(i) What are the values of and i at time 0? (Note that p cannot jump at the time of the change.) How does an increase in , the speed of price adjustment, affect y(0)? Explain intuitively.

in) What is the path of after time 0?

(b) Suppose we measure the total amount of output volatility caused by the change in m as V = j y(f) dt. How is V affected by an increase in the speed of price adjustment, ?

5.16. Redo the regression reported in equation (5.40):

(a) Incorporating more recent data.

(b) Incorporating more recent data, and using M2 rather than Ml.

Chapter 6

MICROECONOMIC FOUNDATIONS OF INCOMPLETE NOMINAL ADJUSTMENT

This chapter is concerned with the microeconomic foundations of shiggish adjustment of nominal prices and wages. This subject is important for two reasons. First, it is central to Keynesian models. One of the models main predictions is that monetary shocks have real effects, and the critical feature of the models that gives rise to this prediction is the presence of sluggish nominal adjustment. But, as described in the concluding section of the previous chapter, the evidence concerning whether monetary shocks have important real effects is controversial; thus the relevance of Keynesian models is not clear. One way to shed light on this issue is to investigate what microeconomic conditions are needed for nominal stickiness to arise. For example, some critics of traditional Keynesian models argue that the models assumptions about price stickiness are inconsistent with any reasonable model of microeconomic behavior; they therefore conclude that microeconomic theory provides a strong case against the models relevance. More generally, if the conditions needed for nominal stickiness appear implausible or inconsistent with microeconomic evidence, this would suggest that gradual nominal adjustment is imlikely to be important. If the needed conditions appear realistic, on the other hand, this would support the importance of nominal stickiness.

Second, the nature of incomplete nominal adjustment is important for policy. For example, we will see that if monetary shocks have real effects for the reasons described by the Lucas imperfect-information model (which is presented in Part A of the chapter), systematic feedback rules from economic developments to monetary policy have no effect on the real economy. Similarly, if nominal prices and wages are fully flexible, monetary policy is

irrelevant to real variables. At the other extreme, if there is a stable relationship between output and inflation, then (as we saw in Chapter 5) monetary policy can raise output permanently. And as we will see, the nature of incomplete nominal adjustment also has imphcations for such issues as the output costs of alternative approaches to reducing inflation, the output-inflation relationship under different conditions, and the impact of stabilization policy on average output.

It is important to emphasize that the issue we are interested in is incomplete adjustment of nominal prices and wages. There are many reasons-involving imcertainty, information and renegotiation costs, incentives, and so on-why prices and wages may not adjust freely to equate supply and demand, or that firms may not change their prices and wages completely and immediately in response to shocks. But simply introducing some departure from perfect markets is not enough to imply that nominal disturbances matter. All of the models of unemployment in Chapter 10, for example, are real models. If one appends a monetary sector to those models without any further comphcations, the classical dichotomy continues to hold: monetary disturbances simply cause aU nominal prices and wages to change, leaving the real equilibrium (with whatever non-Walrasian features it involves) unchanged. Any microeconomic basis for failure of the classical dichotomy requires some kind of nominal imperfection.

The models that follow examine three candidate nominal imperfections. In the model of Part A, which is based on the work of Lucas (1972) and Phelps (1970), the nominal imperfection is that producers do not observe the aggregate price level; as a result, they make their production decisions without full knowledge of the relative prices they wiU receive for their goods. In the models of staggered adjustment in Part B, monetary shocks have real effects because not all prices or wages are adjusted simultaneously. Finally, in Part C, the real effects of monetary changes stem from small costs of changing nominal prices or wages or from some other small friction in nominal adjustment.

Part A The Lucas Imperfect-Information Model

6.1 Overview

The central idea of the Lucas-Phelps model is that when a producer observes a change in the price of his or her product, he or she does not know whether it reflects a change in the goods relative price or a change in the aggregate price level. A change in the relative price alters the optimal amount to produce. A change in the aggregate price level, on the other hand, leaves optimal production unchanged.