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Introduction To The New Keynesian Framework And Its Applications

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Question:

Discuss about the Introduction To The New Keynesian Framework And Its Applications.

 

Answer:

This question relates to the example given in the lecture on the topic of substitution bias.

Suppose the CPI basket for 2010 (base year) is composed of 50 cups of coffee at $2 per cup, 50 cups of tea at $2 per cup and 100 scones at $1 each.

In year 2011, a frost hit a major coffee-producing country, causing the price of coffee to double.

  1. What is the rate of inflation from year 2010 to year 2011?

New price of coffee = $4

Inflation rate = ($4 - $2)/$2

= 100%

  1. Assume consumers like coffee and tea equally well, therefore, the increase in the price of coffee encourages them to forgo coffee and drink tea instead (switch from consuming 50 cups of coffee and 50 cups of tea to consuming 100 cups of tea). What is the adjusted rate of inflation?

New amount of coffee consumed = 0 cups

Net change in amount of coffee consumed = -100%

Adjusted inflation = (1+1)/ (1-1) -1 = -100%

  1. Comparing the results from part (1) and (2), please explain the substitution bias?

The substitution bias takes into account the effect of increase in price of a product on the quantity demanded of that product. In this case the adjusted inflation rate is a negative which means that as the prices of coffee increase, the quantity demanded of coffee also decreases by 100%

 

References

Galí, J. (2015). Monetary policy, inflation, and the business cycle: an introduction to the new Keynesian framework and its applications. Princeton University Press.

Malmendier, U., & Nagel, S. (2015). Learning from inflation experiences. The Quarterly Journal of Economics, 131(1), 53-87.

OR

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