Question

Consider the following observations on business cycles.  Private sector expenditures on durable consumer and investment goods is much more sensitive to the business cycle than expenditure on nondurable goods and services; durable goods expenditures decline during business cycle contractions and rise during expansions.  Durable goods manufacturers typically do not reduce their prices during the early phase of business contractions, nor do they raise prices during the early stages of business expansions.

(a)    Why would downward price-rigidity in the durable goods sector of an economy magnify and prolong a business contraction?  Why would consumer expenditures increase and the economy begin expanding when manufacturers eventually reduce prices?  Finally, why would manufacturers' pricing policies typically adjust effective prices through buyer rebates or low-interest financing rather than lowering the manufacturers' prices to distributors?  Carefully explain.

(b)    Keynesians have typically argued that downward wage and price rigidity is important in explaining prolonged recessions.  These same Keynesians have given little attention to the importance of temporary upwardprice rigidity.  Why is the assumption of upward price rigidity useful in explaining why an expansionary monetary policy that is "fully anticipated" (or observed at the time it occurs) will have an expansionary effect on real output? Carefully explain.

Answer 1

Question:

a). Answer:

(a)    Why would downward price-rigidity in the durable goods sector of an economy magnify and prolong a business contraction?  Why would consumer expenditures increase and the economy begin expanding when manufacturers eventually reduce prices?  Finally, why would manufacturers' pricing policies typically adjust effective prices through buyer rebates or low-interest financing rather than lowering the manufacturers' prices to distributors?  Carefully explain.

During the recession AD is very low due to low confidence level of consumers and investors also. A low AD push the output and price level at the low low level and the economy shrink rapidly. During the recession expansionary policies do not affect more AD immidiately and its take some time to increase and when AD increase its increase output and price level. When manufacturers eventually reduce prices then decreasing price positively affect AD in the economy and AD increase. increasing AD increase output and price level both. During the recession or crisis AD is very low due to low confidence level of consumers and investors also. So, price level is low with low output level also. But when the consumer borrow at low interest rate (cost) due to expansionary monetary policy or get rebates then its encourage consumers to consume more taht increase consumption level. Consumption play an important role in AD and contribute for more than 60% and increasing consumption incraese AD. When AD increase its increase price level and output level both. But it is not necessary that the consumers will get attractive price due to lowering the manufacturers' prices to distributors.

b). Answer:

(b) Keynesians have typically argued that downward wage and price rigidity is important in explaining prolonged recessions.  These same Keynesians have given little attention to the importance of temporary upward price rigidity.  Why is the assumption of upward price rigidity useful in explaining why an expansionary monetary policy that is "fully anticipated" (or observed at the time it occurs) will have an expansionary effect on real output? Carefully explain.

During the recession AD is very low due to low confidence level of consumers and investors also. A low AD push the output and price level at the low low level and the economy shrink rapidly. During the recession expansionary policies do not affect more AD immidiately and its take some time to increase. When the wages and price level are at low level for a lon-term then its indicate about the recession in the economy. Upward price rigidity is not important because its may be the cause of expansionary monetray policy. But the impact of monetary policy is temporary and its not effective in the long-run. Keynesians do believe in an indirect link between the money supply and real GDP. They believe that expansionary monetary policy increases the supply of loanable funds available through the banking system that decrease interest rates. According to Keynesians, monetary policy can affect real GDP indirectly. But it is posibility taht banks can simply refuse to lend out their excess reserves then it will not increase money supply in the economy. Another important argument by Keynesians is that factors of AD may not be sensitive to the lower interest rates.