Chap 15

Chapter15
Money and Business Cycles I:

The Price-Misperceptions Model
Macroeconomics Chapter
Effects of Money in the Equilibrium

Business-Cycle Model
In our equilibrium business-cycle model
Monetary shocks => no effects on real economy

technology shocks
real quantity of money demanded, L(Y, i).

If M does not respond to changes in the

real quantity demanded, P will move in the
direction opposite to the change in L(Y, i).
The model predicts that P would be

countercyclical
low in booms and high in recessions.

If the monetary authority wants to stabilize

the price level, P, it should adjust the
nominal quantity of money, M, to balance
the changes in the real quantity demanded,
L(Y, i).
In this case, M will be procyclical.
Empirical evidence suggests that money is

not as neutral as predicted by our
equilibrium business-cycle model.
The price-misperceptions model

provides a possible explanation for the nonneutrality of money.
Households sometimes misinterpret

changes in nominal prices and wage rates
as changes in relative prices and real wage
rates.
A Model with Non-Neutral Effects of

Money
the
important difference from before is

that households have incomplete current
information about prices in the
economy.

The
price level, P, the relevant variable

is the price of a market basket of
goods. These goods will be purchased
from many locations at various times.
Therefore, a worker will typically lack
good current information about some of
these prices.
denote
by Pe the price that a worker

expects to pay for a market basket of
goods.
The effects from an increase in the

nominal quantity of money
what
happens when workers do not

understand that an increase in the
nominal wage rate, w, stems from a
monetary expansion that inflates all
nominal values, including the price
level, P.
Each worker may think instead that the rise

in w constitutes an increase in his or her real
wage rate, w/P. The perceived real wage
rate is the ratio of w to the expected price
level, Pe. This ratio, w/Pe, rises if the
expected price level, Pe, increases
proportionately by less than w.
If w/Pe increases, the worker increases the

quantity of labor supplied, Ls.
10

Money
w/Pe=
( w/P)( P/Pe)
for a given actual real wage rate, w/P, an
increase in P/Pe raises the perceived real
wage rate, w/Pe.
if workers are underestimating the price
levelso that Pe< Pthey must be
overestimating their real wage rate.
w/Pe > w/P.
11
12

Money
Because
of price misperceptions, the

increase in P raises the quantity of labor
supplied at a given w/P.
an increase in the nominal quantity of
money, M, that creates an unperceived
rise in the price level affects the real
economy and is, therefore, non-neutral.
Specifically, an increase in M raises the
quantity of labor input, L.
13

Money
The
rise in labor input, L, will lead to an

expansion of production. That is, real
GDP, Y, increases in accordance with the
production function:
Y= A F( K, L)
14
Money is Neutral in the Long Run
The expected price level, Pe, adjusts

toward the actual price level, P, in the
long run.
15

Money
is Neutral in the Long Run
The effects of an increase in M on these real

variables are only temporary.
In the long run, an increase in M leaves the

real variables unchanged.
The price level, P, and the nominal wage rate,

w, rise by the same proportion as the
increase in M. We conclude that, in the long
run, money is neutral.
16
Only Unperceived Inflation Affects

Real Variables
Lucas hypothesis on monetary

shocks:
the real effect of a given size monetary
shock is larger, the more stable the
underlying monetary environment.
17
Predictions for Economic Fluctuations

Now
we can use the price-misperceptions

model to get alternative predictions of
cyclical patterns for macroeconomic
variables.
In this analysis, we imagine that
economic fluctuations result from
monetary shocksthat is, exogenous
variations in the nominal quantity of
money, M.
18
19
Empirical Evidences
Friedman
and Schwartzs Monetary History
Changes in the behavior of the money stock

have been closely associated with changes in
economic activity, money income, and prices.
The interrelation between monetary and
economic change has been highly stable.
Monetary changes have often had an
independent origin; they have not been
simply a reflection of changes in economic
activity.
20
Empirical Evidence on the Real

Effects of Monetary Shocks
Unanticipated
money growth
an increase in unanticipated money

growth raised real GDP over periods of a
year or more.
21
Empirical Evidence
Romer
policy
and Romer on Federal Reserve
Christina Romer and David Romer (2003)

attempt to isolate exogenous monetary
shocks. They measured these shocks by
looking at changes during meetings of the
Federal Reserves Federal Open Market
Committee (FOMC) in the target for the
Federal Funds rate.
22
Empirical Evidence on the Real Effects of

Monetary Shocks
A brief overview
At this point, the empirical evidence suggests
that positive monetary shocks tend to expand
the real economy, whereas negative monetary
shocks tend to contract the real economy.
However, the evidence is not 100% conclusive,
and we surely lack reliable estimates of the
strength of this relationship.
23
Real Shocks
How
does price misperceptions affect

our previous analysis of a shock to the
technology level, A.
Increase in A raises real GDP, Y, but

lowers the price level, P, at least if the
monetary authority holds constant the
nominal quantity of money, M.
24
Real Shocks
We
assumed that households had

accurate current information about the
price level, P.
We now assume, as in the pricemisperceptions model, that the
expected price level, Pe , lags behind
the actual price level, P.
25
Real Shocks
In
a boom, when P declines, Pe

decreases by less than P.
Hence, P/Pe fallsthat is, workers
overestimate P during a boom.
Workers underestimate their real wage
rate, w/P: the perceived real wage rate,
w/Pe , falls below w/P.
Ls , decreases for a given w/P.
26
27
Real Shocks The summary

Because of price misperceptions, unanticipated
increases in the nominal quantity of money, M,
raise real GDP, Y, and labor input, L, in the
short run. Since money was neutral in the
model without price misperceptions, we can
also say that these misperceptions accentuate
the real effects of monetary shocks.
Price misperceptions lessen the short-run real
effects of real shocks. A favorable shock to the
technology level, A, still raises Y and L, but by
less than before.
28
Rules Versus Discretion
Under a monetary rule, the central

bank commits itself to a designated
mode of conducting policy.
Under discretion, the authority
leaves open the possibility for
surprisesthat is, for monetary
shocks.
29
The real economy reacts to a change in the

nominal quantity of money, M, only when
the change is unanticipatedin particular,
only when the money shocks causes the
price level, P, to deviate from its perceived
level, Pe.
Consequently, the monetary authority may

be motivated to create price surprises as a
way to affect real economic activity.
30
For given inflationary expectations, e, the

monetary authority faces a trade-off when
considering whether to use its policy
instruments to raise the inflation rate, .
An increase in is beneficial because it

raises the inflation surprise, e, and
thereby expands real GDP, Y, and labor
input, L.
31
The trade-off between the benefits

and costs of inflation determines the
inflation rate, denoted by ^, that
the monetary authority selects.
32
33
At *, the policymaker is optimizing for

given expectations, and expectations are
rational.
34
Central banks in most advanced economies

have become committed to low and stable
inflation.
This objective is stated in terms of

inflation targeting
35
36

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Chap 15

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Chapter15

Money and Business Cycles I:

Effects of Money in the Equilibrium

In our equilibrium business-cycle model

Monetary shocks => no effects on real economy

real quantity of money demanded, L(Y, i).

Effects of Money in the Equilibrium

If M does not respond to changes in the

The model predicts that P would be

Effects of Money in the Equilibrium

If the monetary authority wants to stabilize

The Price-Misperceptions Model

Empirical evidence suggests that money is

The price-misperceptions model

Households sometimes misinterpret

The Price-Misperceptions Model

A Model with Non-Neutral Effects of

important difference from before is

The Price-Misperceptions Model

The Price-Misperceptions Model

price level, P, the relevant variable

by Pe the price that a worker

The Price-Misperceptions Model

The effects from an increase in the

happens when workers do not

The Price-Misperceptions Model

Each worker may think instead that the rise

If w/Pe increases, the worker increases the

The Price-Misperceptions Model

A Model with Non-Neutral Effects of

The Price-Misperceptions Model

The Price-Misperceptions Model

A Model with Non-Neutral Effects of

of price misperceptions, the

The Price-Misperceptions Model

A Model with Non-Neutral Effects of

rise in labor input, L, will lead to an

The Price-Misperceptions Model

Money is Neutral in the Long Run

The expected price level, Pe, adjusts

The Price-Misperceptions Model

is Neutral in the Long Run

The effects of an increase in M on these real

In the long run, an increase in M leaves the

The price level, P, and the nominal wage rate,

The Price-Misperceptions Model

Only Unperceived Inflation Affects

Lucas hypothesis on monetary

The Price-Misperceptions Model

Predictions for Economic Fluctuations

we can use the price-misperceptions

The Price-Misperceptions Model

The Price-Misperceptions Model

and Schwartzs Monetary History

Changes in the behavior of the money stock

The Price-Misperceptions Model

Empirical Evidence on the Real

an increase in unanticipated money

The Price-Misperceptions Model

and Romer on Federal Reserve

Christina Romer and David Romer (2003)

The Price-Misperceptions Model

Empirical Evidence on the Real Effects of