Question 3: Classical Dichotomy and Sticky Prices

What is the classical dichotomy?

The idea that real variables (output, consumption, employment) are independent of nominal variables (price level, money supply) in an economy with perfect competition and flexible prices.

Does the classical dichotomy hold in RBC models with perfect competition?

Yes, because prices are flexible and real and nominal variables are separate.

Does the classical dichotomy hold with monopolistic competition and sticky prices?

No, because price rigidity allows nominal shocks to affect real variables in the short run.

Why does monopolistic competition with sticky prices break the classical dichotomy?

Because firms set prices with markups and cannot adjust instantly, so nominal disturbances affect real output and employment.

What mechanisms cause sticky prices in New Keynesian models?

Menu costs or staggered price contracts (e.g., Calvo pricing) that delay price adjustments.

What is the economic consequence of sticky prices?

Unexpected monetary or demand shocks cause real effects on output and employment because prices adjust slowly.

What does the New Keynesian Phillips Curve (NKPC) describe?

The relationship between inflation, the output gap, and expected future inflation in an economy with sticky prices.

What is the formula for the NKPC?

πt = κ xt + β Et[π{t+1}]

What does κ represent in the NKPC?

The sensitivity of inflation to the output gap or marginal cost.

What does the NKPC imply about inflation and real activity?

That current inflation depends on both the output gap (distance from potential output) and expected future inflation, making inflation and real variables interdependent.