increases from M 0 to M 1. Short run supply curves
remaining at the same level SAS 0 the price level rises to Pe1 as the money supply
increases. As the price level rises to Pe, the labour demand curve shifts to N 1d which
intersects the la bour supply curve Ns0 at point B and determines the wage rate W 1
as a result employment of labour increases to N 1. In the Keynesian model in the
short run the expected price level is not related to current level of policy variables
and therefore aggregate supply curve and the positions of aggregate supply and
labour supply curves do not remain fixed in short run in t he rational expectations
model. The main reason for the same is that in the rational expectation model is
that when expansionary fiscal policy is full anticipated in response to recession
situation or rise in unemployment that may emerge. The public antici pates the
increase in the money supply which results in a rise in the expected price level to
Pe1. This is due to rational expectations; the workers who supply their services are
very well aware that increase in money supply will make the prices rise to Pe1 price
level. This rise in the expected price level will make workers demand more money
wages and this will cause a leftward shift in the labour supply curve to Ns1 (Pe1)
and a leftward shift in the aggregate supply curve of output to the new position
SAS 1 (Pe1) as shown in the figure. It will be seen from Panel (A) that the new short
run aggregate supply curve SAS 1 intersects the new aggregate demand curve AD 1
at point H and determines a higher price Pe2.
As the price level rises to (Pe2) the labour demand will further shift to left to new
position Nd2 (Pe2). With all these changes in the labour market and product market
a new equilibrium will be established where the output and labour employment will
be restored to their original levels, N 0 and Y 0 respectively. Wage rate will rise to
the same extent as the rise in the price level.
Thus, according to the rational expectations model while the price level and the
money wage rate will raise permanently on one hand, on the other hand output and
employment level will remain the same. According to the rational expectations the
original levels of employment and the output will be restored in short run and there
is no time gap in the adjustment process because changes in the price level are
correctly pe rceived by the workers as the money supply is increased by the policy
makers.
3.4 Policy Implications of New Classical Approach
The rational expectation model points out the ineffectiveness of the economic
policy as it shows that the real variables output and employment levels remain
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32 MACROECONOMICS - II
economists point out that discretionary demand management policies are ineffective whether they are monetary or fiscal measures to attain economic
stability in their view of rational expectations by labour suppliers and other
economic agents. According to the new classical ec onomists the workers don’t
make systematic mistakes in their price predictions. In the rational expectations
theory not only policy actions by the government (or the central bank in case of
monetary policy) but also the price effects of the policy are corr ectly predicted.
This results in immediate response to the anticipated price and renders economic
policy ineffective; thereby there is no impact on the output as well as the
employment level.
In the figure below presents the new classical view of effects o f decline in private
investment demand. Panel (A) shows the product market the aggregate demand
curve with private investment demand equal to I 0 is AD 0 and aggregate curve is
SAS 0. The equilibrium price P 0 and output Y 0 is determined at the intersection of
aggregate demand curve AD 0 and the short run supply curve SAS 0. Similarly in the
corresponding situation in the product market the demand curve of labour is Nd0
given the price level P 0 determined the product market and Ns0 is the supply curve
of labour. The wage rate W 0 is determined by the supply curve of labour Ns0 and
demand curve of labour Nd0.
Figure No. 3.2

In fig. If the workers with their rational expectations anticipate the decline in
investment demand, they would predict a fall in price level to P 1. With workers
anticipating the price level to P 1 they would supply more labour as their real wages
would rise with a fall in the price level to P 1, money wages remaining at same level
that is W 0. This results the supply curve of labour will shit to the right to Ns1
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33Chapter 3: New Classical Economics - I
indicating more labour will be supplied. With labour supply curve shifting rightwards short run aggregate supply of output will also shift to the right to new
position SAS 1 in panel A. At original output Y 0 the new aggregate supply curve
SAS 1 together with new aggregate demand AD 1 determine price P 2. It will be seen
from panel B that with price level equal to P2 labour demand curve shifts further to
the left to new position Nd2 which together with labour supply curve Ns1 determine
the wage rate W 2 and employment N 0 which represents the full employment of
labour. Thus, in the new short -run equilibrium in case of anticipated change and
with the assumption of rational assumptions, prices and wages has fallen
sufficiently which helps restore equilibrium of potential ou tput Y 0 and employment
N0 which prevailed initially.
Like classical economists, the new classical economists too were opposed to the
idea of adopting expansionary monetary and fiscal policy to encourage the private
investment demand to attain stability in output as well as employment. The new
classical economists assumed that the rational expectation which helps the
economy to sustain the demand shocks such as decline in private investment. This
brought about the irrelevance of economic policies to stabiliz e economy.
Check Progress 1. What do you understand by New Classical Economist views? 2. Explain the Rational Expectation Model with the help of diagram. 3. Explain Implications of New classical Economists.
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References: Macro Economics by Dr. H. L. Ahuja
3.5 Concept and Meaning of Dsge
3.5.1 Introduction
Economics is a social science which studies the human behaviour as regard to
problem of choice in order to satisfy their unlimited wants with help of limited
resources at their disposal. This gives rise to the concept of scarcity which refers to
limited re sources which are used to satisfy unlimited wants of the society. It is due
to this scarcity that gives rise to questions like: what to produce? How to produce?
How much to produce? munotes.in

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34 MACROECONOMICS - IIEconomics divides the problems into two categories microeconomics and macroeconomics. Microeconomics studies the economic problems at individual
level whether it is an individual, a firm, consumers or households. While the
macroeconomics studies the whole economy, it focuses on aggregated sectors
within the economy. Here, the major stress is on policy recommendations,
evaluation of aspects like general price level, employment and overall economic
output.
From above we can see that macroeconomics studies the performance of the
economy as a whole. It tries to bring to areas withi n the economy which are
hindering macroeconomic objectives. Macroeconomics raises questions which involve balancing between various aspects of the economy. To implement successful policies it is very important to
have a proper understanding of the strength of the competing aspects of the policy
question at hand. To understand the strength of these aspects it is important to run
experiments in the economy, to understand and evaluate the outcomes. This
however, is not possible to do due to various factors lik e cost, time and ethical
reasons, thus such experiments are run on the models developed to understand
economies.
To understand this in a better way, let us consider a policy question that has
competing aspects. How will the economy be affected if the gover nment spending
is increased? The study which answers this question suggests that an increase in
the government spending would boost aggregate demand and output. This would
however lead to a reduction in the private spending, which in turn would result in
a reduction in the output. This mainly happens because of the concerns about fiscal
solvency.
Model building involves some aspect of the theory; this is mainly because the
model should be a representative of some aspect of ‘real -life’. However, the main
problem with this approach is that we don’t come to know whether the effect of the
theory is stronger than the effect of some external factor. This assessment is done
by Dynamic Stochastic General Equilibrium (DSGE) models should be utilized.
3.5.2 Meaning of DSGE
Dynamic Stochastic General Equilibrium (DSGE) or DGE or SDGE model is based
on applied general equilibrium theory and microeconomic principles. It is a method
in macroeconomics which tries to explain economic phenomena like economic
growth, business cycles and the effects of economic policy through econometric
models. Like other equilibrium models DSGE analyses the interaction of many
microeconomic decisions and aims to describe the behaviour of the economy as a munotes.in

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35Chapter 3: New Classical Economics - I
whole. DSGE models consider t he decisions which correspond to main quantities
studied in macroeconomics such as labour demand, labour supply, investment,
saving, consumption etc.
As the name suggests, DSGE models are dynamic (studies how the economy
develops over a period of time), s tochastic (considers the fact that the economy is
affected by random shocks), general (refers to the entire economy as a whole), and
of equilibrium (subscribing to the Walrasian general equilibrium theory).
3.6 Dynamic Stochastic General Equilibrium (DSGE ) Models
According to macroeconomics (and macroeconomic research), DSGE models are
very good representations of how does a market economy works. It gives an
alternative approach to the traditional approach which was a static representation
of the economy, and can be used for various purposes. In order to analyse the
economic policy, DSGE models considers three important and interrelated aspects
which are demand, supply and the monetary policy.
The DSGE models’ equations are based on the assumptions regarding the behaviour of the main agents within the economy that is households, firms and the
government. These agents that are households, firms and the government interact
with each other in the market until some ‘general equilibrium’ point is attained. In
this type of economy it is assumed that there are only two type of goods, one
intermediate goods and the other final goods. Intermediate goods are used in the
manufacture of final goods. On the other hand final goods are the ones which satisf y
the current needs of the households in the economy.
In the model, the households are the final consumers of the final goods produced
by various firms in the economy. As there are there two types of goods in the
economy that is intermediate goods and the final goods so there are two types of
firms as well, one producing the intermediate goods and the other one producing
the final goods in the economy. These firms then package their differentiated goods
and sell them in the market.
Of all the three interrel ated aspects that is demand, supply and monetary policy, the
monetary policy component of DSGE model is the stochastic in nature. It means
that there is some part of the model which is randomly determined. These events
are unpredictable and don’t have any stable pattern of their occurrence. This results
in economic fluctuations and adds uncertainty in the economy
Now understanding the relationships between the agents, assumptions about each
agent are made and individual sets of equations are then developed. munotes.in

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36 MACROECONOMICS - II1. Maximize Utility DSGE Model
0D[(W >™ȕt { (Ct 1- ı/ 1- IJ - (Lt 1 + įIJ`@
(Ct, Lt, K t)
Where,
t = Time
E = Expectations
ȕ 'LVFRXQWIDFWRU
L = Number of hours work
ı Relative risk aversion
Į = Marginal disutility with labour supply
The major problem of the household is to maximize utility which can be done by
increasing consumption which increases utility and on the other hand longer
working hours would decrease utility.
Since households cannot consume unlimited number of goods, as t hey are subject
to budget constraint which says that all sources of income must be equal to all uses
of income. 2. Budget Constraint DSGE Model
Pt (Ct + It) ”:t Lt + R t Kt + ʍt
Where,
P = Price Level
I = Investment
W = Wage Level
L = Number of hours Worked
R = Return on Capital
ʌ 'LYLGHQGV
t = Time
When we consider the maximization problem it can be found that (with all other
factors remaining constant) any increase in the consumption can only happen when
working hours are increased or with longer working hours. Thus, a trade -off can be
seen between consumption and leisure. A detailed evaluation will reveal that the munotes.in

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37Chapter 3: New Classical Economics - I
household m ust choose between consumption of additional goods today itself or
future consumption. Which of these effects would be stronger? 3. Production function DSGE Model
Yt = A t Ktį/Wį
Where,
Y = Output
t = Time
A = Total factor of productivity
Į (ODVWLFLW\RIFDSLWDO
ĮFDQDOVREHWKRXJKWRIDVFDSLWDO¶VVKDUHRIRXWSXWDQG (1- ĮZRXOGEHODERXU
share of output.
For the production of goods and services the firm uses inputs like capi tal and
labour. Ideally, the production function should exhibit a constant return to scale.
Here, the increase in the output is exactly in the same proportion as increase in the
inputs, this suggests that there is no wastage of inputs. After achieving the point of
maximization, it is normally found that there is a decrease in the real wages which
in turn would lead to higher quantity of labour being demanded. This normally
happens as at lower wage rate; the firms are willing to hire more labour. 4. Maximise Profit DSGE Model
PD[ʌ t = A t KtĮ Lt 1-Į Pt - Wt Lt - Rt Kt
Where,
ʌ 3URILW
t = Time
K = Capital
Į &DSLWDO¶VVKDUHRIRXWSXW
L = Labour
1 – Į ODERXU¶VVKDUHRIRXWSXW
P = Price level
W = Wage rate
R = Return on Capital munotes.in

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38 MACROECONOMICS - II
While operating in a perfectly competitive market the firm’s goal is to maximize
profits. Here, the assumption of perfect competition would not always be true, but
it is assumed as it represe nts the ideal situation and efficiently operating markets .
In perfect competition situation firms will not earn any profit in the long run. As
there are no barriers to new entrants due to perfect competition the when market
price rises more firms will ente r into the market to earn higher profits, but as soon
as these firms enter the market the price will drop down to the earlier levels.
Once the optimum conditions are reached the market will clear off or achieve
“General Equilibrium” when all the internal f actors of the model which define the
equilibrium are fully satisfied. This means that from the previous example: When
the prices are given, the household will decide as to how much it should invest,
consume and work where the basic aim of the household is to maximize utility. At
the same time a firm will have to make decisions like how much to produce by
choosing optimum amount of labour and capital, taking input prices as given and
subject to technology.
Over here, we are discussing the economic scenario where we are considering
economic activity and trying to analyse and evaluate economic policies. It is
believed that DSGE models are applicable to many more scenarios and situations.
Now let us take an example of a content creation platform is trying to get more and
more users to publish more and increase platform’s overall engagement. Can
adding a new feature of say, premium users be a good idea? The premium users
would have access to exclusive groups and feature s which the regular users would
not have access to.
This theory suggests that such schemes will encourage users to join the exclusive
user groups; this will lead to increase in the engagement. On the other hand
concerns about exclusion can cause creators t o think negatively and reduce the
overall usage of the platform. Now to understand which of these outcomes are more
likely, given the relative strength. For assessing this DSGE models should be used.
Check Progress:
1. What do you understand by DSGE Models ?
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39Chapter 3: New Classical Economics - I
3.7 Summary 1. According to the classical economists to stable aggregate output and employment
and to manage aggregate demand there is no need of Government or Central Bank
interference in the form of either fiscal or monetary policies. 2. Similarly new classical economist s too asserted the view of non -intervention of the
government and Central Bank. 3. The new classical economists advocated and supported the idea of anticipated
change in aggregate demand and supply, wage of labour and price level of output
change in a way th at restores equilibrium at full of employment level of output.
Due to such similarities in their view rational expectations model is referred to as
new classical economics. 4. The DSGE models’ equations are based on the assumptions regarding the behaviour of the main agents within the economy that is households, firms and the
government. These agents that are households, firms and the government interact
with each other in the market until some ‘general equilibrium’ point is attained. 5. DSGE attempts to economic concepts like economic growth, business cycles and
the effects of economic policy through econometric models based on applied
general equilibrium theory and microeconomic principles.
3.8 Questions 1. Q1. Define New Classical Economics in detail. 2. Q2. Examin e New Classical Economics based on Rational Expectation model. 3. Q3. What are the Policy Implications of New Classical Approach? 4. Q4. Define DSGE Model in detail.
3.9 References:
Macroeconomics by David Romer
Macroeconomics by Olivier Blanchard

™™™™™™™ 5.
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40 MACROECONOMICS - II
Unit 2
4 NEW CLASSICAL ECONOMICS - II
Unit Structure
4.0 Objectives
4.1 Introduction
4.2 Concept of Government Budget Constraint
4.3 Money / Bond Financing of Budget Deficit
4.4 Deficit Financing of Budget Deficit
4.5 Wealth Effect of Debt Financing
4.6 Debt – Financing of Budget Deficit: The view of Ricardian Equivalence
4.7 Summary
4.8 Questions
4.0 OBJECTIVES 1. To know the concept of Government Budget constraint 2. To know the impact of money / bond financing of Budget Deficit of the economies. 3. To know the impact of deficit financing of budget deficit of the economies. 4. To know the wealth effect of debt financing 5. To understand the Ricardian Equivalence of debt financing of budget deficit
4.1 INTRODUCTION
Direct and indirect taxes are a major source of its receipt through which it finances
its expenditure. However, when the government expenditure increases, the government finds it difficult raise further funds from taxation route, therefore it
resorts to borrowing funds from the public or printing money to finance its budget
deficit. An increase in taxes on the other hand would act as a disincentive to work
more, would adversely savings and investment and would also encourage tax
evasion. Laffer curve concept brings out the point that an increase in the tax rate
beyond a certain point would lead to a decline in the revenue from taxes. So here munotes.in

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41Chapter 4: New Classical Economics - II
we see that there is clear limitation of increasing revenue through taxes to finance
the increased expenditure of the government.
4.2 CONCEPT OF GOVERNMENT BUDGET CONSTRAINT
When financing of the increased expenditure becomes increasingly difficult for the
government through normal taxes, it faces a resource constraint resulting in budget
deficit which is also nowadays called fiscal deficit. Governm ent budget constraint
is reflected in budget or fiscal deficit.
The general form of government budget constraint is written as:
G = T + ¨B + ¨M …. (1)
Where,
G = Government Expenditure (including subsidies and interest payments on debt
T = Tax revenue
¨B = New borrowing from the market (through sale of bonds and securities)
¨M = New printed money issued to finance government expenditure
According to the budge t constraint equation (1), government expenditure in a year
FDQEHILQDQFHGE\WD[UHYHQXH7QHZERUURZLQJ¨%E\WKHJRYHUQPHQWIURP
the market (both within and outside the country) through sale of its bonds and by
FUHDWLQJQHZKLJKSRZHUHGPRQH\¨0 which is also called money financing.
Budget constraint equation can be re -written as
G – 7 ¨%¨0«
G – T = Budget deficit (also called fiscal deficit) that must be financed by new
ERUURZLQJ¨%E\WKHJRYHUQPHQWWKURXJKVDOHRIERQGVD nd creation of new
KLJKSRZHUHGPRQH\¨0ZKLFKLVFDOOHGPRQH\ILQDQFLQJ7KXV
Budget deficit = New Borrowing (i.e. sale of Bonds) + Printed money
Government can finance its fiscal deficit by either printing money (also called
seiniorage) or by public borrowings which can be in form of selling bonds to the
public which includes insurance companies, banks and financial institutions. Such
borrowings ad d to the government debt. Government pays interest annually on its
debt and to repay the principal amount on maturity of such bonds or securities.
J. M. Keynes placed his point view, while asserting that during recessionary
conditions which primarily arise due to deficiency of aggregate demand, adoption
of deliberate policy of framing budget is necessary to get rid of recession and once
again restore full employment equilibrium. Recently, also many economists are munotes.in

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42 MACROECONOMICS - II
arguing over the appropriate methods of fina ncing the budget deficit and its
consequences on the economy as whole. It is very crucial to discuss the results of
budget deficit and mode of financing the persistent large budget deficit which
occurs each year irrespective of fact whether the economy is a developed economy
like United States or a developing economy like India. This has resulted in a dual
problem with mounting burden of public debt on one hand and inflation on the
other.
Check Progress:
1. Explain concept of Government Budget Constraint wi th the help of equation?
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4.3 MONEY / BOND FINANCING OF BUDGET DEFICIT
The government meet s its increased expenditure and finance s its deficit by printing
high powered money. The revenue which the government raises through printing
of money is called seignior -age. By printing notes in order to finance its budget
deficit the government increases the money supply in the economy. Two vi ews
have been kept forward regarding the effect of increase in money supply on
inflation. As per the Keynesian view the increased money supply during depression
when both labour and production capacity are lying idle due to lack of aggregate
demand, prices won’t rise much and the effect of the increase in money supply will
lead to a raise in output or income. With the rise in the real income, given the rate
of taxation will bring higher revenue in form of taxation which will ultimately lead
to a reduction i n the budget deficit in the short run. However, on the other hand if
the economy is operating at a near full employment, printing money to finance the
deficit will give rise to inflation. Printing of the currency notes by the government
in order to raise r evenue for financing the budget deficit will cause inflation and is
like an inflation tax. The main reason of this happening is that the government is
able to get resources through printed money which causes inflation and reduces the
real value of holding of money by the public.
First of all let us explain a situation in the Keynesian model where the price level
is fixed, and the economy is in recession mainly due to demand deficiency and a
high level of unemployment of resources prevails in the economy. The tax function
can be written as:
T = t (Y) munotes.in

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43Chapter 4: New Classical Economics - II
Where,
t = Rate of tax
Y = Real income
T = Total tax revenue
If G is government expenditure, then budget deficit (BD) is given by
BD = G – t (Y) …… (1)
If G – t (Y) = 0, budget deficit will b e zero and therefore the budget will be balanced
budget . If G – t (Y) > 0 there will be budget deficit which is known deficit budget .
If the Government finances its deficit through money creation, then the short -term
macro equilibrium can be written as
Y = Y (G, M) …… (2)
The short run equilibrium which is represented in the fig. is a simple IS -LM. Here
the equilibrium income Y 0 and interest rate r 0 are determined by the intersection of
the IS and LM curves at point E. Now suppose, if at this equilibrium G – t(Y) > 0.
In order to meet this budget deficit government creates high powered money. Due
to this the money supply in the economy increases and LM curve shifts to the right
to the new position LM 1.
Figure No. 4.1

It can be seen in the above figure that as the level of equilibrium income increases
to Y 1 the interest rate falls to r 1. As it is assumed here that the economy is in
depression expansion in money supply will lead to increase in demand but will not
cause any rise in price level.
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44 MACROECONOMICS - II
The adjustment process under this simple IS -LM model with fixed price level when
new money is created to meet budget deficit is shown below
dM / dt = [P {G – t (Y)}] ……. (3)
Substituting Y by Y (M , G) in equation (3) above we have
dM / dt = [P {G – t (YM, G)}] ……. (4)
In the equations (3) and (4) above shows the growth the high-powered mone y(M)
over a period of time which helps in financing the budget deficit which is G – t(Y)
multiplied by the price level. If there is a balanced budget where G – t(Y) = 0 over
the years, from equation (3) it follows that dM/dt = 0.
In the above model since a depression situation is being represented, the price level
would remain unchanged even when more money is created to finance budget
deficit. However, if the rate of growth of money exceeds this with a stable demand
function for the currency, inflation wil l result.
Check Progress:
1. What do you understand by bond financing of budget financing?
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4.4 DEFICIT FINANCING OF BUDGET DEFICIT
4.4.1 Concept
The government finances the budget deficit by borrowing from the public which it
does by issuing bonds to the public. The government sells these bonds which carry
interest through financial intermediaries like banks and fin ancial institutions. The
banks subscribe to the bonds issued by the government with currency deposits of
the public. Therefore, debt financing of the budget deficit is also known as bond -
finance of budget deficit. The funds so borrowed by the government ar e used to
increase its expenditure; however this results in an increase in public debt which
has both short run and long run consequences. Budget deficit may also result due
to reduction in taxes even though the government expenditure remains constant.
This deficit too can be financed by issuing bo nds to the banks or public. The
government has not only to pay interest on the borrowing it does from the public
but has even to repay the principal sum so borrowed for which it may levy higher
taxes in future. munotes.in

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45Chapter 4: New Classical Economics - II
The Keynesian economists have advocated the u se of expansionary effect of debt
financing of government expenditure or budget deficit. According to the Keynesian
model the increase in government expenditure through use of borrowed money
with price level remaining constant results in an upward shift in expenditure (C + I
+ G) curve. The increased debt financed government expenditure will bring about
expansion in output as well as the income. As the income will rise, with increase
in output, at a given tax rate the tax revenue collected will also rise s this in turn will
reduce the budget deficit or even ultimately eliminate the same and the budget will
become a balanced budget. This can be shown through IS -LM model where IS and
LM curves are drawn in the fig. where the money supply is given in the economy
with Y* is the full employment level of output
Figure No. 4.2

With debt -financing increasing in the government expenditure IS a curve shift to
the right from IS 0 to IS 1 with LM curve remaining the same, even though
equilibrium is at initial income level Y 0. This resu lts in an increase in the national
income to Y 1. This will result in an increase in the tax revenue collection of the
government and in turn the budget deficit will be reduced and even eliminated over
a period of time. In the fig. it can be seen that this will lead to an increase in the
interest rate but however, it will not full offset the expansionary effect as debt -
finance increases the government expenditure.
4.4.2 CRITICISM OF DEFICIT FINANCING OF BUDGET DEFICIT
The debt -financed government expenditure is hugely offset by the crowding -out
effect of debt financing on private investment, this point have been brought out by
the critics. The crowding -out effect on private investment takes place in various
ways.
munotes.in

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46 MACROECONOMICS - II1. The rate of interest rises as government borrows funds to finance the budget deficit this is due to the fact it will lead to the increase in demand for lendable fund. The rise in the interest rate will lead to a decline in the private investment. Thus, debt-financing increases government expenditure which leads to crowding -out of private investment. 2. Crowding out effect, affects the private investment as net expansionary effect of increase in government expenditure is negligible. At the same time the society has to bear the burden of increase in public debt due to debt -financed expansion in government expenditure. If the budget deficit is caused to reduction in taxes, even if government expenditure remains constant, then also there will be a rise in the interest rate which in turn will cause crowding out effect on private investment. 3. The main reason for this is the reduction in taxes increases the consumption expenditure which in turn reduces the savings of the people. This leads to reduction in savings which causes interest rates to raise leading to a fall in the private investment. Check Progress: 1. Explain the concept of Budget deficit through deficit financing issuing currency notes. ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 2. What are the limitations of deficit financing of budget deficit? ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- munotes.in

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47Chapter 4: New Classical Economics - II
4.5 WEALTH EFFECT OF DEBT -FINANCING
While discussing the crowding out effect, the wealth effect of debt fi nancing has
completely been ignored. While issuing bonds to finance the budget deficit
government helps in creation of private wealth. This is mainly due to the fact that
such bonds are considered to be wealth by the people to whom they are allotted.
Patin kin and Friedman have included the concept of wealth in their money demand
function. According to their model, apart from other factors, real value of wealth
determines demand for money. Wealth effect of bond financing of budget if
recognized, then it exer cises important influence on the dynamic behaviour of the
economy. While debt -financing of budget deficit government issues bonds to the
public which increases the wealth of people which in turn raises the demand for
money. With increase in the demand for money and supply of money remaining
constant there will be a leftward shift in the LM curve, for instance, from LM 0 to
LM 1 in fig. (Note: when financing of government expenditure is done by printing
of new currency notes, LM curve will shift downward, i.e. to the right).
Figure No. 4.3

With an increase in the government expenditure, IS curve shifts to the right to the
new position IS 1 which in turn raises the aggregate income, the wealth effect of
bonds issued by the government to finance the budget deficit causes a leftward shift
in the LM curve which leads to an increase in the rate of interest and thereby
crowding out of the private investment. As per the Friedman model the wealth
effect is quite substantial and completely offsets the expansionary effect of the
increase in the government expenditure. In the figure initially the equilibrium level
of income is at Y 0, with an increase i n the government expenditure which is being
financed by the issue of bonds to the public the IS curve shifts from IS 0 to IS 1 and
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48 MACROECONOMICS - II
due to the wealth effect LM curve shifts leftwards to LM 1. Here we can see that the
interest rates rises from r 0 to r 1 which do es not have any effect on the level of
income which remains unchanged at Y 0 level. As there is an increase in the interest
rates the private investment falls so much so that it completely neutralizes the
expansionary effect of debt -financed budget deficit. Due to t his, the budget deficit
continues to exist and debt goes on accumulating and becomes unmanageable.
Conclusion
Over here we have seen that when the budget deficit is debt -financed it leads to an
expansionary effect on the economy however this has been challenged on the
ground of crowding -out effect. However, according to the views of various
economists the crowding out effect of debt financing has been highly exaggerated.
In fact, crowding out effect of debt financing of budget deficit has a limit ed or
negligible impact especially when the economy is working at less than the full
employment level of income. Mostly, to meet the budget deficit the government
floats bonds to finance the same to overcome economic depression when there is
under -employment of resources equilibrium and because of this there exists an
output gap. Evidences show that the wealth effect of sale of bonds is not significant.
Check Progress:
1. Explain Wealth effect of debt financing.
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4.6 DEBT -FINANCING OF BUDGET DEFICIT: THE VIEW OF
RICARDIAN EQUIVALENCE
Keynesian views on fiscal policy were criticized by the early neo classical
economists as according to them it ignored “crowding out effect”. Crowding out
occurs when there is a rise in the interest rates due to expansionary fiscal policy
which ultimately leads to a decline in the business in vestment thereby limiting or
reducing the effects of the fiscal expansion policy. The Keynesian economists
ultimately accepted the fact of crowding out effect and now the focus of debate
shifted to the fact of how much crowding out actually occurs. The neo classical
economists kept their view forward and said that the fiscal policy was totally
ineffective as increase in the government expenditure would lead to an equal
decrease in the private investment spending, this would neutralize the effect of the
increase in government expenditure and ultimately there will no effect on the munotes.in

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49Chapter 4: New Classical Economics - II
aggregate demand. Against this, the Keynesian economists argued for incomplete
crowding out, thus they accepted the fact that though the fiscal policy would be
weaker than what they originally thought but still would be effective to a certain
extent.
New criticisms of the fiscal policy were introduced by Robert Barro and other new
classical economists. If the people are having rational expectations, then any
change in the government b udget may have an impact on their private saving. For
example, if the government has a budget deficit , the people may feel that higher
budget deficit would mean that they will have to pay more taxes in future to clear
off all the government borrowings, so they should start saving now. On the other
hand, if the government prepares a surplus budget, the people may feel that with
surplus budget or a low deficit budget the government is in no need of funds and
they may expect a tax cut in the tax rates in futur e and this would not encourage
current savings in the economy.
According to Ricardian equivalence the theory that the rational private households
might shift their savings in order to offset the government borrowing s or savings.
It is known as Ri cardian eq uivalence as the idea is related to the writings of the
economist David Ricardo in early 19th century (1772 -1823). If this theory of Ricardian equivalence is completely true, then if there is any increase in government expenditure would lead to an increase in budget deficit which would
lead to a decrease in the consumption expenditure which in turn would lead the
households to save more as they may anticipate future tax liability. This would
neutralize the effect of government expenditure on aggregate deman d and the fiscal policy would be totally ineffective. According to the theory of Ricardian equivalence an increase in government borrowing would increase the private
saving by an equal amount, while on the other hand any decrease in the government
borrowin g would reduce private savings. Sometimes this theory holds true whereas
at other times it may not hold true at all.
Definition of Ricardian equivalence : Here the idea is that if the consumers
anticipate that they will receive a tax rebate or a tax cut which will be financed by
government borrowings then they also anticipate there will be a rise in future taxes.
So one can say that their lifetime income rem ains the same and so the consumer’s
spending would also remain the same.
Similarly on the other hand, if there is a higher government spending which are
being financed by borrowings, it will imply that there will be lower spending in the
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50 MACROECONOMICS - II
For this t heory to hold true, if the tax cut is financed by higher government
borrowings then such borrowings would have no impact on the aggregate demand
as the consumer would save the tax rebate or tax cut to pay the future increase in
taxes.
Assumptions of Ricard ian equivalence 1. Income Life -cycle hypothesis : Consumers would like to spread their consumption
over their entire course of life. Thus, if the consumers are anticipating any rise in
taxes in the future then they will save from their current tax cuts or reba tes so that
they are able to pay future tax rises. 2. Rational expectations : Consumers have rational expectations so if there is any tax
cuts they respond to the same to realizing that there might be a probably a future
tax rise. 3. Perfect capital markets : If in need the households can borrow to finance their
consumer spending. 4. Intergenerational altruism : If there is any tax cut or tax rebate for the current
generation it may imply higher taxes or tax rise for the future generations.
Therefore, the current gener ation would respond to current tax cuts or rebates by
trying to save and give more wealth to the next generation so that they can pay for
the future tax rises.
Impact of tax cuts under Ricardian Equivalence
Figure No. 4.4

The principle behind Ricardian equivalence can be illustrated by this simple trade -
off.
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51Chapter 4: New Classical Economics - II
Cut in the tax rates leads to an increase in the disposable income in the short -term,
however in the long -term the disposable income reduces. From this, the rational
consumers always believe that the ir life time income will not change even if there
is a tax cut or a tax rebate.
However, in reality it is only the private sector that sometimes adjusts its savings
that also only partially to offset government budget deficits and surpluses. When
the budge t deficits are very huge there are some signs of increase in the savings.
Various studies in the U.S. have shown that when the government borrowing
increases by $1, there is an increase in the private saving to the tune of 30 cents.
Even the World Bank stu dies which were conducted in late 90s, having a look at
the government expenditure and private saving behaviour around the world, found
similar results.
So when the government budget runs into huge deficits there is an increase in the
private savings to a certain extent, and similarly these private savings drop
drastically when the government budget runs into large surpluses. However, it is
observed that the offsetting effect of the private savings as against government
borrowings are much less than the one is to one ratio. So the fiscal policy can be
less effective in absence of Ricardian equivalence. The effect also varies from
country to country, time to time and also over short run and the long run.
Problems with Ricardian equivalence
There are various p roblems with this theory of Ricardian equivalence 1. Consumers are not rational.
A lot of households would not anticipate that the tax cuts or tax rebates would
ultimately lead to tax rise in the future. On the other hand, many households are not
able to predict the future budget deficits and so are unable to predict future tax
increases as well. 2. If the economy is at Point A
An increase in the government spending can lead to a fall in the private spending.
There is a crowding out effect, but however if the economy is at the point of
inefficiency (C) then it is quite possible that government spending can increase
without any fa ll in the private sector spending. 3. The idea tax cuts are saved is misleading.
During recession the average propensity to consume may decline, however this is
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52 MACROECONOMICS - II
that people do spend some of the tax cuts, even if their average propensity to save
increases. 4. Tax cuts can boost growth and diminish borrowing requirements .
During recession the government borrowings increases mainly due to factors like
lower tax revenue, higher spendi ng on unemployment benefits etc. If tax cuts and
rebates increase spending in the economy and encourage economic growth, this
increased growth will in turn lead to better tax revenue which will help reduce
government borrowings. So if the growth rate of th e economy increases and the
economy is able to recover from the recession then this will improve government’
fiscal position. 5. No Crowding out in a recession.
During recession expansionary fiscal policy is a way of utilizing private saving in
the economy, as during recession private sector saving rise mainly due to lack of
confidence. Though it is generally believed that more the government spending
financed by borrowing will lead to a decrease in private sector spending. However,
this is not always necess ary when government uses the private sector savings in
order to increase aggregate demand. 6. Multiplier effect.
An increase in the government spending may lead to an increase in the spending
in the economy which may finally lead to an increase in the GDP which may be
much larger than the increase in the government spending in the economy.
Check Progress:
1. Explai n the concept of Ricardian equivalence.
--------------------------------------------------------------------------------------------------
------- -------------------------------------------------------------------------------------------
--------------------------------------------------------------------------------------------------
------------------------------------------------------------------- -------------------------------
---------------------------------------------------------------------------------------------
4.7 SUMMARY 1. When government finds it difficult to raise revenue to finance its increased
expenditure through taxation then the government faces revenue constraint and the
government has to resort to budget deficit. 2. Budget deficit financing is done by two important internal resources either by
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53Chapter 4: New Classical Economics - II3. When government sells bonds and securities or prints new money in the market to
fill the gap of revenue and expenditure, it is called money/ bond of budget finance
but it creat es inflation in the economy. 4. When government issues bonds to fill the gap between revenue and expenditure is
called bond finance of budget deficit. According to this method government can
eliminate or reduce budget deficit.
4.8 QUESTIONS 1. Explain Government Budget Constraint in detail. 2. Explain Bond financing of budget financing with the help of diagram. 3. Examine the concept of Deficit financing of budget deficit with the help of
diagram. What are its limitations? 4. Explain Wealth effect of debt financing with t he help of diagram. 5. What is Ricardian equivalence? What problems are associated with Ricardian
equivalence?
™™™™™™™

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54 MACROECONOMICS - II
Module 3
5 NEW KEYNESIAN ECONOMICS - I

Unit Structure :
5.0 Objectives
5.1 Meaning and introduction to New keynesian Economics
5.2 Mankiw's New Keynesian Model
5.3 Mankiw's New Keynesian model in mathematical form.
5.4 New Keynesian Economics and Disequilibrium.
5.5 Questions
5.6 References
5.0 Objectives
• To understand New Keynesian model
• To know the concept of stickiness in prices under New Keynesian Economics.
• To understand the concept of menu cost
• To interpret mathematical derivation of mankiw New Keynesian analysis.
• To understand the concept of Disequilibrium.
5.1 The new Keynesian Economics. The new Keynesian have given us short run price stickiness by using microeconomic theory and thus f orm theoretical foundations. The New Keynesian
Economics is based on the imperfect competition under imperfectly competitive
firm have the downward Sloping demand curve. The downward slope of demand
curve under imperfect competition implies that cut in pri ce by firm will cause some
increase in sales but rival firms are likely to cut their prices too so that it may not
be profitable to change or adjust prices.

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55Chapter 5: New Keynesian Economics-I
Elements of New Keynesian model:
1. A New Keynesian model believe in imperfect competition.
2. Earlier Keynesian model was based on money wage rigidity. The new
Keynesian model is interested in focus on price stickiness
3. A new Keynesian model also assume the stickiness of real variables such as
real wages, relative price level in the face of cha nges in Aggregate demand.
4. New Keynesian model is demand determined It assume that firms set prices
and produce whatever is demand. Thus, with the increase in demand firms
produce and sell more output if they do not change their prices.
5. A New Keyne sian model assumes that demand for labour depends on real
aggregate demand and Real wages. Due to fall in aggregate demand for
output employment and a decline and thus leading to more unemployment. If
wage not is rigid that will affect employment and Hence unemployment will
also increase more.
5.2 Mankiw's New Keynesian model:
Traditional Keynesian model assume that perfect competition prevails in product
market. The New Keynesian model is believer of the thought that firm must not be
working perfect compe tition. Because under perfect competition in the product
market prices are determined by demand for and supply of a product an individual
firm can not influence or no control over the price of the product. Under perfectly
competitive firm their is absence of stickiness of prices.
On the contrary Mankiw and other New Keynesian economists explain that under
imperfect competitive market
Eg. monopoly and oligopoly type of market
In the product market, the firms prefer to keep their prices constant (i.e. sticky )
basically when there is decrease in aggregate demand. The slope of demand curve
under imperfect market for product is downward sloping. Any volatility i.e.
changes in market structure say fall in aggregate demand due to contraction in
money supply, firm under imperfectly competitive market does not reduce price,
due to which he may loose some of customer but not all of them. According to
Richard Froyen “Monopolist competitors and oligopolist have some influence over
the price of their products. In fact t he incentive to lower prices may be fairly weak
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56 MACROECONOMICS - II
will lose sales, but the sales they retain will still be at the relatively high initial
price. Also, if all firms hold to the initial price, no Individual f irm will lose Sales"
Menu cost: a menu cost is the cost to a firm resulting from changing its
prices . The basic reason of not changing price according to the Mankiw and other
new Keynesian economists is that due to change in aggregate demand for their
product, firm has to undergo several adjustments which involve some cost. To
change prices, firm has t o bear problems like a firm has to print a new catalogue
and forward it to its consumers, distribute new price list among its sales staff. The
system of involving cost of making price adjustment are called menu cost.
This occurs in case of restaurants p ractice. When hotels or restaurants changes
prices they print new menus and incur cost on it.
Some of the economist argued upon the beli eves of new Keynesian economists.
According to them menu cost effects are quite small and hence it is not that much
impa ctful behind stickiness of price in the face of decrease in aggregate demand.
Though the explanation of New Keynesian economists for price stickiness has been
criticized but Mankiw argues that “small does not mean inconsequential; even
though menu cost are small, they can have a large effects on the economy as a
whole.”
Mankiw recommended aggregate demand externality.
Aggregate demand Externality has beneficial effect – It refers to a price by a firm
will not influence or affect positively and benefit other firms too. According to
Mankiw, “The firm makes decision by comparing the benefit of a price cut higher
sales and profit to the cost of price adjustment yet because of the aggregate demand
externality, the benefit to the society of the price cut would exc eed the benefit to
the firm. The firm ignores this externality when making its decision, so it may
decide not to pay the menu cost and cut its price even though the price cut is socially
desirable. Hence sticky prices may be optimal for those setting price s even though
they are undesirable for the economy as a whole.”
Other factors responsible for sticky prices : -
1, Potential loss of consumer goodwill
2. Higher price cuts by rival firms
1. When firm raises the price of his product , consumer goodwill is lost but cut
in prices by a firm during the period of recession indicates that it will raise
when economy recover from recession period. Changing price due to
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57Chapter 5: New Keynesian Economics-I
change is not much influential to consumer so do not react to change in
price. Thus, firms prefer to keep prices sticky.
2. Other reason for price stickiness can be : cost cutting prices during the
period of recession is that i t can lead to higher price cut s by the rival firms
or it may even create the situation of price war which harm every firm in
the market structure. This is applicable in oligopolistic market where each
firm keep cut throat competition related to price. They keep their eyes on
the pricin g decision of their rival firms.
Thus, we can conclude that if the above cost of price adjustment are high enough,
there will be price stickiness. And if prices do not adjust in response to changes in
aggregate demand, the volatility in demand influence bu siness cycle, which leads
to recession and booms in the economy.
5.3 Mankiw’s New Keynesian Model in Mathematical form:
The mathematical representation of Mankiw New Keynesian model is based on
basic assumptions. Let assume that there are large number of f irms. Each firm as
some / partial monopoly over its products. The example of such market is
monopolistic competitive market and oligopoly market.
Ö Let Yi is the demand facing by each firm. Pi is the relative price of the
product of a firm to the overall pri ce level (P)
Ö And Y is the aggregate demand for the product
Hence Demand function for each firm
ݕ௜ൌቀ௉೔
௉ቁି௘
ܻ௘வଵ--------------------------- (1)
• Equation (1) represents that demand for a firm’s product depends on its
relative prices ቀ௉೔
௉ቁ
• Price elasticity of demand (e) and
• Aggregate demand (Y)
To make it more easy Mankiw assume that real aggregate demand (Y) is
determined by the real money supply, i.e. ܻൌெ
௉
Substituting ெ
௉ for Y in equation (1) we get,
ܻ௜ൌቀ௉೔
௉ቁି௘
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58 MACROECONOMICS - II
Equation (2) represents that deman d facing a firm depends on its relative price to
the overall price ቀ௉௜
௉ቁƒ†‘‡›•—’’Ž›ቀெ
௉ቁ
which determine aggregate demand. Besides, the relative price of a firm determines its relative position on the
given aggregate demand for the product.
An imperfectly competitive firm will set its price by adding a mark -up over
marginal cost.
Hence,
Pi=௘
௘ିଵ୵
ெ௉ై
Here ௘
௘ିଵ is mark -up
୵
ெ௉ై is marginal cost
A firms profit which we denote by ߨ can be obtained by multiplying the d ifference
between price and Marginal cost multiplied by the amount of output demanded and
sold.
Thus, Profit ( ߨሻൌቀ݅ܲെ୵
ெ௉ైቁ Yi ---------------- (4)
Now suppose the nominal money supply decreases due to which there is decreases
in aggregate demand, with price remaining unchanged. In terms of equation (2)
with the fall in M, demand for output of each firm, Y will dec line which will result
in recession, price of each firm remaining unchanged.
Thus, fall in demand requires reduction in prices by the firms. Reduction in price
by firms leads to downward – sloping demand curve will lead to more sales and
profits.
But price adjustment by firms according to Mankiw would yield only second order
gain and even small menu cost exceed it. Hence firm will not adjust prices.
Resulting to no change in average price with the change in i.e. by reduced demand
conditions for output recession will take place in the economy. Hence deduction in
output (Y) of the firm, the profits as measured by equation (4) will fall.
Important to note is that Mankiw explains that as compared to menu cost of price
adjustment optimum gain from price cutt ing will be minute very small.
Conditions of Second Order:
1. If the difference between the existing price and profit – maximising (i.e.,
optimal) price is small, the potential gain of making price adjustment is very
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59Chapter 5: New Keynesian Economics-I2. If price elasticity of demand for firm’s product is low, the increase in profit is less sensitive to adjusting price to the exactly new profit maximising level.
Thus firms do not adjust prices in the face of change in demand because in their
price – making decisions, they do not take into a ccount the external demand
benefits of adjusting their prices.
Hence from above explanation, we can conclude here that price level (P) and
relative prices of the firms remains same. Thus, reduction in aggregate demand
results in reduction in output i.e., r ecession in the economy.
Price adjustment and co -ordination failure:
As it is proved mathematically as well that firms do not adjust price even though
aggregate demand fall, due to which recession in the economy prevails. Recession
is the situation which is socially undesirable for the economy. Because during
recession, economic variables/activity slow down. Low productivity, less output,
low national income ultimately reduces GDP of economy.
Hence co -ordination among firms become necessary. But due to lack of co -ordination among firms, uncertainty prevails in the product market. Firms anticipate that what prices other firms will be setting.
Thus, according to Mankiw, “If the two firms could coordinate, they would both
cut their pri ces and reach the preferred outcome. In the real -world coordination is
often difficult because the number of firms setting prices is large. The moral of the
story is that prices can be sticky simply because people expect them to be sticky,
even though stic kiness is no one’s interest.”
5.4 New Keynesian Economics and Disequilibrium:
The non - Walrasian disequilibrium approach to macro -economics received a
significant but relatively short -lived interest in the 1970’s and early 1980’s, after
which it became f orgotten as macro -economic research shifted again its interest to
New Keynesian model based on the assumptions of market clearing. The Neo -
classical model assumes price and wage flexibility, while New Keynesian just
inverse of it, that is some degree of ri gidity in prices and/or wages, leading to short
run fluctuation in output and unemployment around their potential.
The disequilibrium approach does not rely on the general equilibrium assumption
and instead consider the possibility of significant non market clearing i.e., continuous divergence between supply and demand, implying rationing by the
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60 MACROECONOMICS - IIIt defines regions of disequilibrium and analyses disequilibrium as a result of shocks, policy adjustment and wage and price adjustments. The New Keynesian models given that disequilibrium approach rely on the restrictive and unnecessary general equilibrium assumption, viz. equality of demand and supply in the goods and labour market. The significant disequilibrium framework in the labour market is given by the labour demand and labour supply functions, the short side principle determining actual employment and a nominal wage adjustment equilibrium that incorporate the excess labour as its main element. The nominal wage adjustment (Price adjustment) function determines that wages adjust to any (ex-ante) excess demand or supply in the labour market. The process of adjustment of wages and prices to disequilibrium is sometimes referred to as Neo Keynesian case, wage adjust faster than price Ö Disequilibrium analysis distinguish four different macroeconomic regimes. 1) Keynesian unemployment is characterized by excess supply in the goods
and labour market. 2) Classical unemployment is characterized by excess demand in the goods
market a nd excess supply in the labour market. 3) Repressed Inflation occurs in the case of excess demand in both the goods
and labour market. 4) Labour Hoarding / underconsumption results in case of excess supply in the
goods market excess demand in the labour market. Ö Different regime have different implication over economic activity. The
Keynesian unemployment regime focuses on monetary and Fiscal stimuli to
increase output and employment toward actual position of equilibrium.
Factors responsible for disequilibrium nee d to be adjusted with respect to
price and wages which is inherently slow in Keynesian model. Ö On the contrary, the classical unemployment regime concentrates on reduction of real wages to increase employment; reducing taxes on labour
income. Ö The repressed inflation regime requires restrictive monetary and fiscal
policies to reduce inflation. Ö The labour hoarding regime needs an increase in wages to restore equilibrium
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61Chapter 5: New Keynesian Economics-I
A disequilibrium model with regime switches behaves in an intri nsically non -linear
manner due to the occurrence of regime switches. It produces different policy
prescription.
5.5 Questions
Q1. Explain New Keynesian Economics.
Q2. Describe Mankiw’s New Keynesian Model.
Q3. Mathematically describe Mankiw’s New Keynesian Model.
Q4. Describe New Keynesian economics and disequilibrium.
5.6 References
1. Mankiw N Gregory (2008) ,” New Keynesian Economics” The concise
encyclopaedia of economics. Library of economics and Liberty Retrieved.
27 September, 2010.
2. Edward Shapiro Macroeconom ics Analysis, 5th edition, Galgota Publication (P) Ltd, New Delhi 110002, Year 1997.
3. Romer, David, 2012, Advances Macroeconomics, McGraw -Hill, Fourth
Edition.
4. Dr H.L. Ahuja, Macro Economics Theory and Policy, S. Chand and
Company Ltd., Ram Nagar, New Delhi -110055, Fifteen Revised Edition.
5. Wickens, Michael, 2011, Macroeconomic theory and the Dynamic General
Equilibrium Approach, Princeton university press.

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62 MACROECONOMICS - II
Module 3
6 NEW KEYNESIAN ECONOMICS - II
Unit Structure :
6.0 Objectives
6.1 New Keynesian Economics and Multiple Disequilibria
6.2 Hysteresis Reconstructing the Keynesian multiplier
6.3 New Keynesian (N.K) Model of inflation
6.4 Questions
6.5 References
6.0 Objective s
• To Understand the concept of New Keynesian economics and multiple disequilibria
• To know the Hysteresis Reconstructing the Keynesian multiplier
• To understand N.K mo del
6.1 New Keynesian Economics and multiple Equilibria:
As per the study of John H. Cochrane, Standard Solution of New Keynesian model observed deep recession and deflation in a liquidity trap, when the natural rate of
interest is negative and the nominal rate is stuck at zero.
6.1.1 New Keynesian economics is a school of macroeconomics that strive to
provide microeconomics foundation for keynesian economics. Like new classical
approach, New keynesian macroeconomics analysis assumes that household and
firms have rational expectatio n. New keynesian believe that there exist imperfect
competition wage and price stickiness and other form of market failure exist in New
keynesian model economy due to these factors fail to attain full employment.
Discretionary policy making may lead to mul tiple equilibria in linear quadratic
rational expectations models once the possibility is taken into account that the
policy makers and other agent may respond to lagged endogenous variables that do
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63Chapter 6: New Keynesian Economics-II
6.1.2 Multiple equilibria is the existence of more than one solution to the equations
describing the equilibrium of an economic model. The multiple equilibria can be
locally unique or these can be a continuum of equilibria. If the equilibria are locally
unique there is generally an odd number of them. This fact is useful in computing
the set of Nash equilibria for a game: Example - if there are two pur strategy
equilibria there must be at least one mixed strategy equilibrium.
Modern New Keynesian economics can be interpreted as an effort to combine the
methodological tools developed by real business cycle theory with some of the
central tenets of Keynesian economics tracing back to Keynes Own General
Theory, published in 1936.
Modern framework of fluctuation pioneered by real business cycle theorist is a
reliance on dynamic, stochastic, general equilibrium modern macro or New
Keynesian economics adopted static, deterministic and partial framework.
6.1.3 Business cycle approach
1) The behaviour of households, firms and policymakers
2) Some market clearing or resources constraints
3) The evolution of one or more exogenous variables which fluctuate in the
economy.
Addition in or changes prescribed by New Keynesian Economist in bus iness cycle
apparatus.
1) It introduces nominal varia bles explicitly prices, wages, a nominal interest
rate
2) It departs from the assumption of perfect competition in the goods market,
allowing for positive price mark -ups.
3) It introduces nominal ri gidities, generally using the formalism proposed by
Calvo (1983), whereby only a constant fraction of firms, drawn randomly
from the population are allowed to adjust the price of their goods.
The assumption of imperfect competition is often extended to the labour market as
well with the introduction of wage rigidities (nominal or real)
6.1.4 Properties of New Keynesian economy
1) Exogenous changes in monetary policy, have non -trivial effects on real
variables, not only on nominal ones.
2) The economy's equilibrium response to any shock is not independent of
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64 MACROECONOMICS - II
Relationship of New Keynesian Economy
1) The Dynamic is equation interpret the current output gap is equal to the
difference between the expected output gap one period in the future and an
amount that is proportional to the gap between the real interest rate and the
natural interest rate.
2) New Keynesian Phillips curve (NKPC) represents that inflation depe nds on
expected inflation one period ahead and the output gap.
3) It represents interest rate rule, which describes how the nominal rate of
interest is determined.
Figure No. 6.1

The Basic Keynesian model
In the above diagram bit represents the equilibrium of economy. The AD schedule
combines the dynamic is equation and the interest rate rule, giving rise to an inverse
relation between inflation and the output gap, for any given expectations, NKPC
Schedule represents positive relation between the same two variables presented by
the New Keynesian Phillips curve, given inflation expectations. The economy's
equilibrium is determined by the intersection of AD and NKPC curve at point E°.
6.1.5 Two dimensions of New Keynesian mod el of multiple equilibria
1) An Exogenous monetary policy shock will affect not only nominal variable, but also real ones. Leads to output and inflation keeping natural rate unchanged.
2) Monetary policy non neutrality occurs because the response of output (and
other real variables) to a non-monetary shock, i.e a shock that changes the
natural levels of o utput and the interest rate, adopted by central bank.
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65Chapter 6: New Keynesian Economics-II
6.2 Hysteresis Reconstructing the Keynesian multiplier
Hysteresis in economics refers to an event in the economy that persists even after
the factors that led to that event have been removed or otherwi se run their course. Hysteresis can include the delayed effects of unemployment whereby the unemployment rate continues to rise even after the economy has recovered.
Hysteresis can indicate a permanent change in the workforce from the loss of job
skills ma king workers less employable even after a recession has ended .
In New Keynesian model hysteresis takes the form of a decrease in labour market
matching efficiency as the average duration of unemployment rises . Hysteresis is
presented to generate larger and more persistent responses of the unemployment
rate and unemployment duration to productivity intertemporal preferences and
monetary shocks.
Professor Blanchard and summer (1986) has coined the term hysteresis high
unemployment and in the context of Europe in the 1980s featured an "insider -
outsider" mechanism.
Model:
With the contribution of continuous efforts taken by various economist e.g.
Ravenna and Walsh (2011) krouse and Lubik (2007) etc model has been framed.
6.2.1 Household
A representative household of unit measure manimises expected lifetime utility
from consumption according to the following problem.
ܷൌܧ෍ߚ௧ܦ௧஼೟భష഑
ଵିఙஶ
௧ୀ଴ (1)
• ߪ is the inverse of the intertemporal elasticity of substitution.
• C is consumption is an aggregate of market produced goods Cm and output
from home production Zh is the unemployed household members productivity and L is the fraction of the household that is employed.
Thus C = Cm + Zh ( l- L )
• The discount factor, ߚ is multiplied by an intertemporal preference shifter,
D - variation in the household impati ence shocks to this variable can be
thought of as representing shocks to desired saving which might for example,
results from a financial crisis.
Discount Shock
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66 MACROECONOMICS - II
D has a mean of 1. The household can purchase one period nominal bonds with a
payoff of 1 for price q, and market produced consumption goods at price P. It earns
wage W, and receives the profits ؠˆ”‘–Š‡ˆ‹ƒŽ‰‘‘†•ˆ‹”•Ǥ
Its budget constraint is
ܲ௧ܥ௧௠൅ݍ௧ߚ௧ାଵင߱௧ܮ௧൅ؠߚ௧ (3)
Household Optimization implies
qt = ߚܦݐ൅ͳ
ܦݐቀܥݐ
ܥݐ൅ͳቁߪͳ
ߨݐ൅ͳ൅ͳ (4)
Where ߨ௧ାଵ‹•–Š‡‹ˆŽƒ–‹‘”ƒ–‡„‡–™‡‡–ƒ†ݐ൅ͳ
Š‹•‹’Ž‹‡•–Šƒ–ƒ‹…”‡ƒ•‡‹–ǡ…‡–‡”‹•’ƒ”‹„—•Ž‘™‡”–Š‡’”‹…‡‘ˆ„‘†•
ሺ‘”ǡƒŽ–‡”ƒ–‹˜‡Ž› ǡ”ƒ‹•‡•–Š‡‘‹ƒŽ‹–‡”‡•–”ƒ–‡ǡ‹ǡ™Š‡”‡“–ൌଵ
ଵା௜೟ )
6.2.2 Intermediate goods production:
Firms derive demand for labour and use it to produce a homogeneous intermediate
good using a linear technology
Yt = Z t Lt – kVt (5)
• V is number of vacancy
• productivity Z has a mean of one and follow the process
In Zt = P z In Z t-1 + σ௭ , t (6)
6.2.3 The labour Market
Separations are assumed to occurs at an Exogenous rate ߜ and hires are given by
H, So the labour employed at date t is given by
Lt = (1 – ߜ )Lt-1 + H t (7)
The number of unemployed at the beginning of period t is given by
Ut = 1- (1 – ߜ )Lt11 (8)
matches are formed according to the matching function

ܪ௧ൌܣ௧ܸ௧ଶܷ௧௧ିఈ (9)
• A is productivity of the matching technology
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67Chapter 6: New Keynesian Economics-II
• The probability that a vacancy is successfully filled is thus ܣݔןିଵǡ™Š‹…Š‹•†‡…”‡ƒ•‹‰‹šǡ
™Š‹Ž‡–Š‡’”‘„ƒ„‹Ž‹–› –Šƒ–ƒ—‡’Ž‘›‡† ™‘”‡”™‹ŽŽˆ‹†ƒŒ‘„‰‹˜‡„›ܣݔן
The average duration of unemployed, denoted M, evolves according to
ܯ௧ൌ௎೟షభ
௎೟ሺͳെݔ௧ିଵሻܯ௧ିଵ൅ͳ (10)
use of bar sign to represent steady state the steady state duration of unemployment
is given by the inverse of the hiring rate i.e ܯൌଵ
஺௫ഀതതതതതത Hysteresis enters the model
as a decrease in matching efficiency as the duration of unemployment increase
accord ing to
ܣ௧ൌܣҧ௘െߛቀெಽ
ெെͳቁ (11)
:KHUHƖLVDQRUPDOLVDWLRQFRQVWDQW:KHQ ߛ =0 it represents " No hysteresis "
according to (Ball 1999 ). In the absence of hysteresis firms respond to the shock
by sharply reducing vacancies which leads to a jump in unem ployment. Hysteresis
implies that hiring will be more costly in the future, so in the presence of hysteresis
firms will not cut back their hiring as much in the present. The smoother adjustment
of vacancies under hysteresis causes unemployment to rise for several period
before beginning to fall because of matching efficiency is lower after the shock,
hysteresis implies firms need to post more vacancies in the later periods.
• The decrease in the productivity can be leading to negative supply shocks
ultimat ely leading to inflation in the economy because of such impact output
gap also held in the economy ultimately through Taylor rule there is increase
in rate of interest. Due to hysteresis, inflation and interest rate return to their
steady state more slowly overtime.
• The natural rate of unemployment can be provided by the unemployment rate
that would prevail under flexible prices and real wages, taking as given the
changes in hiring cost due to hysteresis. As per the study of stiglitz (1994)
imperfect cap ital markets and credit rationing may well exacerbate the effect
of recessions, hampering the recovery of the growth rate even further. Other
than that recurrent negative demand shocks, such as those deriving from
austerity or labour market flexibilization policies, might yield reduced long
run rate of growth. A first microeconomic channel which might induce
hysteresis is the lower innovation rate associated with a reduction in the
aggre gate demand, which turn out in a decline in the productivity growth.
A revival of the debate on hysteresis has emerged in the aftermath of the Great
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68 MACROECONOMICS - II
still below the required rat e if it relate with the 2008 Recession period which lead
to important strong notion of hysteresis.
6.3 New Keynesian Model of Inflation
6.3.1 New Keynesian macroeconomics models have become workhouse f or
monetary policy analysis by academic economists and central banks. It relates to
the nominal rigidities via monopolistically competitive firm and household that set
optimal prices and wages at infrequent intervals.
New Keynesian models introduced three networking channel via which inflation is
costly.
1. Since firms set prices at different times, there is price dispersion across firms.
This price dispersion increases at higher rates of tread inflation and entails a
loss of efficiency in production .
2. Since firms set prices under monopolistic competition, t heir prices are higher
than their marginal cost of production. The rate of trend inflation has an effect
on the average mark up set by firms and therefore on the size of the distortion
that results from monopoly power, which constitute an additional source of
inefficiency.
3. At higher level of trend inflation, firms pricing decision are relatively less
sensitive to their marginal cost monetary policy acts via its effects on
aggregate demand which in turn is related to firm's real marginal cost.
Therefore, monetary policy becomes less effective at higher rates of inflation.
This leads to higher variability of inflation, which is also costly.
6.3.2 New Keynesian Phillips curve, consistent with the rational expectations.
Some of the famous formulation has been used to by John Taylor and Stanley
Fischer using of Calvo pricing, The form of price rigidity faced by the Calvo firm
is given as follows.
=> Each period, only a random fraction (1 -ߠ )of firms are able to reset their price;
all other firms keep their prices unchanged when firms do get to reset their price ,
they must take into account that the price may be fi xed for many periods. It is
believe that they do this by choosing a long price, Z t that minimises the "loss
function"
ܮሺݖ௧ሻൌ෌ሺߚߠሻ௞ܧ௧ሺݖ௧െܲ௧ା௞כሻଶஶ
௞ୀ଴ (1)
Where ߚ‹•„‡–™‡‡œ‡”‘ƒ†‘‡ƒ†ܲ௧ା௞כ is the log of optical price that the
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Optimal Reset Pri ce
The actual solution for the optimal value Z t (i.e. the price chosen by the firms who
get to reset) is quite simple . Each of the terms featuring the choice variable Z t - that
is, each of the ሺݖ௧െܲ௧ା௞௫ሻଶ terms - need to be differentiated with respect to Z t and
then the sum of these derivatives is set equal to zero.
ܮᇱሺݖ௧ሻൌʹ෌ሺߚߠሻ௞ܧ௧ሺݖ௧െܲ௧ା௞כሻఈ
௞ୀ଴ൌͲ (2)
Separating out the Z t terms from the ܲ௧ା௞כ terms this implies (3)
෌ሺߚߠሻ௞ఈ
௞ୀ଴ൌଵ
ଵିఏఉ (4)

To re -write the equation as
௭೟
ଵିఏఉൌ෌ሺߚߠሻ௞ߝ௧ܲ௧ା௞כఈ
௞ୀ଴ (5)
ݖ௧ൌሺͳെߚߠሻ෌ሺߚߠሻ௞ߝ௧ܲ௧ା௞כఈ
௞ୀ଴ (6)
All this equation says that the optimal solution is for the firm to set it's price equal
to a weighted average of the prices that it wou ld have expect to set in the future if
there weren't any price rigidities unable to change price each period, the firm
chooses to try to keep close "on average" to the right price.
This is assumed as “frictionless optimal” price ܲ௧כ . The firms optimal pr icing
strategy without frictions would involve setting prices as a fi xed markup over
marginal cost.
ܲ௧כൌߤ൅݉ܥ௧ (7)
The optimal reset price can be written as
ݖ௧ൌሺͳെߚߠሻ෍ሺߚߠሻ௞ܧ௧൫ݑ൅݉஼೟శೖ൯ఈ
௞ୀ଴ (8)
The New - Keynesian Phillips curve
The behaviour of aggregate inflation in the Calvo Economy.
The aggregate price level is the calva economy is just a weighted average of last
periods aggregate price level and the new reset price, where the weight is
determined by ߠԢ.
ܲ௧ൌߠܲ௧ିଵ൅ሺͳെߠሻݖ௧ (9)
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The above equation can be re - arran ged to express the reset price as a function of
the current and past aggregate price levels
ݖ௧ൌଵ
ଵିఏሺܲ௧െߠܲ௧ିଵሻ (10)
Equation ( 8) for the optimal reset price, the first order stochastic difference
equation
ݕ௧ൌܽݔ௧൅ܾܧ௧௬೟శభ (11)
Can be solved to give
ݕ௧ൌܽ෌ܾ௞ܧ௧ݔ௧ఈ
௞ୀ଴൅݇ (12)
Examining equation (8) , we can see that Z t must obey a first order stochastic
difference equation with
ݕ௧ൌݐܼ (13)
ݔ௧ൌߤ൅݉ܿ௧ (14)
ܽൌͳെߚߠ (15)
ܾൌߚߠ (16)
Reset price is
ݖ௧ൌߚߠܧଵݖ௧ାଵ൅ሺͳെߚߠሻሺߤ൅݉ܥ௧ሻ (17)
Substituting in the expression for zt in equation (10) we get
ଵ
ଵିఏ൫ܲ௧െߠ௉೟షభ൯ൌఏఉ
ଵିఏ൫ܧ௧௉೟శభെߠ݌௧൯൅
ሺͳെߚߠሻሺߤ൅ܯܥ௧ሻ (18)
It can be simplified
ߨ௧ൌߚܧగ೟శభାሺభషഇሻሺభషഇഁሻ
ഇሺߤ൅݉ܥ௧െܲ௧ሻ (19)
Where ߨ௧ൌܲ௧െߠ௉೟షభ is inflation rate. This equation is known as the New -
Keynesian phillips curve. It states that inflation is a function of two factors
i) Next periods inflation rate , ܧ௧ߨ௧ାଵ
ii) The gap between the frictionless optimal price level
ߤ൅݉ܥ௧ƒ†–Š‡…—””‡–’”‹…‡Ž‡˜‡Žܲ௧Ǥ
‘–Š‡”™ƒ›–‘•–ƒ–‡–Š‹•‹•–Šƒ–‹ˆŽƒ–‹‘†‡’‡†•’‘•‹–‹˜‡Ž› ‘”‡ƒŽƒ”‰‹ƒŽ
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Firms in the Calvo model would like to keep their price as a fixed markup over
marginal cost if the ratio of marginal cost to price is getting high (i.e if ݉ܥ௧െܲ௧)
then this will spark inflationary pressures because those firms that are resetting
prices will, on average, be raising them
6.3.3 The NKPC and Lucas critique:
It is widely accepted that inflation expectations will move upwards overtime if
output remain above its potential level and that is little or scope for policymakers
to choose a trade of between inflation and output which is in the form of ߨ௧ൌߨ௧ିଵ൅ߙെߚߤ௧
So there is relationship between change in inflation and level of unemployment.
According to the NKPC, low inflation can be achieved immediately by the central bank announcing (and the public believing) that it is committing itself to eliminating positive output gaps in the future.
Clarida, Gali and Gertler (1999) presents a compact version of the standard New
Keynesian model which embodies nominal p rice rigidity only wages are flexible
and the labour market clears at all times. Extending the model to include nominal
wage rigidity is straightforward, but leads to a more complicated system of
equation.
In imperfectly competitive firms like monopolistic competitive market firms take
into account their cost of production and the expected future path of prices over the
horizon for which they fix their prices.
New Keynesian phillips curve (NKPC) current inflation to future expected inflation
ߨ௧ൌߣݔ௧൅ߚܧ௧ߨ௧ାଵ൅ߤ௧
Ɣ Here ߨ௧ is the deviation of inflation from its long -run level.
Ɣ ݔ௧ Is the output gap, the proportional divergence between the curr ent level
of output and the level that would prevail if price s were perfectly flexible.
Ɣ ܧ௧ Is the expectation operation conditional on information available at
time t
Ɣ ܷ௧ is the disturbance term that is tacked on to the equation and has the
interpre tation of a cost push shocks .
Ɣ ߚ is a parameter that measures individuals subjective discount rates
Ɣ ߣ‹•ƒ’‘•‹–‹˜‡’ƒ”ƒ‡–‡” –Šƒ–†‡’‡†•‘–Š‡…Šƒ”ƒ…–‡”‹•–‹…• ‘ˆˆ‹”•
’”‘†—…–‹‘ ˆ—…–‹‘ǡ–Š‡†‡‰”‡‡‘ˆ•—„•–‹–—–ƒ„‹Ž‹–› ƒ…”‘••†‹ˆˆ‡”‡––›’‡•‘ˆ‰‘‘†•ǡ–Š‡ˆ”‡“—‡…›ƒ–™Š‹…Šˆ‹”•…Šƒ‰‡–Š‡‹”’”‹…‡ƒ†‘ߚ. munotes.in

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72 MACROECONOMICS - II
6.3.4 Assumptions to derive NKPC
1) Firms have a constant probability of being able to revise their prices in any
given period as per the study of calvo(1983)
2) Either the long run trend rate of inflation is equal to zero (following yun
1996), in period when firms do not reoptimize their prices at a rate determined
by trend inflation.
3) The NKPC is derived by aggregating the optimal price - setting decision
across firms and th en taking a first order approximation of the resulting
equation around the trend rate of inflation, which must be zero unless the yun
(1996) assumption is used.
4) The aggregate capital stock is fixed in the short run, but capital can be
reallocated instantan eously and costlessly across different firms.
6.3.5 The cost of inflation in New Keynesian models
By implementing the pricing behaviour of firms in long run equilibrium, it is
possible to show that there is a negative trade - off between average (trend) inflation
and output in New Keynesian marco economic model according to Ascari (2004).
Causes of negative trade off
1) If firms fix their prices for several periods, their relative prices will decline
over time if trend inflation is positive.
2) Firms will fron t -end load their prices so that they are initially higher that the
overall price level when firms are allowed to
3) Firms will produce less of their goods than is socially optimal when they first
set their prices and as inflation erodes their relative price , will wind up
producing too much of their goods. If a social planner could allocate
resources he or she would equalize the marginal productivity of each type of
good produced by the monopolistically competitive firm.
4) Price dispersion is an increasing func tion of trend inflation and Real Gross
Domestic product (GDP) is a decreasing function of steady state inflation
Taylor pricing, the quantitative effects of price dispersion are smaller by an order
of magnitude than under calvo pricing
Taylor pricing holds that firms keep their prices constant for a fixed, rather than a
random , number of period with positive trend inflation the firms with the lowest
relative prices have not changed their prices for the number of periods equal to one
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Under calvo pricing, the firms with the lowest relative prices have kept their prices
constant for an indefinitely long period of time, even if the average number of
period between price change is relativel y low.
The quantitative difference for price dispersion between calvo pricing and taylor
pricing has important consequences for the welfare cost of trend inflation.
The inflation rate at which the average markup is minimized depends on all the
structural p arameters of the model including the elasticity of substitution across
different type of goods and the average length of the nominal price rigidity.
When the prices of all firms increase at the rate of inflation, the slope of phillips
curve is independent of trend inflation.
6.3.6 Monetary policy becomes less effective at higher rate of inflation:
The reduced effectiveness of monetary policy is a cost of inflation. Ascari and
Ropele (2006) show that, under discretionary monetary policy, it is optimal for t he
central bank to respond less strongly to variations in inflation resulting from cost -
push shocks.
Implications for monetary policy.
The three channel through which inflation is costly have implications both for
monetary policy in the long run (the choice of the steady state level of inflation)
and for the conduct of short - run stabilization policy (the optimal degree of price -
level stability)
6.3.7 Optimal trend inflation in New Keynesian model :
1) According to walman (2001) price dispersion is minim ized in the steady state
when trend inflation is equal to zero. The cost resulting from the markup
distortion are minimized at a low positive rate of inflation , when choosing
an optimal rate of trend inflation the costs of these two distortions would have
to be balanced at the margin.
2) As per the study of Amanoet at (2007) and Ambler and Entekhabi (2006) if
the trend rate of technological progress is positive, the trend rates of wage
and price inflation would have to differ so that real wages could grow along
the economical balance growth path. In the New Keynesian model technical
progress increases the benefits of lowering the trend rate of price inflation
towards zero.
3) The flattering of the Phillips curve at higher rates of trend inflation would
also favour a trend inflation rate of zero in order to maximize the efficacy of
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74 MACROECONOMICS - II
4) New Keynesian model concerns the optimal degree of price lev el variability.
5) Great Economist Good friend and king assumes only nominal price rigidity,
and they believe that monetary policy. as optimal if it allows the economy to
attain the same equilibrium that it would under flexible prices.
Thus, from above we can conclude that New Keynesian models have immensely
enriched our qualitative understanding of the costs of inflation. They can be
implemented by central banks for the foreseeable future as forecasting tools and for
analysing the optimal conduct of monet ary policy.
6.4 Questions
Q1. Explain N.K model of macroeconomics, with respect to inflation.
Q2. What do you understand term Hysteresis Reconstructing the Keynesian
multiplier.
Q3. Describe the New Keynesian Economics and multiple Disequilibria.
6.5 Refe rences
1. Heijdra, Ben J. and Frederick Van Der Ploeg, 2002, Foundations of modern
macroeconomics, Oxford University press, Oxford.
2. Dr. H.L Ahuja, Macro Economics, Theory and policy. S. Chand and
Company Ltd. Ram Nagar, New Delhi 110055, Fifteenth Revised Edition.
3. Edward Shapiro Macro Economic Analysis, 5th edition Galgotia Publication
(P) Ltd, New Delhi 110002, year 1997.
4. for module III Macro Economic New Keynesian, Arcand, J. Brezis (1993)
Disequilibrium dynamic during the great de pression. J. Macro exon 15(3) -
583-589.
5. Van Aarle, Bas (2017): Macroeconomic fluctuations in a New Keynesian
disequilibrium model, Journal of Economic structure, ISSN 2193 -2409,
Springer, Heidelberg, vol. 6, 155 -1 opp. 1 -20
6. Rudiger Dornbusch Stanley Fischer, Richard Startz, Macroeconomies, Ninth
edition. McGraw Hill education private limited 2004.
7. Mankiw, N. Gregory (2008). "New Keynesian Economics "The concise
Encyclopaedia of Economics. Library of Economics and Liberty Retrieved
27 September 201 0
8. Blanchard, O.J., Khan, C.M (1980). The solution of linear difference models
under rational expectations Econometrica 48,1305 -1311
9. Jordi Gali (2012), centre de Recerca en Economia International
10 Steve Ambler, The costs of Inflation in New Keyne sian model.

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75Chapter 7: Macroeconomic Policy - I
Module 4
7 MACROECONOMIC POLICY - I
Unit structure:
7.0 Objectives
7.1 Macroeconomic Policy
7.2 Rules versus Discretion
7.2.1 Rules versus discretion argument in monetary policy
7.2.2 Viewpoints of different economists on rules vs discretion
7.3 Credibility & Reputation
7.3.1 Importance of Credibility and Reputation
7.3.2 Reputation and Credibility: An Alternative Keynesian Approach
7.4 Questions
7.5 References
7.0 Objectives
1. To understand macro economic policy
2. To know the importance of rules and discretion in monetary policy.
3. To establish the relationship between credibility and reputation.
4. To understand the Keynesian approach to reputation and credibility
7.1 Macroeconomic Policy
Macro economic po licy focuses on limit ing the effects of the trade cycle s to
achieve economic goals . Macroeconomic policies are designed to achieve specific
objectives. Aims at a stable economic environment to attend sustainable economic
growth.
Like price stabil ity, full employment, maximize the level of national income,
current account balance, providing economic growth to raise the utility and standard of living of participants in the economy. Several secondary objectives are
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designed to influence the aggregate Supply and aggregate demand of the given
economy . Fiscal policy functions over the level and types of taxes levied and the
level an d form of government borrowing, changes in the level and configuration of
government spending. Governments provide open stimulus to economic activity
through recurrent and capital expenditure, and indirectly, through the effects of
spending, taxes, transfe rs on private consumpti on, investment , and net exports.
Fiscal policy is the only arm of macroeconomic policy openly controlled by the
government. Under current institutional provisions , Fiscal policy aims at inducing
aggregate demand by fluctuating tax- expenditure -debt program of the government.
The credit for using this kind of fiscal policy in the 1930s goes to J.M. Keynes who
discredited the monetary policy as a means of attaining some of the macr o-
economic goals . Monetary policy may be defined as a policy employing the central bank’s control of the supply of money as an instrument for achieving macroeconomic goals. Traditional monetary policies include the adjustment of
interest rates, open market operations, and setting bank reserve requirements .
Supply -side policies are designed to make markets work more efficiently . There
are two main types of supply -side policies. Free-market supply -side
policies involve less or no government interference via policies to increase
competiti veness . For example, privati zation, deregulation, lower income tax rates,
and reduced power of trade unions. Interventionist supply -side policies involve
government intervention to overcome market failure. For instance, government
spending will be higher on transport, education , and communication. Supp ly-side
policy instruments are Selling state-owned a ssets to the private sector.
Deregulation - is the exclusion of government power in a particular industry, usually
endorsed to create more competition within the industry. Over the years, the
struggle between proponents of regulation and deregulation has shifted market
conditions . Redu cing income tax rates. - increase the incentives for people to work
harder, leading to an increase in labor supply by an increase in labor hours offered
and more output. Similarly, a cut in corporation tax gives firms more retained profit
they can use for further investment and serves as an incentive. Deregulate Labour
Markets - Reducing the power of labor unions , reducing unemployment benefits ,
removing minimum wages All these reforms aim at making the labor market more
flexible. E.g. When it is easier and/or cheaper for firms to hire and fire workers,
they will be more likely to hire . Deregulate financial markets. - deregulation of
financial markets can surge the volatility of interest rates. before July 1991 the RBI
regulation put ceilings on the interest rates that could be paid on various categories
of deposits by banks and other financia l (depository) institutions. In the present
scenario , commercial banks and other banking institutions can fix their rates of
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The e xchange rate adjustment is another policy measure . Demand and supply in
the foreign exchange markets lead to the establishment of a nominal exchange
rate at a point in time. An exchange rate adjustment is a procedure adopted to
eliminate the valuation effects arising from movements in exchange rates from data
expressed in a common currency . in the given unit we will observe the relationship
between exchange rate and inflation targeting as a macroeconomic policy measure
In the real world scenario many policies are subject to both inside and outside lags,
in the time from which it is recognized that policy should be applied to the time it
is applied (inside lag) , and from the time policy is applied to the time it has
effects (outside lag). It is commonly supposed that fiscal policy (i.e. changes in tax
rates or government spending) has a very long inside lag, but a short outside lag.
Budgets are often passed late. Monetary policy is assumed to have a very short
inside lag, but a long outside one. Largely because of its short inside lag, and
because fiscal po licy may have concerns other than economic stabilization, we shall
make the common assumption that only monetary policy is used to stabilize output.
The macroeconomics theories are pro pounded by various branches like classical,
new classical , Keyne sian, New Keynesian. monetarist . let us view some of their
area of work as we are going to explore the next topics in the light of these
macroecon omic policies.
7.2 Rules vs Discretion
Economist s generally categorize policy -making frameworks as either rules or
discretion. Rules offer time consistency. T he outcome demanded by the public in
the short run is consistent with the outcome anticipated in the long run. Monetary
policy with rules h as the following facets -policy responses that follow pre -
specified plans, direction s to markets instead of leaving it on agents. Rules make
it easier for policymakers to be seen as credibly committed to a good policy and
evading easy temptation s such as short -term inflation to facilitate employment
growth .
Types of rules
a) Constant money growth rule : The money supply is kept growing at a constant
rate regardless of the state of the economy. money is the sole source of
fluctuating demand
b) Activist rule : Policy should react to the level of output as well as to inflation.
considers both output gap ( ›െ›୮ሻ‹ˆŽƒ–‹‘ሺɎെɎ୘) [The output gap is an
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78 MACROECONOMICS - II
its potential output. Potential output is the maximum amount of goods and services
an economy can turn out when it is most efficient —that is, at full capacity. Often,
potential output is referred to as the production capacity of the economy. And
inflation gap is Real or Actual GDP – Anticipated GDP]
According to Kydland & Prescott , (1977) Rules are valuable because the public
observes policymakers and expectations that a ffect their likely actions. In the 1930s
monetary rules were also promoted by Henry Simons to reduce uncertainty about
the price level and, thereby, facilitate private -sector planning. The best illustration
of such rules can be by Milton Friedman, suggesting a constant money growth rule
as a reasonable policy. One more such rule was also f ormulated by Stanford
Economist John Taylor. In his recommendations for central banks to keep interest
rates relatively high (tight monetary policy) when inflation is above its target that
is when the economy is above its full -employment level & a relative ly low -interest
rate in the opposite situation .
There has long been debate over whether the policy should be set by following a
rule or by using discretion, which is reoptimizing uninterruptedly . It might initially
seem that since under discretio n, one always has the option of following a rule, that
rules would always be do minated by discretion. We shall see later that this is not
the case, because the ver y ability to be free to act may create undesirable
consequences. W e will focus on the case fo r simple rules, rather than more
complicated ones but keeping in mind that in principle rules could be enormously
complicated. The traditional case for rules has focused on the uncertainty
associated with economic policy. It may well be the case that if the effects of the
policy instrument on output are not wel l understood, that policy might be
destabilizing rather than stabilizing. We will look at this argument which illustrate s
this point coming from the views of Milton Friedman.
Suppose there is some variable Xt that the policymaker wishes to stabilize. Let Zt
denote the behavior of that variable when economic policy is applied, and let Yt be
the effects of the policy on the variable. Then Zt = Xt + Yt, or the behavior of the
variable under policy = the behavior without policy + the effects of the policy.
Stabilization policy will only be effective when ɐ୸ଶ൏ɐ୶ଶ or the variance of the
variable under the policy is lower than the variance without policy. From the
definitions of X, Y and Z we see that :
ɐ୸ଶൌɐ୶ଶ൅ɐ୷ଶ൅ʹ”୶୷ɐ୶ɐ୷
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Where”୶୷‹•–Š‡…‘””‡Žƒ–‹‘„‡–™‡‡šƒ†›Ǥ‡…‡’‘Ž‹…›‹•‘Ž›•–ƒ„‹Ž‹œ‹‰‹ˆ”୶୷൏െͳ
ʹɐ›
ɐš
First, note that this indicates that policy essentia lly is countercyclical. Second, note
that the requirements this condition places on the policy may be hard to fulfill in
practice. If the standard deviation of the effects of the policy is equal to the standard
deviation of the policy variable itself, then the p olicy must go in the right direction
at least half of the time ( i.e., the correlation must be between ( -5 and -1). The
presence of lags may result in policymakers stimulating the economy as recovery
is already beginning or dampening it as it reaches its p eak. Note that this condition
is more easily met the smaller the effects of policy on the variable are. It is
reasonable to assume that policy effects are smaller than the variance of the policy
is. Simple policy rules, in which, for example, the rule is t o fix the growth rate of
some policy instrument s are examples of policies with small variance. Discretionary policies also in principle could have a small variance, although in
practice they may not. Thus this relationship has been taken as a suggestion that
simple policy rules are most likely to be stabilizing .
Whereas discretion provides widespread latitude to design the best policy in
response to the given situation. new policy each period provides flexibility in
unforeseen scenarios. If the discretionary policy is chosen by policy makers, then
they make no obligation to future actions or activities. They may implement a
policy more expansionary than firms and general people expect, as a result , there
will be an increase in the economic out put and reduce unemployment in the short
run. when the environment is uncertain and policy -makers proclamations are
credible by the general public in such cases Discretion may better serve the public
interest. They may have better inflation performance in the long run if they do not
try to surprise people with an expans ionary poli cy.
7.2.1 Rules versus discretion argument in monetary policy
As Mishkin and most economists characterize inflation targeting as a monetary
policy framework that can be called "limited discretion” or constrained discretion
which combines the advantages attributed to the traditional rules with discretionary
policy. Thus, they discard the impression of dichotomy rules - discretionary policy.
as rules can be too rigid as they cannot see any contingency, another problem with
rules is they do not follow the use of judgment. Thirdly if rules are imposed without
proper knowledge of the model of the economy any policy rule will be proved to
be wrong. F urther structural changes in the economy would lead to a change in
coefficients in economic models this makes the case for discretion. Monetary munotes.in

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policy credibility problem occurs when those who set the monetary policy wants to
achieve an optimal monetary po licy rule or a plan for future policy at a time –଴,
chosen arbitrarily. The monetary authority will have to maximize a function under
certain constraints derived from the need to ensure the balance of the private sector.
When they select the best policy f or a time (–଴+s) in the future the policymaker
must take account of how the policy for the period ( –଴+s) will affect the behavior
of private economic agents from time t to time (–଴+s) When it comes to ( –଴+s) arises
the following problem: the trajectory of monetary policy determined at time t will
be any longer optimal? A policy is a time consistent if the activities planned at a
time –଴ for time (–଴+s) remains optimal when it comes to being implemented
effective ly at the time ( –଴+s). Usually, according to expert studies of monetary policy, it will no longer be optimal. Since consumer decisions taken between times –଴and (–଴+s) have been already adopted, monetary policy can no longer influence
them. Monetary policymaker faces problems, other than those which were valid at
the time –଴this will make him prefer a different policy. In this case, the original
choice that he did will be dynamically inconsistent . An optimal monetary policy
strategy at the time –଴ is dynamically inconsistent if at the time ( –଴+s), when
should be adopted is no longer optimal.
In general, there must be some externalities and should not be a sufficient number
of tools to control them (a condition which usually occurs in most economies) for
that dynamic inconsistency
phenomenon to app ear. If monetary policy decision -maker is obliged to respect for
the pe riod
(–଴൅•ሻ–Š‡…‘†—…–†‡–‡”‹‡† ƒ––Š‡–‹‡–଴because the cost of monetary
policy change is too large, the dynamic inconsiste ncy problem becomes irrelevant.
In reality, monetary policy is conducted in a dis cretionary environment in which
decisions are taken sequentially and a review of the decisions taken by policymakers is a common practice. In this case, priv ate agents will anticipate the
future incentive of monetary policymakers to abandon the plan proved to be
optimal ex -ante and would expect instead to be impleme nted an ex -post optimal
policy. Kydland and Prescott (1977) show that, in a discretionary enviro nment, in
which policymakers will choose to follow the strategy takin g into account only the
present situation, this will not normally result in maximizing the social function.
Starting from the benefits it might produce unexpected inflation by increasing
output and hence, reduce unemployment below the natural rate and also increase
government revenue by nominal depreciation of government debt, whic h woul d
have the same effect as levying a new tax income, Barro and Gordon (1983) show munotes.in

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that a rule-based monetary policy leads to lower costs than a discretionary policy.
In the case of using monetary policy rules, the bank will choose the level of
inflation which agrees with expected inflation. The consequence of this leads to
lower costs related to inflation, the use of monetary policy rules lead s to more
satisfactory results than discretiona ry policy, which coincides with inferences
extended by Kydland and Prescott. The existence of inflation bias in the case of
discretionary policy occur s for two reasons: One is the fact that the central bank is
stimulated to produce inflation more than the expected inflation when economic
agents' expectations are set and the s econd reason is that the central bank can not
constrain to gain a zero rate of inflation.
An e xplanation is that monetary policymaker s cannot be credible regarding the
policy of zero rate s of inflation. Thus, even if he announces that the inflation rate
will be zero and the judgments of private agents will be based on the assumption
that inflation will be zero, is in his interest to induce a rise in the price level.
7.2.2 Viewpoints of different econ omists on rules vs discretion
The argument of rules versus discretion was origin ated in the writings of Henry
Simons . A policy rule can be specifi ed as fixing the quantity of currency and
demand deposits, or gen eral as when the monetary authority announces to the
public the course of action it will take for various states of th e economy, putting its
reputation behind it. Although rules can be set up in an equation form, such as the
Taylor Rule, they require variables such as the natural level of output and expected
prices that are only approximate.
A rule can be active, as when it is increasing the money supply when the economy
is on a decline ,
When the money supply is increased by a fixed percent age annually it 's called the
passive policy rule.
Meaning -wise rules are normative but some of them are descriptive, meaning that
they predict values close to what the authorities allow. The danger with rules is the
tendency to substitute administrative authority for rules, which tends to weaken
competition and expand government activities. In 1990, President George H. W.
Bush switched the term “policy rule” with “ policy system” in his message to
Congress. Discretion requires delegating responsibilities to economic institutions
such as the Federa l Reserve (or central bank) to decide macroeconomic objectives
and policies as they see suitable . The world of uncertainty demands discretionary
policies as per Kenneth Arrow . A decision improves with time and experience,
which requires information that is available only sequentially. A decision -maker
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action to take. The d iscretionary policy may be inconsistent when it does not
change the initial conditions that create a disruption. or shortsighted when a policy
requires lags to materialize. The argument over rules versus discretion empirically
continued . If a rule is place d on the money supply, the monetarists look for a n
underlying link between money and prices. The definition of money and a stable
velocity -of-circulation function are necessary for empirical investigation. A
currency plus demand -deposit definition is not s ufficient for rules to w ork because
people hoard money (preferring liquidity) , many “near money” substitutes may
exist, wage and price rigid ity exist . If wage and price rigidities are only slight, then
a rule might work, but it would need the nonexistence of substitutes such as equity
or bonds; it would also require that loans be held for long periods so that repayment
on the principal is not required. For Simon, such a systemic policy appears
paradoxical, as it would necessitate an intelligent monetary system on the one hand
and credibility of rules on the other.
Milton Friedman extended the argument by articulating two rules on the money
supply, the k -percent rule, and a Friedman rule, which he later referred to as the “5
percent and the 2 percent rules,” respectively . In the 5 percent rule, “the aggregate
quantity of money is automatically determined by the requirements of domestic
stabil ity”. To cover the international scene as well, Friedman complemented the 5
percent rule with a flexible exchange rate. The 5 percent rule, however, runs up
against rigidities and lag effects in the economy, which are short -run in nature. The
long-run 2 pe rcent rule requires nominal interest rates to equal the opportunity cost
of producing money for the interest rate to be approximately zero. More rec ently
Geoffrey Brennan and J. Buchanan have accepted monetary rules on political
grounds –containing discretion, permit the central bank to generate higher socially
optimal inflation rate .so that they can enjoy the revenue from money creation.
The exploration for a stable velocity -of-money function was secondary . Because
the velocity function was variable in the short run instead Friedman turned to more
general shreds of evidence , including the use of his permanent -income concept for
further empirical analysis. According to Fi nn Kydland and Edward Prescott 1977 ,
policy rules could improve social optimum. A change in administration leads
people to change their expectations and their current decisions. People have
expectations about the tax policies of different administrations. Onc e people have
some knowledge of such changes, they adjust their expectations and set i nto motion
a series of chan ges that may or may not get into an equilibrium under the current
state of the economy. Some policy rules are suboptimal in the sense that their
response mechanisms depend on early conditions, and to continue the initial policy
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Robert J. Barro and David Gordon opined that people would adjust their expectation s of inflation to eliminate surprise inflation, creating a potential for a
higher money supply and inflation in equilibrium. If policy rules are implemented,
such expectations -driven inflation would not occur, but policyma kers would have
an incentive to break the rule —cheating —because higher inflation means less
unemployment and more growth, according to the Phillips curve .
Policymakers and the public are in a game -like situation if policymakers are
concerned about their “reputation” or “credibility.” The incentive to be credible is
based on the substitution of short -term incentives for higher -level in centives from
lower inflation in the long run. Taylor extended his policy rule to price and nominal
income rules for the open economy under fixed versus flexible exchange rates.
7.3 Credibility and Reputation
In the mid -1980 s with the branch of New Classical economics ( rational
expectations) revo lution there was a paradigm shift in terms of monetary policy
operation with the formation of a new consent , where price stability became the
main object ive for the monetary authority Based on the working of economists like
Muth , Lucas , Sargent , and Wallace --monetary policy should not be used to affect
real output and employment, but to keep inflation under control. Provided there is
the absence of informational barriers and money illusion . The combined acceptance
of the fol lowing assumptions like rational expectations, a continuous market -
clearing equilibrium economy assuming fully flexible prices , and the profit -utility
maximizing behavior , bring forward several important deductions about economic
policy inferences . Among these inferences we can identify, the monetary policy
inefficacy to upset output and employment at short and long terms; the disinflation
costs that fall on real activity; the time -inconsistency problem from optimal
discretionary policies; the importance of reputation and credibility for the monetary
authority and its policies, respectively, and; the develop ment of " technology
commitment " and rules that restrict monetary policy and attempt to avoid the
inflationary bias and the time -inconsistency problem.
As New Classical econo mics has progressed significantly. These developments in
monetary theory have highlighted the importance of the central banks' reputation
and the credibility of their policies for the conduction of monetary policy and the
perceived results in the economy ... While new models regarding credibility and
reputation have combined New Classical assumptions within their frameworks
leading, at the same time, the acquired results to become well-matched with the
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policy will be more effective if the goals and aims monitored by central banks are
considered credible by the public and if the policy is applied by central banks with
a strong reputation of being an institution mainl y worried about price stability. The
theoretical foundation that explains the development of works concerned with the
reputation and credibility of central banks and their policies is based on the
literature of ‘Rules rather than discretion . The arguments regarding the monetary
policy's credibility and the central banks' reputation were presented for the fi rst
time by Fellner and by Kydland and Prescott (1977) - for the case of credibility -
and, later, by B arro and Gordon for the case of reputation - when they analy zed
economies presenting high and unwanted inflati on rates. An attempt was made to
prove that credibility and reputation represent key elements for finding the solution
to the inflationary bias and the time -inconsistency problems by the works of both
Kydland and Prescott and Barro and Gordon . Credibility is associated with the
degree of confidence that the public has in the central bank's ability and determination to keep itself on an announced goal and to achieve it, that is, if the
policies (or plans) are credible, reputation is related to the public's belief about the
preferences of the policymaker and to the expectations formed by the public about
the actions that monetary authoriti es will take. Hereafter reputation is subject to
public expectations about actions by the central bank and monetary authorities’
Monetary policies will be more effective and then will achieve a good amount of
credibility if central banks strengthen their reputation and follow a rule concerned
with inflat ion stability . Central bankers and economists have acknowledged some
basic principles guidelines for central banks to conduct their policies and better
reach their g oals.
These principles are price stability, fiscal policy should b e aligned with monetary
policy, time-inconsiste ncy is a problem to be avoided, monetary po licy should be
forward -looking, accountability , monetary policy should be concerned about output as w ell as price fluctuations and stability of the financial system , sustainable
economic growth, low u nemployment rat e, monetary policy working through real
interest rates and expectations. With the concepts of the monetary economy,
effective demand and Keynesian liquidity preference , the possibility for output and
employment improvement as well as inflatio n stability has become the goals for
central banks. Thus, the progress concerning the influence of reputation and
credibility over the economy must be enlarged assisting the examination of a new
approach that considers that monetary policies are not neutral. The role of central
bankers' reputation and the credibility of their policies must be replaced since both
exercise influence over the expectations of the public, causing changes in aggregate
demand. The capability of central banks in particular and monetary policy , in munotes.in

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general, to affect the actual and future economic perfo rmances through public
decisions depends on their ability to influence private -sector expectations regarding
not only the future path of the interest rate and the future state of the econ omy but
also the way they implement actual and future policies, make their announcem ents
and account to the public. Exploring the concepts of reputation and credibility and
their importance in a context where central banks' policies are not neutral, that
means , monetary policies affect real and nominal variables. How the reputation is
developed by the monetary authority and the commitmen t to a strict rule -based
policy affect the state of expectations, and then the economic performance,
enabling a particular situation that we call "credibility trap" - which makes
monetary policy ineffective to affe ct real activity when ne cessary.
7.3.1 Importance of Credibility and Reputation
At the same time that macroeconomic theory suffered radical transformations, led
by the revolution of rational expectations, a new discussion emerged from the
following problem: how social losses should be minimized when actions of
economic policy must be taken at several periods. Let's suppose the following
situation to understand the time -inconsistency problem: the government formulates
what it considers to be an optimal policy as a domina nt player and then announces
its intentions to the private sector who is a follower of policies ; if this policy is
believed, then in the next periods, it may not remain optimal, since the government
finds that it has an incentive to go back on a promise on its previously announced
optimal policy. In this sense, an optimal policy suggested at time t is time -
inconsistent if re -optimization at t + n implies a different optimal policy, consequently, time -inconsistent policies will significantly weaken the cr edibility of
future announced policies.
The a rgument of the New Classical approach that since the monetary authority has
no pre -commitment with an announced policy and usually makes use of its
discretionary powers, it will have an incentive to cheat, makin g the announced
policy time -inconsistent and then non -credible. The approach secures those
discretionary policies produce sub -optimal results since display an infl ationary
bias. Here so -called considered as optimal policy loses its credibility due to time
inconsistency hence increases its chances to become neither feasible nor optimal.
The orthodox approac h about credibility :
With the provisions , the economic system and active policies are eminently stable .
Besides, it suggests that monetary policies would only be effe ctive if , policymakers
would have an incentive to cheat to promote output increases (even if transitory). However, once private agents' expectations about inflation are corrected, munotes.in

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unemployment would lean to yield its natural rate, but with a higher equilibrium
inflation rate. It means that optimizing actions implemented by a monetary
authority with discretionary powers tend to carry the economy to suboptimal
equilibriums, with higher levels of inflation. Hence the conclusion is the possibility
of changing the monetary supply exogenously , trying to make less than the natural
rate of unemployment , leads to losses of monetary policy credibility since agents
recognize the incentive to promote unexpected expans ions. Therefore, credibility
improvements are unequivocally related to the expectation that monetary policy is
not going to change, that is, the monetary authority will follow its announcements
and will be executed based on mechanisms that make discretiona ry actions
impossible.
According to economists Blackburn and Christensen "the concept of credibility is
not well defined in economics and has received different interpretations by
different authors. Perhaps the most general interpretation is the extent to which
beliefs about the current and future course of economic policy are consistent with
the program originally announced by policymakers". Whereas Drazen presents two
different perceptions about credibility: the first one is the credibility of the
policymaker mean s the policymaker will do what exactly he says and the credibility
of the policy means the expectation that policy would be carried out . New Classical
economics suggests, for a monetary policy to be considered credible it must follow
a rule in which the agents will believe that the monetary authority is not going to
break a promise . Hence, to affirm that a policy is credible the public must believe
in the rule and, through expectations, in the results , the monetary authority is trying
to reach. As expectations are well-thought -out in important monetary program
element s, the lack of credibility of a certain policy may thwart , or even obstruct ,
the reach of a certain goal due to formed expectations. The policy is credibility
criteria are based (a) on the expectations formed by the public about its effects on
the economy, (b ) on the policymaker's cre dibility and reputation , and (c ) on the
circumstances the policymaker is going to face. A policy may be feasible in one set
of circumstances, but not in others, that is, " expectations of how external environment will develop, rather than the credibility of the policymaker, will then
be crucial in assessing whether the policy is credible " (by DRAZEN)
A credible monetary policy, following the New Classical thought , have the
following features:
Firstly, Policy implementation is done by an independent central bank through a
rule which bounds the monetary authority's actions, avoiding the time -
inconsistency problem and the inflation bias; Secondly, seeks to keep inflation
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of employment and output at the long term; Thirdly, converges the expectations of
the public to its goal, and consequently, makes the public believe that the implemented policy will be carried out and the goal will be reached as fast as
possible, and; reductions in the costs of disinflation in the short run whenever a
policy against inflation must be implemented.
Central banks will attempt to establi sh a specific sort of reputation, to achieve the
credibility of their policies and affect the expectations of people. The concept of
reputation can be thought of in terms of the actions an agent is expected to take.
"Reputation often refers to generally held beliefs abou t an individual's or a group's
character " According to the reputation built by central banks, the public form s
expectations about the policymakers' future actions. For instance, as the monetary
authority's reputation of being to ugh on inflation becomes stronger, it strengthens
the confidence in expectations regarding future monetary authority's actions seeking to establish and maintain a stable price environment. This is the sort of
reputation that the New Classical economics suggests to central banks; an
institution that must attempt to build the reputation of being hard on inflation.
According to this approach, the monetary policy credibility depends on the
expectations that the publi c form for monetary authorities’ future actions against
inflation.
Economic entities and units are often con cerned about central banks'. Since the
public attempts to foresee central banks' future activities based on what it has
observed in the pa st - and, of making use of all available information - it is
important to perceive that reputation plays a fundamental role for that because it
reflects some sort of repeated behavior that policymakers have always presented.
Barro and Gordon were the first to build a game model to analy ze policymakers'
reputat ions. Backus and Driffill added to this an infinite time horizon model in
which the public is uncertain about the preferences of the policymaker. The
subsequent models inspired in the work s of Kydland and Prescott, Fellner suggests
that there is no case for the shortcut to gain credibility and make reputation stronger
hence both must be built and nurtured over time. The New Classical economics
regards that central bank can best improve their credibility and reputation by
keeping a consistent record of inflation within the target and by not compl ying with
pressure for short -term gains in economic growth at the expense of long -term price
stability. Moreover, the monetary policy should be conducted by a stringent rule
that makes the public's expectations about policymakers' future actions well-
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Undeniably , credibility and reputation can considerably impr ove the effectiveness of monetary policies since they increase the confidence of the agents on expectations regarding future central banks' actions. Policy signals from credible
monetary authorities with resilient and well -defined reputations will be better
understood and generally accepted by market participants and the public, resulting
in a more effective m onetary transmission mechanism through expectations and a
lower cost of disinflation whenever a policy of this sort m ight be implemented.
The New Classical models used the P hillips curve to describe the trade -off between
unemployment (output) and inflation whenever unexpected monetary policies were
implemented. As these models make use of rational expectations, the inexi stence
of the trade -off is accepted in the long term, suggesting that central banks should
pursue only price stability. In other words, monetary policies must not be used to
affect real activity, because a higher rate of inflation and the output and the
unemployment at their natural rates will be the long -run results. So, the central
banks' reputation must be of an institution tough on inflation which will not
implement policies attempting to keep unemployment below its natural rate, that
is, an institution that will follow rigorously the monet ary rule to keep inflation low
and stable and to increase the credibility of its policies.
Sicsú (1997 ) criticized the basic assumptions of New Classical monetary policies
models. He argued that the economy does not have a natural tendency toward an
equili brium position; the equilibrium stability property would not prevail if
expectations, nonetheless rational, may be heterogeneous. Hence, if expectations
may be heterogeneous, they can also be disappointed and then mistakes can happen.
Mistakes can change t he parameters that sustain the equilibrium position suitable
to the natural rate of unemployment. Consequently, the unique property will not be
valid either. Chick (1983), however, argues against the use of the Phillips curve as
a general and representativ e model of the economy 's functioning. The alternative
Keynesian approach, here proposed, also argues against the use of the New
Classical Phillips curve as the framework which may represent the general
functioning of the economy and which will guide monetary polic y. The work of
Libânio (2008) explores the idea that aggregate demand matters for economic
activity, both in the short run and in the long run. To that extent, it discussed the
endogeneity of the natural rate of growth, Recent models that con sider the modus
operandi (procedure) of the economy based on the New Classical assumptions
suggest central banks implementing and following some sort of nominal interest
rate rule to control infl ation . Although , as this rule does not consider the kind of
inflation pressure, treating any kind of inflation as being caused by demand, tends
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growth in the long run, therefore, in the futur e, leading to a situation that we call
"credibility trap" .
7.3.2 Reputation and Credibility : An Alternative Keynesian Approach
According to Keynesians, in the context of the monetary economy " fluctuations in
effective demand and employment occur because, in a world in which the future is uncertain and unknown, individuals prefer to retain money, postponing consumption and investment decisions ". The expectations and the state of confidence of the agents play important roles in the decision -making p rocess in an
environment of "fundamental uncertainty". Hence, money and monetary policies
also play important roles, as the agents, in condition s of uncertainty, may prefer
liquidity instead of acquiring goods through cons umption or investment. To find
out how central banks can affect the performance of the economy through the
influence of their reputation and the credibility of their policies, it is necessary to
understand how economic agents make decisions based on their expectations and
their state o f confidence in these expectations. Therefore, it is essential to know the
determining elements of expectations and confidence and how these elements are
affected by central banks' reputation and credibility.
It is a consent among economists that expectati ons are an important monetary
policy transmission channel. In this sense, aiming at linking the reputation -
credibility binomial with the process of expectations formation . As full knowledge
does not exist at the moment in which a relevant economic decision must be taken,
the economic agents make use of the available information, their tacit knowledge
about the living context and about the institutions ( central bank) able to affect them ,
and their imagination informing potential set-ups. Based on these elements, they
form expectations that will guide their decisions in a monetary economy. As these
expectations are considered an important monetary transmission channel, the
monetary authority will increase its possibility of reaching its g oals if the agents
share the same beliefs about the future and if they are endowed with enough
confidence in the expected results which are capab le of affecting their concerns.
Confidence is a fundamental component o f the transmission process of monetary
policies through expectations; it reflects the agents' perceptions and degree of belief
concerning the disposition of the monetary authority and the way it conducts the
monetary policy.
The concept of central banks' re putat ion -according to the Keynesian approach
involves the agents' st ate of perception concerning the preferences of the monetary
authority, the actions expected to be taken by t he monetary authority, and the
monetary authority's character and features . Wh en this discernment suddenly munotes.in

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changes modifications may emerge in the uncertainty perceived, provoking the
worsening of the "state of expectations" of the public through the state of
confidence. Consequently , the uncertainty perceived, affected by the public's
knowledge, may increase or decrease as per central banks' reputation, to the
credibility of the policy adopted, and, to the context in which central banks acts.
Although t he central banks' reputation dep ends on past events, it can affect
expectations about future events. Therefore, it is expected that monetary authorities, presenting a solid and well -defined reputation of being institutions
concerned with price stability and growth. Reputation and credibility serve as
cataly zers in the process of merging expectations and confidence to the policymakers' scheduled objectives. The confidence in monetary policies and on
central banks is decisive for the monetary policy effectiveness through expectations . Growth needs to induce the agents to change financial a ssets for
capital goods , that is, to change interest gains for expectations of promising future
profits. Monetary establishments must be also capable of establishing a stable price
environment that will reflect itself on the public's expectations regarding the central
banks' commitment to keeping inflation low and stable. If the private sector expects
that the goals for inflation a nd growth are going to be reached and when central
banks revealed their commitment to both and have been coordinating their policies
with the other economic policies, doing whatever is necessary and coherent for that
to happen, hence the private sector wil l consider these beliefs when deciding and
will readjust prices and form expectations for inflation and demand growth based
on these pieces of information. As central banks present a strong and defined
reputation and act implementing credible and coordinat ed policies aiming at
promoting inflation stability and economic growth, their ability to influence the
"state of expectations" towards more investment decisions is improved. Inversely,
central banks presenting a fragile reputation, in a context of uncerta inty and assuming the New Classical recommendations make the agents' liquidity preference increase because they find it difficult to keep interest rate variability
low. When assuming the idea that monetary policy is not neutral in either the short
or the l ong terms and recognizing that the public not only forms expectations for
inflation, but also for future events that may affect its business' profitability, central
banks can be effective in changing both real and nominal variables. With the idea
that mone tary policy is not neutral, it is conferred to central banks a wider fi eld of
action than the one proposed by the New Classical approach. With the method
central banks conduct their policies, choose their instruments and coordinate their
policies with the other policies, besides providing information for the process of
expectations formation, add knowledge on how they understand the operation of
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For a monetary policy to be considered credible, it must be co nsidered efficient. As
per Sicsú (2001), an efficient monet ary policy would aim at unambiguous goals,
leaves the least room for its tools to be used in contradiction with each other, o r
with other policy tools, makes use of to ols suitable for its goals, gives out clear
signals to agents and financial markets to stimulate them to act in the same
directions desir ed by the policymakers, and can reach a specific goal without
damaging the economic performance as a whole. In this way, an efficient monetary
policy, a nd thus credible, must be performed by an institution competent in
reducing uncertainties, coordinating expectations , and following unlike but feasible
objectives - and not only low and stable inflation, though this is a very important
objective.
The debat e concerning how the monetary policy should be conducted and what are
its effects on the economy has always been the core of the " rules rather
than discretion " literature, which in turn, is supported by another discussion:
whether the monetary policy neutr ality in both the short and the long terms is valid
(and effective) or not. Broadly those who defend the neutrality argue in favor of
the need of using some strict rule -based policy to guarantee (i) the application of
dynamically consistent actions, (ii) the avoidance of the inflation bias , and, as a
consequence, (iii) the accomplishment of the main central bank objective which is
stable and low inflation - according to the New Classical economics. Central banks
attempt to thrive in forming a lo w and stable price level which supports reducing
inflation variations and interest rate variations to get desirable growth However,
the use of a strict monetary policy rule, throu gh interest rate manipulations is
capable of reducing and stabilizing the observed inflation as much as the inflati on
expectations, in a situation of high idle capacity and considering that monetary
policy can affect output and employment; it may lead the econo my to present low
economic growth rates below those socially desirable, as much as it creates an
adverse envir onment for investment decisions.
The Keynesian approach , suggests that full employment , as well as inflation
stability policies, should be implemented by the combination and coordination of
three types of instruments: monetary policies, fiscal policies , and income policies .
Fiscal Policy was designed to sustain long -term expectations as to the aggregate
level of income the state wa s committed to support ing. Income policies would
regulate the wage/price relation to avoid ing cost inflation. The role of monetary
policy, under these conditions, would be to provide active balances for transaction
needs and to prevent increases in liquidi ty preference from being translated into
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applied . None of them can be thought of as Keynesian when taken in seclusion
because they would create difficulties for the econ omy that could end up in a crisis.
Hence the definition and design of policies should consider the following principles: institutions should be created to achieve more efficient and permanent
coordination of agents, allowing them to devel op coherent strategies; a set of
instruments must be developed, paying particular attention to the timin g of their
operation, and; specif ic policies should be chosen not i n isolation but as parts of a
global plan to control and to steer the economy (these should not be fiscal policies
decided independently of monetary policies or any other).
In the post -Keynesian approach, there are many an d different causes for inflation,
and, hence, there are several types of inflation Conferring this view, these are the
types of inflation that may be classified: wage inflation, profit , or degree of
monopoly inflation imported inflation , demand inflation , inflation of decreasing
returns to scale , tax inflation , and, inflationary shocks . Since different forms of
inflation are recognized, accordingly , for each type of inflation, a specific anti -
inflationary tool should be used. For instance , the cases of wage and profits, degree
of monopoly, inflation should be f ought through the strategy of tax-based on
incomes policy ; regarding imported inflation, a combination of exchange -rate,
monetary, tax , and industrial policies could be used; tax inflation should be avoided by governments themselves through fiscal policies committed with macroeconomic stability as a whole, and not ju st with price stability. D emand
inflation, according to post -Keynesians, should be f ought through contractionary
macroeconomic policies, mainly through reductions in government spending . Post-
Keynesian suggest much more than an anti -inflationary macroeco nomic polic y, to
improve the macroeconomic performance as a whole, the chances of the existence
of the "cr edibility trap" are reduced.
According to the alternative Keynesian approach, central banks improve their
capacity to affect the "state of expectations" of the agents, and then, through
monetary interventions succeed in reaching their predetermined goals as fast as
possible and with more effectiveness, they must define and strengthen their
reputation and implement efficient and credible polic ies, without neglecting their
capacity and responsibility to improve the economy as a whole - it means that
output and employment must not be set apart.
Undoubtedly, monetary policy exerts influence on inflation through interest rate
manipulations provided that it affects aggregate demand. However, the inflationary
process is not always associated with demand warming, wh ich requires other sorts
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a unique instrument and by assi gning to central banks the exclusive commitment
to price stability, other aspects of economic life which have the power to
compromise the potential of economic growth in the long term may be affected.
One such argument is by the New Classical economics, fo r the adoption of a rule
for the monetary policy (like an interest rate rule) is its effects upon expectations
of inflation and then upon the observed inflation. Those who defend the conduction
of the monetary policy over a rigid rule judge the success of the policy built
exclusively on inflation performance, that is, based on the deviations of the
inflation or the expectations of inflation to the target. They attribute virtually zero
weight to real activity performance or any other possible economic objective. These
results are not taken by the parameters and/or statistics that appraise the success of
monetary policy and its credibility.
The rule -based policy for combat inflation over interest rate manipulations makes
no di stinction between the firms and or the markets that are responsible for the
process of inflation and thos e that are not. As a consequence , many firms which are
acting compatibl y with price stability will be punished when the interest rate is
raised. Some of these firms may not resist high financial costs and the weak
demand, starting a process of bankruptcy that will result in a higher unemployment
rate. Other firms may give up on realizing the investments that will be necessary to
absorb the workers still unemployed. So, when it is recognized that the beginning
of an inflationary process may not always be attributed to an increase in demand,
it gives rise to the need of issuing a precise inflationary diagnosis which will be
conclusive for the choice of the instrument or for the combination of instruments
that will help to reduce and stabiliz e the inflationary process.
When central banks act over a firm mechanical interest rate rul e concerned with
only one objective, that is, aiming at maintaining inflation l ow and stable, it
disregards the process of price formation as a result of distributive conflict between
groups and agents with specific goals, meaning that the rule affects dis tinct
economic groups with different additions in a different way; the different impacts
on firms presenting different cost structures, resulting on particular sorts of
reactions from the firms, and; the consequences for the process of fund accumulation. Therefore, this kind of policy is not suggested for this purpose as
well as the development of a reputation follo wing the New Classical ways , since
they do not allow the creation of a favourable environment for the course of
economic growth. Instead , they create a situation of "credibility trap" for central
banks, making it impractical through expectations channel for central banks to
improve the economic performance as a whole; Since to keep this reputation
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Let’s consider t he Keynesian approach for a successful monetary p olicy must take
into account the acquired economic growth, the obtained inflation' stability, the
installed capacity used to level, the promo ted income distribution, and the acquired
monetary -financial system stability. Central banks must regard the impacts of their
policies upon the process of pricing and their significances for the internal fund
accumulation, as well as upon liquidity preference and investment decisions.
7.4 Questions
Q1. How does discretion policy differ from policy rule?
Q2. What is the Importance of credibility and reputation in formulating economic
policy ?
Q3. Explain the reputation and credibility in the light of Keynesian and post -
Keynesian approaches ?
Q4. Explain the viewpoints of different economists on rules vs discretion?
7.5 Refer ences
1. Unconventional monetary policy , Reserve bank of Australia.
2. Lecture Notes in Macroeconomics , John C. Driscoll .
3. Rules Rather than Discretion: The Inconsistency of Optimal Plans , Finn E.
Kydland and Edward C. Prescott .
4. Reputation, credibility, and monetary policy effectiveness , Gabriel Caldas
Montes.
5. Rules vs. Discretion: the wrong c hoice could open the floodgates , Mark D.
Vaughan .
6. Macroeconomic theory, A Dynam ic General Equilibrium Approach , Michael
Wickens .

™™™™™™™
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Module 4
8 MACROECONOMIC POLICY - II
Unit structure:
8.0 Objectives
8.1 Dynamic Inconsistency banks
8.1.1 Dynamic consistency in banks, financial in termediaries
8.2 Financial Intermediaries and Unconventional Monetary Policy
8.2.1 Instruments of unconventional monetary policy
8.3 Inflation Targeting and Exchange Rates
8.4 Questions
8.0 Objectives
1. To understand the concept of dynamic consistency and inconsistency in the
banking system .
2. To know the impact of unconventional monetary policy.
3. To establish a relationship between financial intermediaries and unconventional monetary policy
4. To know various instruments of unconventional monetary policy.
5. To establish the relationship between in flation targeting and exchange rates.
8.1 Dynamic Inconsistency
In economics , dynamic inconsistency is a situation in which a decision
maker's preferences change over time in such a way that a preference can become inconsistent at another point in time. to understand this concept we must
understand time preferences In economics, time preference is the current relative
valuation placed on receiving a good or some cash at an earlier date compared with
receiving it at a later date.[1]Time preferences are captured mathematically in
the discount function . The higher the time preference, t he higher the discount
placed on returns receivable or costs payable in the future. Decision -maker s
themselves may change their prefere nces at different point s of time, inconsistency
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means that there is a disagreement between decision -makers ’ different selves about
what actions should be taken. Formally, consider an economic model with different
carefully worked -out weight s placed on the utilities received by each self. Consider
the possibility that for any given self, the weightings that self places onset of the
utilities could differ from the wei ghtings that another given self places on the set
of utilities. The vital consideration today is the relative weighting between two
particular sets of utilities. If the relative weighting is the same for one given self as
it is for a different given self, then we have a case of time inconsistency. here the
decision -makers will have to select time-inconsistent preferences. If the relative
weightings of all pairs of utilities are all identical for all given selves, then the
decision -maker has time -consistent preferences.
In various forms , dynamic inconsistency rises as an outcome of "projection
bias".The b ehavioral tendenc y is to mispredict their upcoming marginal utilities by
assuming that the y will remain at present levels and consistent. This leads to
incon sistency as marginal utilities for any individual change over time in an
unexpected way f or example . tastes, prefer ences, and habits keep changing altering
consumers ' prefer ences. However, empirical research makes a strong case that time
inconsistency is, in fact, standard in human preferences. This would infer
discrepancy by people's different selves on decisions made and a rejection of the
time consistency aspect of rational choice theory. Economic models include
decision -making over time with the assumption that decision -makers being exponential discounters.
A discount function is used in economic models to describe the weights placed on
rewards received at different points in time. For example, if time is discrete and
utility is time -separable, with the discount function F(t) having a negative first
derivative and with C – defined as consumption at time t, total utility from an infinite
stream of consumption is given
ሺሼ୲ሽ୲ୀ଴ஶሻൌ෍ˆሺ–ሻ—ሺ୲ஶ
୲ୀ଴ሻ
C– is defined as consumption at time t the discount function F(t) having a negative
first derivative .
Consistent policy:
Let P be a sequence of policies for periods of 1 to T (maybe infinite and will be
represente d by t in the following example )
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And D is the corresponding sequence for the economic agent’s decisions.
P= (p 1, p2,p3…… pT)
D= (d 1, d2,d3…… dT)
The social objective function (S) which is aimed to be achieved will be
S (d1, d2…… dT, p1, p2….p T) (1)
Further, agent’s decision in period t depends upon all policy decisions as well as
past policy decisions as foll ows
dt= D t (dt,.,dt-1, p1,….….p T ) (2)
where ͳ൏ݐ൏ܶ
In such a framework an optimal policy if it exists, is that feasible P that maximi zes
equation ( 1) subject to constraints equation (2)
The concept of consistency in this scenario is defined as follows:
A policy P is consistent if, for each period t, Pt maximi zes (1), taking as given
previous decisions,
d1…d t-1 and those future policy decisions (P s for s>t) are similarly selected.
The inconsistency of the optimal plan is demonstrated by a two -period example.
For T=2., P2 is selected to maximi ze
S (d 1, d2, p1, p2) (3)
Subject to d1=D 1(p1,p2)
And d2= D 2(d1,p1,p2) (4)
For a plan to be consistent, p 2 must maximi ze (3), given the past decisions p1,d1 ,
and constraint (4) assuming differ entiability and an interior solution, then
necessarily
ஔୗ
ஔୢଶǤஔୈଶ
ஔ୔ଶ൅ஔୗ
ஔ୔ଶ =0
Exponential discounting yields time -consistent preferences. Exponential discounting and, more generally, time -consistent preferences are often assumed
in rational choice theory since they imply that all of a decision maker's selves will
agree with the choices made by each self. A ny decision that the individual makes
for himself in advance will remain valid (i.e., an optimal choice) as time advances,
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The empirical research mak es a strong case that time inconsistency is, in fact,
standard in human preferences. This would imply disagreement by people's different selves on decisions made and a rejection of the time con sistency aspect of
rational choice theory.
8.1.1 Dynamic in consistency in Banks and Financial Intermediaries :
Central banks now view transparency as a crucial tool for effective policymaking.
In contrast to the old central banking world of purposeful concealment to maximi ze
discretion, rule-like behavior encourages households, businesses , and financial
market participants to anticipate central bank actions that are consistent with
keeping inflation low and stable. An effective way to reduce the time -inconsistency
problem is to give central banks . The primary goal of maintaining price stability
and ensuring the independence of the central bank to achieve the target without
government interference. Such an institutional commitment to price stability can
enhance the credibility of monetary policy and improve its performance. Increase
employment levels or, in a more general outlook , the level of economic activity
usually substantiated by the existence of di stortions in the input market , for
example, distortionary taxation of labor or the presence of transfer programs
monetary policymakers suffer from dynamic inconsistency with inflation expectations, as politicians are best off promising lower inflation .
But once tomorrow comes lowering infl ation may have negative effects, such as
increasing unemployment (tradeoff between inflation and unemployment ).
Dynamic inconsistency rises as monetary policymakers choose to pursue short -
term goals leading to missing the long -term goals. Expansionary monetary policy
will lead, in the short term, quicker economic growth and reduce unemployment ,
and those who choose the monetary policy coordinates will be tempted to adopt
this path, although in the long -term positive results are offset by prices and salaries
rises in the private sector, caused by a rel axed monetary policy. Consequently , in
the lo ng-term inflation will increase, its negative effects altering the economic
situation. According to McCallum central banks can discern long-term negative
effects of those temporary positive in the short -term and avoid them, as long as
they are independent. In most cases, dynamic inconsistency is caused by political
pressures on monetary policymakers. Dynamic inconsistency of monetary policy
is an ex-post deviation from the ex -ante formulated plans when these plans would
have been implemented. Details stemming from the existence of dynamic inconsistency in monetary policy refers to monetary authority under pressures from
the governme nt desires to lead towards subopt imal levels in terms of economic
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inflationary consequences of devaluations assumed to improve the current account
situation. Central bankers make their commitment to price stability to gain
credibility. One way is to ensure that their prospect is long enough that they will
not abandon the long -term goal of low inflation for the short -term advantage of a
temporary boom. Over the past quarter -century, this persuasive logic has led
governments in much of the world to delegate monetary policy to independent
central banks with legally mandated objective s, supervised by officers with long
terms. To enhance policy effectiveness constrained discretion is used by central
bankers and developed a regime of inflation targeting. At the same time, supporters
of policy rules like Taylor , as well as legi slators, policy rules to further limit
discretion. Inflation t argeting is the prevailing monetary policy command in
countries that produce about two -thirds of global GDP. Inflation targ eting depends
on transparency and communication to raise the cost of reneging on the price
stability commitment. Policymakers not only announce a quantitative target for
inflation over at least the next several years, but they routinely report publicly on
their progress in realizing their objective. And, when they adjust their instruments,
central bankers justify their actions in terms of the impact it will have on achieving
their commitment. One of the proposals to counte r the dynamic inconsist ency of
monetary policy and reducing the inflation bias refers to the delegation of monetary
policy formulation and implementation to a "conservative" central banker, defined
as an inflation -averse individual, aversion higher than the social ones. This
delegation does not eliminate the dynamic inconsistency problem but reduces the
inflation bias. Walsh (1995) suggests that, rather than worry about the pursuit of a
conservative central banker, the society should stimulate monetary authority
through a performance contract, so when it pursues its interests, simultaneously
maximizes the welfare of the society. The gain of such a deal is that its application
is independent of informational asymmet ry and also of the effort made by
policymakers to implement monetary policy, viewing the performance concerning
contr actual obligations being made only about monetary vari ables are open in
public to observe.
Lately , inflation t argeting has become the prime monetary policy in countries that
produce about two -thirds of global GDP. Inflation targeting depends on
transparency and communication to raise the cost of reneging on the price stability
obligation . Policymakers not only announce a quantitative tar get for inflation over
at least the next several years, but they frequently report publicly on their progress
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justify their actions in terms of the impact it will have o n achieving their
commitment.
Although the too -big-to-fail guarantee is explicitly a part of bank regulatio n in
many countries, it is observed that bank closure policies also suffer from an implicit
“too-many -to-fail” problem: when the number of bank failures is large, the
regulator finds it ex -post optimal to bail out some or all failed banks, whereas when
the number of bank failures is small, failed banks can be acquired by the surviving
banks. This gives banks incentives to herd and increases the risk that many banks
may fail together. The ex -post optimal regulation may thus be time -inconsistent or
sub-optimal from an ex -ante viewpoint . In con trast to the too -big-to-fail problem
which mai nly affects large banks, we observe that the too -many -to-fail problem
affects small banks more by giving them stronger incentives to herd.
History suggests , particularly in the outcome of the financial crisis of 2007 -2009,
one of the largest problems facing prudential regulators has been that of Too big to
fail (TBTF). To stop a financial collapse and another Great Depression, regulators
in the United States and elsewhere have frequentl y used public money to bail out
the creditors of the largest, most connected, and most complex intermediaries. In
addition to popular revulsion, these bailouts have created a moral hazard —
encouraging financial behemoths to take risks in good times that make the system
more vulnerable to crisis. It is appealing for policymakers m erely to pass legislation
prohibiting bailouts. The Financial CHOICE Act, appr oved by the U.S. House ,
takes exactly this approach . However, as we have argued before , this approach is
destined to fail. Modest declarations lack credibility and not able to limit the risk -
taking conduct of TBTF firms. When in crisis , policymakers will come under
tempting pressure to prevent a financial failure through bailouts. A need arise s,
future legislators will pass new laws cancelling anything in place.
TBTF looks like a problem of time consistency. If in a future crisis, the perceived
alternative is the collapse o f the financial system and depression, policymakers will
go back on any “no bailout” promise they could make. A supervisory central
monetary authori ty that forces enormous financial establishments to internalize the
spill overs of their behaviour onto the financial system as a whole will create
credib ility to contain the TBTF problem. In our view, such a regime has three gears :
high capital requirements that force intermediaries to self -insure against losses; stress tests that safeguard capital adequacy even under the most severe
hostile conditions; and an effective resolution regime that offers for automatic
recapitalization of weakened financial behemoths as well as temporary government
provision of resolution funding . The indication is that the method to avoid a future
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intermediary such as a commercial bank, investment ba nks, mutual fund, or
pension fund investment banks, stockbrokers , and stock exchanges. is an economic
entity that acts as the middleman between two par ties in a financial contract . Many
intermediaries take part in securities exchanges and utilize long -term plans for
managing and growing their funds. The overall economic stability of a country may
be displayed through the actions of financial intermediaries and the growth of the
financial sector.
Financial intermediaries offer many paybacks to the average consumers from asset
management to safety, liquidity , and banking -related economies of scale and asset
management. Financial intermediaries move funds from parties with excess capital
to parties needing funds. The procedure generates efficient markets and drops the
cost of conducting business . Through a financial intermediary, savers can pool their
funds, allowing them to make large investments, which i n turn benefits the entity
in which they are investing. At the same time, financial intermediaries pool risk by
spreading funds across a diverse range of investments and loans. Loans advantage
households and countries by allowing them to devote more money than they have
at the present -day time.
8.2 Financial Intermediaries and U nconventional monetary policy
Monetary policy affects the real economy in part through its effects on financial
institutions. High -frequency occasion studies show that the introduction of unconventional monetary policy had a strong, beneficial impact on banks and,
especially, on life insurance companies and other financial intermediaries.
Unconventional monetary policy is an instrument used by a monetary authority that
falls out o f line with traditional measures. Non -standard monetary policies received
importance during the 2008 fina ncial crisis when the primary means of traditional
monetary policy, which is the adjustment of interest rates, was not enough . These
policies contain quantitative easing, forward guidance, and collateral adjustments.
Unconventional monetary policies came to fame during the 2008 global financial
crisis when traditional monetary policies were not enough to pull up the economies
of developed nations. Worldwide central bankers are discovering that monetary
policies they once viewed as unconventional and temporary are now proving to be
conventional and long -lasting.
2008 financial cr isis and since year 2020,2021 coronavirus pandemic, enforced to
make choices away from conventional monetary policies. The Federal Reserve,
European Central Bank , and most of their international counterparts have become
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recess ion and the threat of deflation. “The coronavirus crisis is many times more
destructive than the financial crisis of 2008,” said Steve Barrow, head of foreign
exchange strategy at Standard Bank. “There’s every reason to believe t hat the move
to tighter mone tary policy will take as long and probably much longer than the post -
financial -crisis period.” Central banks of Australi a, New Zealand , and Canada
purchased government bonds for the first time this year with the latter also
purchasing corporate debt. South Korea and countries like Sweden & South Korea
began purchasing company bonds and commercial paper. More central banks are
also embracing so -called forward guidance, in which they necessitate keeping their
policy loose for a certain period to boost the assurance to investors . Traditional
monetary policies include the adjustment of interest rates, open market operations,
and setting bank reserve requirements. Unconventional monetary policies include
quantitative easing, forward guidance, collateral adjustments, and negative interest
rates. Application of both traditional and unconventional monetary policies,
governments were able to pull their countries out of the recession
In the case the economy is going through a recession, a country's central bank will
implement an expansionary monetary policy. This includes the lowering of interest
rates to make money cheaper to boost spending in the economy. An expansionary
monetary policy also shrinks the reserve requirements of banks, which increases
the money supply in the economy. Lastly, central banks purchase Treasury bonds
on the op en market, increasing the cash reserves of banks. A contractionary
monetary policy would entail the same actions but in the reverse direction.
Throughout the 2008 financial crisis, global economies were viewing to pull their
countries out of recessions by implementing expansionary monetary policies.
However, because the recession was so bad, standard expansionary monetary
policies were not enough. For example, interest rates were dropped to zero or near
zero to fight the crisis. This, however, was not enough to improve the economy.
To supplement the traditional monetary policies, central banks implemented
unconventional measures to pull their economies out of financial distress
8.2.1 Instruments of unconventio nal monetary policy
Unconventional Monetary Policies work through instruments like Quantitative
Easing (QE) , Forward guidance , Negative Interest Rates , and Collateral
Adjustments during a recession, a central bank can buy other securities in the open
market outside of government bonds. This process is known as quantitative easing ,
and it is considered when short -term inte rest rates are at or near zero. D uring the
Great R ecession, interest rates were near zero . QE lowers interest rates while
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flooded with the capital flow to promote lending and liquidity. No new money is
printed during this time. one such illustration is, during the recession, the U.S.
Federal Reserve began buying mortgage -backed securities (MBSs) as part of its
quantitative easing program. During its first round of QE, the central bank purchased $1.25 trillion in MBS As a result of its QE program, the Fed's balance
sheet improved from about $885 billion before the recession to $2.2 trillion in 2008
where it leveled out to about $4.5 trillion in 20 15. Forward guidance is the method
by which a central bank communicates to the public its intentions for future
monetary policy. Such notice allows both individuals and businesses to make
spending and investment decisions for the long term, thereby bringing stability and
confidence to the markets. As a result, forward guidance impacts the current
economic conditions.
Several countries a dopt negative interest rates throughout the financial crisis. T his
policy suggests central banks charge commercial banks an interest rate on their
deposits. The idea is to tempt commercial banks to spend and lend their cash
reserves rather than storing them. The storing of cash reserves will lose value due
to the negative interest rate. Collateral adjustment as an unconventional monetary
policy tool. central banks also exten ded the possibility of what resources and assets
were permissible to be held as collateral agains t lending facilities. the most liquid
assets should be held as collateral, though , in such difficult times, more illiquid
assets were allowed to be held as collateral. Central banks then assume the liquidity
risk of thes e assets. Unconventional monetary policy can also have undesirable
impacts on the economy. If central banks implement QE and increase the money
supply too quickly, it can lead to inflation . It happen s if there is too much money
in the system but only a ce rtain amount of goods available. Negative interest rates
can also have concerns by encouraging people not to save and rather to spend their
money. Furthermore, QE increases the balance sheet of a central bank, which can
be a risk to manage, and also uninte ntionally determines the types of assets
available to the private sector, possibly leading it to buy riskier assets
Unconventional monetary policy has the same aims as conventional monetary
policy. It can lower interest rates further than is possible by adjustments to the
policy interest rate alone (which may be at its effective lower bound). As with a
lower cash rate, this reduces the cost of borrowing, puts downwar d pressure on the
exchange rate, and leads to higher prices for some assets than otherwise (which
make s it easier for people to borrow and increases their confidence to spend).
Unconventional policy measures that offer liquidity to stressed financial markets
also support financial stability. Through forward guidance reduces uncertainty
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104 MACROECONOMICS - II8.2.1 The negative side of unconventional monetary policy The inclination of central banks to provide liquidity may decrease the incentive of financial institutions to hold adequate buffers, which could make future episodes of financial stress more likely. Damage bank profitability and reduce the capacity of banks to lend, allow less productive firms to continue when they would not normally be viable (though this is not relevant for firms that would otherwise operate normally if not for the economic consequences of COVID -19) fuel unnecessary increases in asset prices (e.g. rising prices of houses and shares) despite weak economic growth. The part of monetary policy and fiscal policy can become unclear because, if the central bank is purchasing large amounts of government bonds at low-interest rates, this could be interpreted as government spending (a fiscal activity) being financed by money creation. Political or social tensions can arise if the central bank’s asset purchases are seen to disproportionately benefit some groups in society. 8.3 Inflation Targeting and Exchange Rate If the central bank’s asset consumptions are seen to disproportionately advantage some groups in society then political or social tensions can arise an effective role for the exchange rate in policy implementation under an inflation -targeting background can reduce conflicts between the inflation objective and other considerations. Establishing strong policy implementation can be especially challenging for inflation-targeting emerging economies due to their policy legacy and their less developed financial markets. Under inflation targeting, the interest rate is the main monetary policy tool for influencing activity and inflation. Country understanding proposes that foreign exchange market intervention should be implemented in the most systematic way possible. Transparency for the role of the exchange rate concerning policy objectives, operational procedures, and ex -post evaluation reduces the possibility of confusion about the inflation target. There are limits to the transparency of foreign exchange policy implementation, and the country's experience s propose some comprehensive policy transparency practices. The presence of deeper foreign exchange and domestic money markets enhances the effectiveness of changes in the policy stance, including through better signaling of policy intentions. Money market development makes it possible to use domestic monetary instruments rather than relying excessively on foreign exchange intervention, and it also facilitates sterilization According to a study by. Beldi Lamia Mouldi Djelassi how the adoption of inflation targeting influenced exchange rate pass-through (ERPT ) and volatility. The pieces munotes.in

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of evidence suggest that ERPT has declined after inflation targeting adoption for
both price indexes consumer and producer prices for most ec onomies analyzed.
Additionally, results show that the inflation t argeting system can reduce exchange
rate volatility and inflation volatility in all countries. Therefore , the implementation
of an inflation -targeting regime contributes to price stability through the decline of
exchange rate pass -through and exchange rate volatility. During the 1990s, many
countries have reali zed that in the medium and long run, upholding a low and stable
rate of inflation is vital. A high and variable rate of inf lation ca uses adverse social
and economic effects in terms of price distortions that cause the resources to be
diverted to less productive and conspicuous consumption. It results in lower levels
of savings and investment that will adversely affect the long -term growth of the
economy. To protect from the falling value of money, people will hedge into real
estate and purchase precious metal that reduces the available financial savings. In
an open economy, it can result in a flight of capital that causes an unsustainable
balance of payments. Further, the short -run trade -off between unemployment and
price level does not result in higher levels of output and employment in the long
run. The use of intermediary targets like money supply, interest rates , and nominal
GDP do es not give reasonable results. Consequently, the central banks have
initiated to directly target the rate of inflation itself.
8.3.1 Exchange rate pass -through
Exchange rate pass-through (ERPT) is defined as the percentage change of
domestic prices resulting from a 1% change in the exchange rate between domestic
and foreign countries . Let’s see how the exchange rate pass -through has evolved
for both advanced and emerging market economies. We notice that exchange rate
pass-through in emerging economies on average reduced after the financial crisis
and that this decline in pass -through is linked to declining inflation. By contrast, in
advanced economies, where inflation has inclined to be consistently low, exchange
rate pass -through has also remained low. despite the recent decline of ERPT in
emerging economies, pass -through estimates are still lower in advanced than in
emerging economies. The results are consistent with the implications of the menu
cost theory of price setting: when inflation is higher, exchange rate changes are
passed thr ough more quickly and to a larger extent because firms have to adjust
prices regularly anyhow.
A floating exchange rate rule constitutes a prerequisite for well -functioning
inflation targeting regime capital mobility and independent monetary policy cannot
coexist with a pegged exchange rate regime. The link between inflation targeting
and the floating exchange rate has led some economists to state that one of the costs
of the adoption of an IT regime is the higher volatility of exchange rates. Several munotes.in

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106 MACROECONOMICS - IImethods have emerged to examine the effects of inflation targeting on the volatility of the exchange rate. Indeed, many studies compare the volatility of exchange rate s under inflation targeting with fixed or managed exchange rate regime s. Nevertheless, Edwards suggests that it is not a correct strategy to compare these different monetary policies for exchange rate volatility analysis. He presents that the appropriate approach to evaluate the volatility of exchange in the inflation targeting regime should be made by controlling the effects of the exchange rate regime. The- pass-through from changes in the exchange rate to inflation is important fo r any relatively open flexible exchange rate economy.it operates through the effects of The pass-through from variations in the exchange rate to inflation is significant for any relatively open flexible exchange -rate economy. Pass -through operates directly through the effect of exchange rate movements on prices and indirectly through the impact of exchange rate movements on aggregate demand and prices. Generally, the empirical literature finds that pass-through from exchange rate changes into import prices is less than one owing to a variety of factors, particularly transport costs, distribution costs, and price discrimination. Pass-through has been on a trend decline around the world find a threefold decline in pass-through during the 1990s. The reasons for the decline include worldwide disinflation , pricing to market, and credibility gains . Pass -through is relatively important for emerging economies with smaller track records . Emerging markets generally have a low level of financial market development, categorized by limit ed instruments and thin trading, which in turn are not able to play an important role in stabilizing domestic output in the face of external shocks. ERPT appears to decrease with the level of development and increase with openness, and emerging economies have higher and added variable inflation, experience greater exchange rate volatility, and are mo re dollarized. Those economies that adopted full-fledged inflatio n targeting has been found to reduce pass-through. This advocates that the emerging economies with other anchors have to deal with larger exchange rate pass-through. Huge , rapid, and uncertain pass-through can lead central banks to put weight directly on t he exchange rate to reduce the level and volatility of inflation. A change in the exchange rate can rapidly raise inflation and inflation expectations, thus compelling the central bank to quickly take action to influence the exchange rate by changing interest rates or prevailing in the foreign exchange market. However, these dealings may indicate the imprint that the central bank upkeeps the exchange rate above and beyond its impact on inflation. Foreign exchange intervention is covered Output Stability Many emerging economies aim to manage the exchange rate to mitigate the impact on the output of relatively s hort-term exchange rate movements. munotes.in

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107Chapter 8: Macroeconomics II
As per IMF staff reports on flexible exchange -rate eme rging economies find that
intervention is used to limit exchange rate volatility, although the reasons for such
intervention are not always fully expressed . Studies show that exchange rate
volatility has a substantial but small negative effect on trade. using the exchange
rate to flat output volatility can create confusion regarding the obligation to an
inflation target as objective. Full -fledged inflation -targeting economies with long
track records can be relatively transparent and find it easier to credibly explain to
the markets the rationale for exchange rate-flattening interventions. In contrast,
economies with less of a commitment to an inflation target and a tinier track record
have a tougher time intervening to smooth volatility in a way tha t is cl ear to the
market. Supposedly , such interventi on should be aimed at non -permanent exchange
rate shocks, which raises the challenge of arbitrating the duration of such shocks. a
developed country with a supportive set of economic and structural policies allows
for a credible commitment to an inflation target and less relianc e on managing the
exchange rate. Such trade -offs are the outcome of credibility commitments A large
dose of credibility is needed for an emerging economy to reap th e benefits of a full -
fledged inflation -targeting as a nom inal anchor, which allows the floating exchange
rate and thereby enables policy implementation. Also , economies with flexible
exchange rates that have yet to adopt explicit inflation targets can be considered in
transition to a single nominal anchor, and completing this transition requires
establishing the groundwork for a credible commitment to the infl ation target. To
observe thes e differences in credibility across economies with different monetary
and exchange rate regimes, credibility is roughly proxied here by the actual
inflation outturn and by market ratings of long -term local -currency -denominated
government debt. The inflation -targeting economies have much better infl ation
outturns . Stumpy inflation signs that a central bank can make a credible commitment to an inflation target. low and positive inflation is supportive of high
and stable long -term growth such a monetary policy supportive of long -term
growth can be more credible. The lowest inflation rates in present years have been
in the inflation -targeting advanced economies, followed by the inflation -targeting
emerging economies; the emerging economies with other anchors have had the
highest inflation rates. The inflation -targeting economies have higher ratings of
long-term indigenous curre ncy-denominated government debt. Such estimation is
forward -looking and directly captures market perceptions of the degree of long -
term mark et confidence in the stability It would be preferable to use market -based
measur es of cen tral bank credibility. In realism , such measures are available for munotes.in

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108 MACROECONOMICS - II
only a few economies. In addition, comparisons of actual versus targeted inflation
are excluded by the absence of stable quantitative targets for many economies.
Indicators of the stability of inflation expectations in the face of inflationary shocks
would be another good measure of managing the exchange rate to smooth output
volatility . which eventually is the responsibil ity of the central bank even though it
reflects factors beyond the scope of monetary policy.
The inflation -targeting advanced economies have the uppermost ratings, followed
by the inflation -targeting emerging economies and the emerging economies with
other anchors. These i ndicators of credibility, rough ly, suggest that higher credibility is associated with a smaller role for the exchange rate. credibility for
inflation targeting ha s been ext ensively examined. All inflation -targeting
economies are fairly large and developed, which advocates that inflation targeting
requires size and a somewhat advanced economy. An inflation -targeting central
bank needs the directives to follow the inflation target and sufficien t discretion and
autonomy to fix its monetary ins truments as per requirements . A vigorous fiscal
position is crucial, whereas m onetary policy should be dominated by fiscal
priorities because even suboptimal policies can hurt credibility in a country with
high debt and a short history of sound , fiscal managemen t results indicate that the
publically announced implementation of inflation targeting strategies by central
banks in emerging markets, often with much fanfare, is a substantive deviation
from pas t monetary policy formulation and sharply different from non -targeting
emerging ma rkets. As our theoretical model calculates , however, inflation targeting
emerging markets is not following “pure” inflat ion targeting strategies. Instead , we
find that extern al variables play a very important role in the policy rule — inflation -
targeting central banks in emerging markets systematically respond to the real
exchange rate. Of the inflation targeting group, those with a particularly high
concentration in commodity exports change interest rates much more pro -actively
to real exchange rate changes than do the non -commodity intensive group. In
general, results are robust to a variety of model formulations and estimation
strategies .
The influence of real exchange rates is robust in those countries succeeding in IT
policies that are relatively intensive in exporting basic commodities. This is not
surprising since this group is the most vulnerable to terms -of-trade and r eal
exchange rate disturbances. Moreover, the real exchange rate stabilization objective does not seem to be influencing central bank interest rate -setting munotes.in

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109Chapter 8: Macroeconomics II
indirectly because it is a good predictor of future inflation, as would be the case if
inflation is a good predictor and the central bank is forward -looking , i.e. the real
exchange rate is not a strong predictor of future inflation in emerging mark ets. R eal
exchange rate stabilization in commodity -intensive countries appears to be related
to adverse rea l output effects related to real exchange rate volatility .
Theoretically, the real exchange rate to the behavior of monetary policy in an IT
regime is presented in a s implified version , where the policymaker is concerned
about real exchange rate volatility. The wish to mitigate exchange rate volatility
follows the logic, that exchange rate volatility reduces productivity in developing
countries, attributing it to financia l channels. F ind that the of private credit to GDP)
have been heavily exposed to the adverse repercussions of exchange rate volatility.
The adverse effect of volatility may be the result of increasing the expected cost of
funds in circumstances where agency and contract enforcement costs are prevalent,
the finan cial system is shallow, and trade openness is important . the adverse effects
of exchange rate volatility are larger for the less financially developed countries .
These situations tend to be intensified in developing countries relying heavily on
mineral and other commodity exports. A greater weight on justifying exchange rate
volatility inclines towards increase the sensitivity of the policy rule to exchange
rate changes, possibly with sizable welfare effects.
The main aim is stabilizing the real exchange rate in the short -run, where the
policymaker presum es, that the equilibrium REER (real effective exchange rate) is
highly determined , thus most of the short -run shocks may replicate transitory
instabilities . This presumption reflects both the persistency of the REER, and the
wide standard errors associated with predicting equilibrium exchange rates There
are, of course, other po ssible reasons why a central bank purs uing an IT strategy
will choose to also concern itself with the exchange rate. This is true especially in
emerging markets given their shallow currency markets, their short history of stable
inflation, the importance of the exchange rate as an anchor for expectations , and
the probability of currency mismatch exposure in strategically important secto rs.
Given these considerations, we test the degree to which the policy rule adopted by
IT commodity -intensive d eveloping countries differs from that of the IT non -
commodity exporters, finding support to the greater sensitivity of commodity IT
countries to exchange rate changes.
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Let us see one real -time data in Table no. 1
WHY THE EXCHANGE RATE PLAYS A LARGE ROLE IN EMERGING
ECONOMIES
(Indicators of credibility)
Table No. 8.1
Average Consumer Price Index Inflation Policy Name 1997 –
2007
2002 –07
2005 –07
Rating of Long-Term Local - Currency -
Denominated -
Government Debt Inflation-targeting
advanced
economies AAA Median 2.3 1.9 1.8 Standard deviation 1.1 1.1 1.3 Inflation-targeting
emerging
economies

BBB Median 6.6 5.1 4.9 Standard deviation 11.6 4.3 2.5 Non-inflation-targeting
emerging
economies

BB+ Median 9.9 11.0 9.4 Standard deviation 29.6 10.6 4.5 Pegged-exchange -rate
emerging
economie s

BBB Median 3.7 5.6 7.5 Standard deviation 18.6 6.4 4.2 munotes.in

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111Chapter 8: Macroeconomics II
To comprehend the dissimilarities in credibility across economies with different
monetary and exchange rate regimes, credibility is roughly proxied here by the
actual inflation outturn and by market ratings of long -term local -currency -
denominated government debt. The inflation -targeting economies have muc h better
inflation outturns (Table no. 1) A reasonably sized and developed country with a supportive set of economic and structural policies allows for a credible commitment to an inflation target and less reliance on managing the exchange rate.
A large dose of credibility is needed for an emerging economy to reap the benefits
of a full -fledge d inflation -targeting nominal anchor, which liberates the exchange
rate to float and also helps policy implementation. Furthermore, economies with
flexible exchange rates that have yet to adopt explicit inflation targets can be
considered in transition to a single nominal anchor, and completing this transition
requires establishing the groundwork for a credible commitment to the inflation
target. To better understand the differences in credibility across economies with
different monetary and exchange rate r egimes, credibility is roughly proxied here
by the actual inflation outturn and by market ratings of long -term local -currency -
denominated government debt.
Conclusive remarks on -The Role of the Exchange Rate during the Transition to
Inflation Targeting
The exchange rate plays a significant yet ill -defined part in the policy framework
of emerging economies that have a flexible exchange rate but not a full -fledged
inflation -targeting framework (referred to here as “emerging economies with other
anchors”). These economies manage the exchange rate more actively, and policy
implementation tends to be based on foreign exchange intervention that is more ad
hoc and less market -based. Exchange rate channels are probably stronger and more
uncertain for ty pical emerging economies with other anchors because they are less
financially developed, are more dollarized, and have less overall credibility
compared to inflation -targeting emerging economies. Starting an extra orderly ,
consistent, and market -based role for the exchange rate is vital in making the
transition to inflat ion targeting. It also suggest s that giving the exchange rate a
larger weight in the interest rate reaction function or using the exchange rate as the
operating policy target, can generate better macroeconomic performance than using
a policy reaction function dominated by the interest r ate. The degree of domestic
money market development helps shape the choice of the operating target during
the transition. Reducing the weights of the exchange rate in the reaction function
over time is a practical way to transition to an inflation -targeti ng regime. Central
banks moving toward inflation targeting generally need to strengthen their
macroeconomic analysis and develop a systematic approach to policy decision -munotes.in

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112 MACROECONOMICS - IImaking. Financial market development improves policy implementation by reducing the ne ed to depend on foreign exchange intervention and by enabling
sterilization.
8.4 Questions
What is dynamic inconsistency in economics ? Explain its relevance to banks and
financial intermediaries?
Q1. What are the instruments and a ims of unconventional monetary policy?
Q2. Exchange rate and inflation targeting play important role in emerging
economies?
Q3. Exchange rate pass -through is relevant to both advanced and emerging
market econ omies. Explain.
Q4. Is there any negative impact of unconventional monetary policy ?
8.5 References
1 Ben S. Bernanke and Frederic S. Mishkin, “ Inflation Targeting: A New
Framework for Monetary Policy ,” Spring 1997
2 The Relationship Between Exchange Rate and Inflation Targeting in
Emerging Countries - Beldi Lamia Mouldi Djelassi
3 Inflation Targeting and Real Exchange Rate In Emerging markets -
Joshua Aizenman Michael Hutchison and Ilan Noy
4 Arrow, Kenneth ,” Statistical and Economic policy ”, Econometrica 25, 1957
5 A positive theory of monetary policy in a natural rate model - Barro,
Robert J., and David B Gordon.
6 Mark Stone, Scott Roger, Seiichi Shimizu, Anna Nordstrom, Turgut Kis¸inbay, and Jorge Restrepo “ The Role of the Exchange Rate in Inflation
- Targeting Emerging Economies ”,
(INTERNATIONAL MONETARY FUND)

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