In a New Keynesian model, a central bank cuts the nominal interest rate. Inflation expectations are well-anchored. What is the short-run effect on real output, and why?
AReal output is unchanged — lower nominal rates just produce proportionally lower prices with no real effect
BReal output increases — because prices are sticky, the real interest rate falls, stimulating demand that translates into higher output rather than immediately higher prices
CReal output decreases — lower nominal rates signal that the central bank expects a recession, reducing confidence
DReal output increases, but only because the central bank also changed the money supply
This is the core transmission mechanism of New Keynesian monetary policy. With sticky prices, a cut in the nominal rate lowers the real interest rate (real rate = nominal rate − expected inflation, and inflation expectations are anchored). A lower real rate makes borrowing cheaper and saving less attractive, stimulating consumption and investment via the dynamic IS curve. Because prices cannot adjust instantly, the extra demand shows up as higher real output, not just higher prices. In the long run, as firms gradually reset prices, inflation rises and output returns to potential — but the short-run real effect is real.
Question 2 Multiple Choice
A New Keynesian economist argues that imperfect competition is a necessary ingredient — not just a technical convenience — for nominal rigidities to have macroeconomic effects. What is the logic?
APerfect competition causes deflation, which amplifies the effects of sticky prices
BIn perfect competition, firms are price-takers with no discretion over pricing, so a firm that 'cannot adjust its price' faces a non-issue — price stickiness only bites when firms have pricing power
CImperfect competition allows firms to hold inventories, which cushion demand shocks and create the appearance of real effects
DPerfect competition produces too much output, and nominal rigidities are needed to reduce it to the efficient level
In a perfectly competitive market, the market price is determined by the intersection of supply and demand — individual firms have no pricing decision to be sticky *about*. If a price-taking firm 'cannot adjust,' it simply sells whatever the market price is, as before. Nominal rigidities matter only when firms have market power and therefore *set* prices. A monopolistically competitive firm with a downward-sloping demand curve has a pricing decision; if that decision is constrained by menu costs or contracts, it cannot respond to demand shocks by raising prices, and output must absorb the adjustment instead. Imperfect competition is what makes the pricing decision exist in the first place.
Question 3 True / False
In the New Keynesian framework, monetary policy has real effects in the short run but only nominal effects in the long run.
TTrue
FFalse
Answer: True
This is one of the central results of the New Keynesian model and the key distinction from both RBC theory (no real effects at any horizon) and old Keynesian theory (permanent real effects). In the short run, sticky prices mean demand shocks translate into output changes. Over time, as firms gradually reset their prices (in the Calvo pricing model, a random fraction reprices each period), the price level adjusts, the real interest rate returns to its natural level, and output returns to its potential. The long-run neutrality of money is preserved — only the path differs from the RBC view, not the eventual destination.
Question 4 True / False
The New Keynesian Phillips Curve states that current inflation depends on past inflation and the current output gap.
TTrue
FFalse
Answer: False
The New Keynesian Phillips Curve (NKPC) is forward-looking: current inflation depends on *expected future inflation* and the current output gap. This is derived from the optimal pricing behavior of firms that can only reset prices infrequently — a firm setting its price today must forecast the entire future path of marginal costs, which depends on expected future demand. The backward-looking specification (inflation depends on past inflation) characterizes the adaptive expectations Phillips curve of the old Keynesian era. The forward-looking nature of the NKPC has important implications: credible central bank commitments to future policy can directly influence current inflation through expectations.
Question 5 Short Answer
Why do New Keynesian models require *both* imperfect competition and nominal rigidities to generate real effects of monetary policy? What does each ingredient contribute, and why is neither sufficient alone?
Think about your answer, then reveal below.
Model answer: Imperfect competition gives firms pricing power — they set prices rather than taking them from the market. Nominal rigidities mean those prices adjust slowly. Both are necessary: without market power, stickiness is irrelevant because firms have no pricing decision to be sticky about. Without stickiness, market power doesn't prevent immediate price adjustment — firms with power can simply reprice instantly when demand changes, eliminating real effects. Together, they create firms that *can* set prices but *don't* adjust them quickly, so demand shocks hit output rather than prices in the short run.
This is the logical core of the New Keynesian synthesis. RBC models have microfounded optimization but no nominal rigidities, producing monetary neutrality. Old Keynesian models have demand-driven output but no microfoundations. New Keynesian models thread the needle: the microfoundations (imperfect competition, intertemporal optimization) justify why firms have a pricing decision, and the rigidities (menu costs, staggered contracts) explain why that decision responds slowly. The interaction is what produces the non-neutrality.