Question

in the new keynesian model, prices and intrest rates are always positively related. true, false, or uncertain? explain why

Answer 1

In the old Keynesian model or the classical model, the relationship between prices and interest rates was always positive implying that an increase in interest rate will always lead to inflation. But in the new Keynesian model, a discovery has been made, where the prices are sticky and it takes time for the price to rise which implies a sluggish growth of prices with respect to the interest rate. Now the increase in interest rate depicts an increase in output, but all the firms are not increasing their production at the same time or the increase in output is relatively slow when compared to the increased interest rate. Thus in the short run, firms take some time to increase their prices as increased prices might be a cause for losing customers and incurring the associated costs for such an increment in the prices of the products. This makes the price sticky and takes time to get adjusted to the rate of interest. Thus during the short run even though the interest rate increases, prices take a long time to increase or prices are sticky which sometimes makes the price stable instead of leading to inflation and the then the increased interest rate instead of contributing to consumption, contribute to savings as people can hold more money in their hand due to the stable prices.

The output is increased slowly and eventually, one by one, which takes a longer time to adjust the output and consumption gap. For example, the government increases the interest rate to a certain extent, the producers, on the other hand, start increasing their output one at a time, suppose there is an associated cost for increasing the price such as replacement of price tags or change in packaging, now a few producers increased the price which made them lose a few customers as the other producers are still taking time to increase their prices, the consumers will shift from one producer to another preferring lower prices for the products they buy, which in turn might lead to a reduction in the price of the previous producer considering his loss. Here we can see that though the interest rate has been increased the price is taking a long time to get adjusted with the now increased interest rate. This feature of the price is known as the stickiness of price which leads to a sluggish increment in the prices of products. As the price is not increasing with respect to the interest rate, the consumers are left with more money in their hands and thereby they save their money instead of increasing their consumption. This is behavior makes the relationship between price and interest rate uncertain in the new Keynesian model. In real life, it is a time-consuming procedure i.e. the adjustment between price and interest rate. Now when the real-life situations changes there might be outcomes which were not predicted, as in our example, when the producers were taking longer to increase their prices, the producer who already increased the price now is reducing it to the same level as earlier due to the losses he incurred, in classical model this cannot be expected as interest rate always leads to inflation.

The new Keynesian model relies more on real-life situations instead of the theory alone. It can be observed at times that the monetary policies fail to have the outcome that they are supposed to bring. When we consider the real-life situations, the reason for such failures can be observed. In our example, the reason that not all producers increased the price and output at the same time, and the stability of the prices, may fail to bring the expected outcome as expected by the monetary authorities while such increment in interest rate had been made. The savings of the households increased while the extra outputs are still in the godowns waiting for inflation to come up. This output and consumption take time to get to the equilibrium position, sometimes the time is longer and other externalities come into the picture.

Previously a lot of recessions happened due to failed monetary policies which were based on the expectation that interest rate increment will always lead to inflation and increased output with greater consumption expenditure from the household sector of the economy. But in reality it did not happen this way, instead, there was an output gap and price stickiness, which changed the picture and lead to recession. The firms started to increase their output, leading to inflation, whereas the wage rate did not increase as per the rate of inflation, leading to decreased demand and the firms incurred losses. People were left with very little disposable income and personal loans came into the picture, both the firms and households were drowning under credits and eventually the economy suffered.

To curb the effects of such flawed monetary policies, the new Keynesian model is focusing on reality which depicts that the change in interest rate might not affect the price in the short-run, with sticky prices and the output gap. Due to different factors including associated costs due to price rise and loss of business, the price takes a longer time to adjust. Thus from our discussion, we can say that the relationship between prices and interest rates is uncertain in the new Keynesian model especially during the short-run. In the long-run, it might get adjusted but again it is uncertain due to the effect of different externalities and market conditions. Sometimes, due to overproduction in the event of an increased interest rate might actually lead to deflation due to excessive surplus with the producers with low market demand, and thus in this situation interest rate and the price actually got related negatively. Therefore in the new Keynesian model price and interest rate is not always positively related and thereby uncertain.