Question
In the New Keynesian (sticky-price) Model, what is the
primary reason the short-run Aggregate Supply (AS) curve is positively sloped, and what is its ultimate implication?Solution
Solution: The New Keynesian model (like models by Mankiw or Taylor) is characterized by sticky prices (or sticky wages).
- Sticky-Price Mechanism: Due to menu costs, long-term contracts, or coordination failure, some firms' prices or wages are set in advance and do not adjust immediately when there is a change in aggregate demand.
- Positive AS Slope: If aggregate demand increases, the price level (P) rises. Firms with sticky prices (their price P∗ is fixed) find their relative price (P∗/P) has fallen. To maximize profits, they increase their output, as their products are now relatively cheaper. Firms with flexible prices increase their prices and output. The combined effect is an increase in aggregate output (Y) with an increase in the price level (P), leading to a positively sloped short-run AS curve.
- Contrast: Option A refers to the Lucas Imperfect Information Model. Option B refers to the New Classical (or related) efficiency wage argument for unemployment, not the AS curve slope in the New Keynesian context.
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