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Economics 2152A/B
Jennifer Mori

Ch 12 Money in the Intertemporal Model Part IIThe FriedmanLucas ModelThe main rational in this theory is to show how changes to the money supply interact with the real side of the economy In older Keynesian models the effects of money supply changes on real GDP occurred because prices were slow and sluggish to adjust to changes in either demand or supply In this model prices are taken to adjust as is evident from microeconomics Thus this model as all modern models takes microeconomic foundations seriouslyHow to we get at the main points of this modelwe start with the labour market and a representative agentOur representative agent RA does NOT have perfect informationInformation is a key factor in a Lucas model However the RA has information about his own current wage The problem is he cannot be certain about all other prices therefore he has imperfect information about the GENERAL Price levelWhen a shock hits the economy say a change in the money supply the RA does not directly observe it Wages go up and it is impossible for the RA to tell whether the change is just a nominal change W or a real change WP w If the change is nominal then it does not change the purchasing power of wages we assume that prices and wages go up or down by the same amount thus the RA would not change the amount of labour suppliedHowever if the wage rate is real wages go up more that prices then as we know the RA will supply more to labour market due to intertemporal substitution effects on leisure the price of leisure increases with a rise in the current wage therefore the RA takes less leisure and works more Real wagenominal wageprice level or w WP the problem is the RA does not have perfect information on the price level Thus if the nominal wage increases does the RA work more or notShehe would have to make an informed decision based on what was known about the probability of the change being realExperimenta change in the nominal wageWe can set up an experiment to illustrate how this model works Step 1Suppose that there are two and only two possible shocks that can hit the economy Shock 1 could be a permanent increase in the money supply If this occurs then we know that this only increases prices and has no real effects
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