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Chapter 8

ECN 301 Chapter Notes - Chapter 8: Real Interest Rate, Nominal Rigidity, Autonomous Consumption


Department
Economics
Course Code
ECN 301
Professor
David Lee
Chapter
8

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Intermediate Macroeconomics 1: Theory
Week 6
Chapter 8
Real GDP in Canadian History
• The flexible-price model does not give a complete picture of the macroeconomy
– real GDP does not always grow by the same rate as potential output
– the unemployment rate is not always at the natural rate
– inflation is not always steady
Business Cycles
• Fluctuations in economic growth are called business cycles
• A business cycle has two phases
– expansion or boom
• production, employment, and prices all grow rapidly
– recession or depression
• production falls, unemployment rises, and inflation falls
• To understand business cycles, we need a model that does not always guarantee full
employment
• We will no longer assume that prices are flexible
• Instead, prices will be assumed to besticky”
– they will remain fixed at predetermined levels as businesses expand or contract production
The Sticky Price Model
• When prices are "sticky” they will remain fixed as businesses expand or contract production in
response to changes in demand and costs.
• Sticky prices drive a wedge between real GDP and potential output and between the supply of
workers and the demand for labour.
• When prices are "sticky” firms change output in response to changes in aggregate demand
– We then say, output is demand determined.
• Hence, in studying the mechanics of the sticky price model we start with a detailed study of the
components of aggregate expenditures
– Consumption, investment, government expenditures and net exports
Flexible vs. Fixed Price Models
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• To contrast the difference between the flexible price model and the fixed price model consider
the effects of a fall in autonomous consumption (C0).
A Decrease in Autonomous Consumption (C0)
• Under the flexible-price model, the decline in the real interest rate will lead to a decline in the
velocity of money
– the price level will fall
• In the flexible-price model, the consequences of a fall in consumers’ desired baseline
consumption are
– a drop in consumption
– an increase in savings
– a decline in the real interest rate
– a rise in investment
– a rise in the value of the exchange rate
-a decline in the price level
• In the sticky-price model, a drop in consumption leads to a drop in aggregate demand
• As businesses see the demand for their products falling, they cut back production
– they will lay off some of their workers
– incomes will fall
• In the sticky-price model, a drop in consumption does not lead to an increase in savings
– the increase in savings (from the fall in consumption) is exactly offset by a decrease in savings
(from the fall in income)
• The real interest rate is unaffected
– no change in investment or net exports
Summary of A Decrease in Autonomous Consumption (C0)
• In the sticky-price model, the consequences of a fall in consumers’ desired baseline
consumption are
– a drop in consumption
– a decline in production
– a decline in employment
– a decrease in national income
– no change in the real interest rate, investment, or the exchange rate
Expectations
• Price stickiness causes problems only in the short run
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