A central bank unexpectedly increases the money supply by 5%. If all prices in the economy were perfectly flexible, what would happen to real output?
AReal output would rise by 5% in the short run as firms produce more to meet higher nominal demand
BReal output would not change — all prices would rise proportionally, leaving relative prices and real purchasing power unaffected
CReal output would fall because higher prices reduce consumer purchasing power
DReal output would rise permanently as higher nominal demand creates new productive capacity
With perfectly flexible prices, a 5% increase in money supply triggers a 5% rise in all nominal prices. Firms see higher nominal revenue but face proportionally higher nominal costs; consumers have 5% more money but everything costs 5% more. Real variables — quantities produced, relative prices, real wages — are unchanged. This is monetary neutrality. Sticky prices break this symmetry: when firms leave prices unchanged, the increase in nominal spending translates into higher real demand and output.
Question 2 Multiple Choice
A restaurant's optimal profit-maximizing price is $12.00. The restaurant faces a $0.50 menu cost to update its prices. Following a mild demand shock, the optimal price shifts to $12.40. Why might the restaurant rationally choose NOT to reprice, even though $0.40 is left on the table?
ABecause restaurants typically have long-term contracts that prohibit mid-year repricing
BBecause near the profit-maximizing price, the firm's profit loss from being $0.40 off-optimal is second-order (tiny), making a $0.50 cost sufficient to deter adjustment
CBecause customers will switch to competitors if the restaurant raises prices at all
DBecause the $0.40 improvement in price is less than the cost of $0.50, making repricing clearly unprofitable
This is the Mankiw/Akerlof-Yellen insight: the profit function is very flat near its maximum. Being $0.40 below optimal costs the restaurant far less than $0.40 in lost profit — profit loss is second-order in the deviation from optimal price. So a small menu cost of $0.50 easily exceeds the tiny private profit gain from adjusting. But macroeconomically, when thousands of firms make this same rational calculation, prices across the economy are sticky, and monetary shocks produce real output effects — a first-order social consequence from individually tiny private costs.
Question 3 True / False
Nominal wage contracts are a source of nominal rigidity because they fix the nominal wage; but goods prices, being set by market forces, adjust immediately to changes in money supply.
TTrue
FFalse
Answer: False
Both wages and goods prices exhibit nominal rigidity through different mechanisms. Goods prices face menu costs, coordination failures, and information frictions. Wages are sticky due to explicit annual contracts, implicit contracts, efficiency wage considerations, and the asymmetric impact of nominal wage cuts on worker morale. The assumption that wages are sticky while goods prices are flexible (or vice versa) is too simple; New Keynesian models typically incorporate both.
Question 4 True / False
Sticky prices allow monetary policy to have real short-run effects on output because nominal spending increases cannot be absorbed by proportional price increases when prices are rigid.
TTrue
FFalse
Answer: True
This is the central mechanism of New Keynesian macroeconomics. When the central bank increases money supply, if prices were flexible all prices would rise proportionally — monetary neutrality. But with sticky prices, many firms leave their nominal prices unchanged. Households have more money to spend, firms see higher real demand at prevailing prices, and they respond by increasing output and employment. The real effect persists until prices gradually adjust — the speed of that adjustment determines the duration and magnitude of monetary policy's impact on real variables.
Question 5 Short Answer
Explain the 'second-order private cost, first-order social cost' insight from menu cost theory and why it is crucial for understanding the real effects of monetary policy.
Think about your answer, then reveal below.
Model answer: Near the profit-maximizing price, a small deviation from optimal causes a negligible private profit loss (second-order, because the profit function is flat at its maximum). Even a trivially small menu cost can therefore deter a firm from repricing. But the macroeconomic consequence of widespread price stickiness is first-order: when most firms decline to adjust their prices after a monetary shock, aggregate nominal spending increases translate into real output and employment changes rather than being absorbed by proportional price increases. The small private disincentive to adjust produces a large collective failure to clear markets through price adjustment.
This explains why monetary policy is non-neutral in the short run even though each individual firm's failure to reprice costs it almost nothing. It is an externality of pricing inaction: each firm's benefit from not repricing is roughly zero in profit terms, but collectively their stickiness is what gives the central bank power to affect real output. The implication is that monetary policy effectiveness depends critically on the degree of price stickiness in the economy.