Grasping Reality on TypePad, by Brad DeLong

October 3: Sticky-Price Unemployment Business-Cycle Model

We now consider a time span too short for wages and prices to adjust to guarantee "full employment"...

So output Y is not necessarily equal to full-employment potential-output Y*...

We need a new equilibrium condition. Here it is: businesses adjust employment and production to keep their inventories stable--to match aggregate demand...

Other than this change of equilibrium condition, the model remains pretty much the same--but it behaves very differently.

We still have our behavioral relationships:

C = C₀ + C_y(1-t)Y; consumption function
I = I₀ - I_rr; business investment demand
G = G; government purchases
IM = IM_yY; import demand
X = X_fY^f + X_ee; export demand
e = e₀ + e_r(r^f - r)

But there are two differences:

r is now a fixed, given variable--the result of Federal Reserve policy (or of the current money stock and money demand) plus other influences
C + I + G + (X - IM) = Y is now an equilibrium condition--not an identity

• Sticky prices
  • Consequences of sticky prices
    • Flexible-price logic: prices adjust
    • Sticky-price logic: quantities adjust
    • Expectations and sticky-price logic
      • If expectations are fulfilled, then there will never be cases when price stickiness matters: it's only price stickiness plus surprising changes to economic policy or the economic environment that causes deviations from the full-employment model of chapters 6 and 7 *Why are prices sticky?
    • Menu costs
    • Lack of information--confusion of real and nominal magnitudes
    • Sociology: the social consequences of wage cuts
    • Simple "money illusion"
• Income and expenditure
  • Building up total planned expenditure
    • Consumption function
    • Investment spending
    • Government purchases
    • Net exports: exports minus imports
  • Autonomous spending A
  • The marginal propensity to expend on domestic goods: C_y(1-t) - IM_y
  • Sticky-price equilibrium: Y = A/(1-(C_y(1-t) - IM_y))
  • The multiplier: 1/(1-(C_y(1-t) - IM_y))
    • The multiplier used to be much more important than it is today...
• The process of inventory adjustment