1.

Discuss the impact of contractionary policy in classical, keynesian and IS-LM model

 Classical
In classical world contractionary policy will lead to decrease of nominal variable, since
money is neutral A contractionary monetary policy will create disequilibrium in money
market because of the decreasing quantity for money. This will decrease demnand goods
and services. Since Y is constrained at Y* and L*, prices to P1. This will increase real wage
and creates disequilibrium in labour market. Firms will decrease nominal wage until it
reaches equilibrium back. According to fisher transaction approach we know that i= r +
phi that is nominal interey rate reflects the variation of the price level. Real interest rate
is by productivity and thrift to equate savings and investment in the market of loanable
funds. A decrease of price level will also lead to to a fall in tje nominal interest rate. The
final result of contractionary policy is a decrease in the nominal variables ( i.e, nominal
interest rate, nominal wage, and price level) and no change in real variables. Therefore
monetary policy is useless!
 Keynesian
Keynes attacked the classical theory of interest rate which states that it is not possible to
determine real interest rate. Then he developed liquidity preferences theory of interest
rate. According to that money supply is fixed Ms=M. while money demand is dependent
on nominal interest rate and expectations of money. Md = L(i,em).
This theory is derived from financial markets. Consider a
market in which interest rate are very high, so price of
bonds are cheap and money is low. When money demand is
higher then money supply price of bond decreases, interest
rate goes up. In this framework keynes consider monetary
policy is useful but cannot solve all the problems.
Everytime Md changes, CB should adjust Ms inorder to keep
interest rate fixed. This implies money is endogenous
because it responds to variation in Md
 IS-LM
Contractionary policy will shift up the lm curve because money demand increases at
given level of output Md= L(i,y) This will lead to an increase in interest rate so investment
will be lower and so income.
QTM :FISHER MV= PY v- and Y=Y* ΔM→ΔP
Cambridge cs app. M =kPY, Ms is fixed Ms=Md →Ms=kPY*
d

Derivation of IS curve: i↑ Inv↓ E↓ Y↓ goods market in

equilibrium
LM curve: Md(i,Y), MS=Md→Ms=L(i,Y) Y↑ Md↑ i↑

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2. Business cycle
 Classical
The systems is always in equilibrium of full employment thats is supply
creates its own demand. When firm increases its productivity they hire
workers and pay wages. Wage will be spent and this will increase demand.
There is no underproduction or overproduction problem. According to this
framework we can say that business cycles are exogenous
 Keynes
According to keynes, business cycle is caused by variation of
investment which further is caused by the fluctuations in the marginal
efficiency of capital. Enterpreneurial activity depends upon profit
expectation. During the period of expansion. The marginal efficiency of
capital is high. Businessmen are optimistic, investment goes on rapid pace
and employment is high so incomes are rising. Each increment of investment
causing a multiple increase of income. Business cycles are endogenous.
 Monetarism
Friedman argues that instability in the growth of money supply is the source
of most cyclical fluctuations in economic activity. Friedman considers the free
market economy as being naturally stable. According to him it is the
exogenous money shock that affect aggregate demand which in turn
causes cyclical changes in output and employment in the economy
 Real business cycles
Business cycles are exogenous but the shocks come from supply and real
sides. Supply technological shock implies that, there are booms and
recession due to tje technological improvements. RBC states that growth and
cycles can not be separated. Variation in cycles affects variation in growth.
Business cycles are efficient, even recession is efficient. Because people and
firms change their behavior in an optimal way given the exogenous real
shock. Which implies there is no room for policy maker. Every time you do a
policy, you are trading something efficient to inefficient.
 New keynesian
Business cycles come from unexplained exogenous demand and supply
shocks. For example a negative monetary shock will reduce
inflation overtime and aslo output gap reduces. It means a recessions,
because central bank is increay interest rate. Propagation mechanism which
means frictiona and imperfection increases the size of the shocks. In the
short run, monetary policy has real effects. Aggregate demand externalities
(nominal rigidity) and coordination failure present prices and wages to move
in the short run. In the long run monetary policy is useless

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3) Unemployment in Keynesian, RBC and new Keynesian
 Keynes

In keynesian framework once level of production is fixed according to the law of

effective demand, you can determine the labour market. Labour demand is exactly
equal to the marginal productivity of labour. We assume. That we are in perfect
competitive market in which price is equal to marginal cost which is wage. In a
situation of unemployment price falls down and equilibrium restored. In this set up
when wages falls, prices falls too, so the real wage kept fixed. The lfluctuation of
real wages is not able to absorb unemployment. That is why there is coordination
failure. The force that fix real wage in this system is aggregate demand. Variation in
aggregate demand creates variation in income, and in turn induces change in real
wage. That is why keyne thinks that unemployment should be solved in aggregate
level not in labour market.
Keynes through nominal wage is downwardly rigid, that is wage a are not flexible
to move down not because of the assumption but because of
prisoners dilemma game. Workers tend to protect their relative wage in bargaining
process, no group wants to be the first to accept a cut. So in this framework
monetary policy is better to reduce real wage.
We know that nominal real wage cuts do not reduce the real wages, since
prices fall accordingly this double fall could bring the economy to full
employment level. Until now we assume that the level of consumption depends
on the nominal level if income. If we use another version : C = C( Y, NW/P). In this
set up, decreasing in W, P will decreases then NW/P will increase then C
increase and E increase the Y also increases and moreover reduction in
unemployment level. This is the so called Pigou effect and economy has come back
to full employment level not because of a change in real wage but because
of Pigou effect.
Keynes effect is an effect that can be seen in market of money. P reduces then,
increase the real wage, reduce in real interest rate and. Increases in Investment
and increases in Y. This could bring back go full employment level. However in
reality this does not work. First, it is the danger of deflation second the CB can
reduce i by expansionary policy rather than cutting the wages. In perfect
competition P=W and W/P= MPL so in keynes Mark-up does not exist. So
the real wage is countercyclical. Production increases MPL reduces and W/P
↓. However if mark-up is counter cyclical (imperfect competition) Real wage can
be acyclical or procyclical depending on Mark up.

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  RBC
In RBC, to have a procyclical variation of employment you need a very
flexible labour supply, so you have intertemporal substitution
of labour. Labour supply is Ls = (w/p, r), IRP = (1+r) Higher interest rate today
leads to workers to work more today to have more savings.

Assume a positive technology Shock. In shift up

production function and labour demand shift right
because higher technology so
higher productivity. Labor supply curve is highly
flat Because of strong intertemporal substitution
labor. This enables big fluctuations in employment
and small variation in real wage. However in
reality labour supply is very rigid and you need a
big variation in real wage to move employment.

Let's assume the representative agent live for 2 periods an wealth is equal to zero
U= lnC + bln (1-l) s.t. c=wl
Lgramgian function: L = Ln C +B ln (1- l) + λ (wl-c)
FOC for c and l → ,
Labour supply is independent of wage, because with log of utility income and substitution
effect offset each other.
Now we assume agent inves for two period.
L = Ln C1 +B ln (1- l1) + λ (wl-c) + Ln C2 +B ln (1- l2) + λ (w1l1 + ]
FOC for l1 and l2
+ →λ=

 New keynesian
In new keynesian framework, labour market is perfectly competitive, where goods market
characterized by imperfect competition. Menu cost model implies that, if all the firms change
prices at the same time, they change the price at aggregate level, they will change
real demand. on the contrary if firms do not take into account the aggregate demand
externalities, they keep price fixed and they do not affect aggregate demand which is not
optimal condition for society. The aggregate demand externalities work through pigou effect
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which means consumption depends on rel net worth. P reduces, NW/P increases and Y
increases. This may increases the level of employment.
Since we are in imperfect competition W/P < MPL. There is always possibility to increase
production, because increasing one unit of labour the marginal product you get is higher than
the cost. This framework implies under employment level and equilibrium output is
lower than social optimal level. It implies that recession and booms have asymmetric effect
on social welfare. During booms output is getting closer to perfect competition benchmark.
During recession it is moving away.

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4) nominal rigidities and real rigidities
Nominal rigidities imply sticky prices and wages. In monopolistic competition firm choose the
price and can fix it at the same level. Firms do not change price periodically, it depends on your
state, balances. Beyond the nominal rigidities, real rigidities increase the scope of nominal
rigidities. In the case of a shock in the economy which changes demand, real rigidities reduce the
gap between old and new profit maximizing prices. Let assume a supply function pi – p = c + Φy.
In this function real rigidities are captured by Φ, If the optimal price does not response too much
to the variation of production, you have higher real rigidities and the system is more stable.
The source of real rigidities is follows,
1. Marginal cost channel: if the MC doesn’t change so much, as the price is mark up to the
unit cost of production, the me price will be closer to the old one. You need a factor that
reduces this cost procyclicality. MC channel works through imperfect capital markets, input
output linkage and thick market externalities
2. Revenue channel: profit maximizing prices responded to output change. Mark up reduces
the change in cost
3. Real wage rigidities: searching and matching frictions prevent real wage to respond to
output fluctuation. According to efficiency wage theory firms should pay wage higher than
the perfectly competitive equilibrium one in order to convince workers to increase their
effort.
According to staggered price model
Pi = ∑t=o∞ wt E0 [Φmt+(1-Φ)pt] It implies that when firm decide the price level, they have to take
into account not only future price level and probability that the prices they set in time 0, will be
in effect in time t divided by the expected number of periods that price will be in effect (wt), also
their rational expectation about future path of money (Φmt). Since aggregate demand is equal
to money stock (Y=M/P). In this framework money has real effect. Φ Measures the impact of
money on price ( real rigidity). Money shocks change firms price level by less than 1, prices are
sticky. Nominal rigidities lead to gradual adjustment of the price level, and the real rigidity
magnifies the effect of nominal rigidity. So money has real effect, in this framework.

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5) Philips curve and disinflactionary policy
 Neo-classical synthesis:
Phil’s found none linear negative relationship between the growth rate and unemployment. The
original curve states that when the wage inflation is 0, unemployment is 5,5%. Taking the
relationship and assuming imperfect competition, prices can be fixed as a mark-up of unit cost of
production π= f(μ) okuns's law states that there is a negative relationship between
unemployment and income. Assuming that the level of output depends on the level of
employment, mark-up can be written in terms of prices. By linking income to inflation, one can
close the IS-LM model. This model provides demand pull explanation of inflation which means
you have inflation because aggregate demand is higher than aggregate supply. Combination of
IS-LM model and Philips curve implies there is permanent trade-off between iinflation and
unemployment or between inflation and output. Disinflationary policy is useless
 Monetarism
In 1974 oil shocks created unemployment and inflation at the same time it is the so
called stagflation. From empirical point of view Philips curve is disappeared. Friedman argued
that original Philips curve implies that workers are irrational and suffer from money illusion. He
introduced the expectation augmented Philips curve. The main idea is, if CB applies
expansionary monetary policy, inflation will increase and real wages will be lower. In the
bargaining process workers will learn from the past and they will ask for an increase in nominal
wages.
Πt = πte +λ(ut-un) ; λ<0, Πte = πt-1 agents have adaptive expectation
No permanent trade-off between inflation and unemployment. There is trade-off between
inflation and variation of unemployment. That is why it is called acceleration hypothesis. You
can get lower level of unemployment only if you accept inflation increase.

There are family of Philips curve (short-run), and vertical long

run PC, because monetary policy has no effect in the long
run. Disinflationary policies are costly. Suppose you starts
with point A. Imagining CB wants to fight with inflation. CB
can move from A to C by contractionary monetary policy. This
leads unemployment increases. This is going to reduce
expectation of people and in the next period PC shift down.
CB can arrive to point B. If CB wants to move to D, it has to
perform more contractionary policy.

New classical:
The Lucas supply function is similar to expectation augmented Philips curve yt = yn + α . The only
difference instead of unemployment we have production and πte=E(πt|Ωt-1)Which means
πte is rational expectation of inflation today with given information set about past. Since people
are super rational, to anticipate the money change, monetary policy cannot be used. CB is not
able to use the trade-off between inflation and unemployment. BC are exogenous, they come
from monetary policy.

The weak version of rational expectation hypothesis states that people have a set of
information and they use them in an efficient way. The strong version implies that your

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subjective expectations of an economic variable for instance future inflation is exactly equal to
objective expectation. In order to get this result, you are assuming all the agents in the economy
know and share the right model. There is representative agent model. In this model expected
inflation is equall to current inflation plus error term with Gaussian distribution zero mean and
positive variance. Πte = πt-1 + Ɛ. It means that on average agents do not make systematic mistake
on computing inflation.
In this model the disinflationary policies are cossless. As a CB, if you have enough credibility you
can disinflation without increasing unemployment because people have rational expectation.
This model is called old Turkey policy, which did not work empirically during 80s under the
administration of Reagen and Thatcher.
 New Keynesian,
Staggered price model provides the dynamics of prices, however they do not give explanation
why the prices are sticky. There Are some constraint especially in labour market in which price is
hold fixed for number of periods. Assume that in each periode, a fraction α(0<α≤1) of firms
change their prices, nd Xt is optimal price today
Pt = αXt + (1-α) Pt-1 → t = α(Xt – Pt-1)
With calvo’s poisson assumption →Xt= [1 – β(1-α)]pt* + β(1-α)EtXt+1
Substract Pt from both sides and write Xt-Pt as (Xt-Pt-1)- (pt-pt-1)
(Xt-Pt-1)- (pt-pt-1) = [1 – β(1-α)]pt* + β(1-α)EtXt+1
Given πt = α(Xt – Pt-1), then Xt – Pt-1= and EtXt+1 - Pt =
Moreover pt-pt-1 = and pt*-pt-1 Φyt so,
[ – ] ( )
[ – ]
Finally one gets the new keynesian Philip Curve,
→→
The implication is that, in Lucas we had rational expectation of yesterday about the inflation
today. Here on the contrary we have rational expectation of today about future inflation.
The NKPC is derived from the behavior of prices setters facing barriers to price adjustments.
That’s why it is kind of supply function. In NKPC, if you do inflation, not only you do not have
cost, but also you get future output boom. So NKPC is even more extreme than Lucas PC. This
depends on the structure of your experiment.

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6) expanasionary fiscal policy
 Classical
In classical point of view, fiscal policy is useless because of the complete crowding out.

Increase in G leads to r1 -> r2. Higher interset rate leads

to lower consumption also enterpreneur will reduce
their investment due to higer interest rate. Basically
increasein G completely crowding out private
expenditure. According toBritish treasury fiscal policy is
 Keynes useless
In keynesian point of view fiscal policy is highly powerful. An increase in
government expenditure can lead to higher increase in income due to the fiscal
multiplier, . If you increase autonomous component of aggregate
demand you may reach full employment level. A rise in G producesin one hand an
increase in income. From this increase, it comes an increase in consumption and
this determines an increase in savings. However, increase in savings leads to a
reduction of consumption and so income. We end up with a lower level of savings.
Thats why according to Keynes, increasing in saving is never a right strategy to push
the economy away from recession.
 IS-LM
In IS-LM model,the lawof effective demand works. Fiscal policy can be used to
stimulate the economy.

In this framework fiscal policy is effective, but there is a

partial crowding-out. Because when government
expenditure is increased the government is competing
with enterpreneur for the funds. This will lead to a
decrease in investment due to higher interest rate after
expansinary policy

Fiscal policy is a powerfull tool to prevent economy to fall in the so-called poverty trap. It
is also so-called the zero lower bound case, which means when interest rates are close to
zero, monetary policy is useless. In this case people holding a lot of moneybecause they
think interest rate are so low and expext to increase in the future. So monetarypolicy is
not able to change interest rate in which CB annot stimulate the system.in this case LM
curve moreor less hosrizontal, fiscal policy much more powerfull to reach full
employment level.