SOLUTIONS TO CHAPTER 7

Problem 7.1
When t is even, the price level is given by
(1) pt = fpt1 + (1 – f)pt2,
where pt1 denotes the price set for t by the fraction f of firms who set their prices in the odd period t – 1,
and pt2 denotes the price set for t by the fraction (1 – f) of firms who set their prices in the even period
t – 2. Now, pt1 equals the expectation as of period t – 1 of pt* and thus
(2) pt1 = Et-1 pt* = Et-1 [mt + (1 – ϕ)pt ].
Substituting equation (1) into equation (2) and using the fact that pt2 is already known when p1t is set and
is thus not uncertain, yields
(3) pt1 = Et-1 mt + (1 - ) [fpt1 + (1 – f)pt2 ].
Some simple algebra allows us to solve for pt1 :
 (1  )(1  f ) 2
(4) p1t  E t 1m t  pt .
1  (1  ) f 1  (1  ) f

Now, pt2 equals the expectation as of period t – 2 of pt* and thus

(5) pt2 = Et-2 pt* = Et-2 [mt + (1 – )pt ].
Substituting equation (1) into equation (5) yields
(6) pt2 = Et-2 mt + (1 – ) [fEt-2 pt1 + (1 – f)pt2 ].
We need to find Et-2 pt1 . Since the left- and right-hand sides of equation (4) are equal and since
expectations are rational, the expectation as of period t – 2 of these two expressions must be equal. That
is, we have
 (1  )(1  f ) 2
(7) E t 2 p1t  E t 2 m t  pt ,
1  (1  ) f 1  (1  ) f
where we have used the law of iterated projections so that Et-2 Et-1 mt = Et-2 mt . Substituting equation (7)
into equation (6) yields
 f (1  )(1  f ) f 2 
(8) p 2t  E t 2 m t  (1  )  E t 2 m t  p t  (1  f ) p 2t  .
 1  (1  ) f 1  (1  ) f 
Collecting terms gives us
   (1  ) f  (1  ) f   (1  )(1  f ) f  (1  f )  (1  )(1  f ) f  2
(9) p 2t    E t 2 m t  (1  )   pt ,
 1  (1  ) f   1  (1  ) f 
which simplifies to
 (1  )(1  f ) 2
(10) p 2t  E t 2 m t  pt .
1  (1  ) f 1  (1  ) f
Collecting the terms in pt2 gives us
1  (1  )f  (1  )(1  f )  2 
(11)  p t  E t 2 m t ,
 1  (1  )f  1  (1  )f
or simply
 
(12) p 2t  E t 2 m t .
1  (1  ) f 1  (1  ) f
And thus the price set in period t – 2 is given by
(13) pt2 = Et-2 mt .

Now to solve for the price set for t by those setting price in t – 1, substitute equation (13) into equation
(4):
7-2 Solutions to Chapter 7

 (1  )(1  f )
(14) p1t  E t 1m t  E t 2 m t .
1  (1  ) f 1  (1  ) f
Adding and subtracting Et-2 mt to the right-hand side of equation (14) yields
  (1  )(1  f )  1  (1  ) f 
(15) p1t  E t 2 m t  E t 1m t    E t 2 m t .
1  (1  ) f  1  (1  ) f 
Since (1 – )(1 – f) – 1 + (1 – )f = – (1 – )f + (1 – ) – 1 + (1 – )f = – , equation (15) can be rewritten
as

(16) p1t  E t 2 m t 
1  (1  ) f
 E t1m t  E t2 m t  .
To get an expression for the aggregate price level, substitute the formulas for pt1 and pt2, equations (16)
and (13), into equation (1):
  
(17) p t  f  E t 2 m t 
1  (1  ) f
 E t 1m t  E t 2 m t    (1  f ) E t 2 m t .
 
Simplifying yields
f
(18) p t  E t 2 m t 
1  (1  ) f
 E t1m t  E t2 m t  .

To solve for output in period t, substitute equation (18) into the expression for aggregate demand,
yt = mt – pt :
f
(19) y t  m t  E t 2 m t 
1  (1  ) f
 E t1m t  E t2 m t  .
Collecting the terms in Et-2 mt as well as adding and subtracting Et-1 mt to the right-hand side of equation
(19) gives us
  f  1  (1  ) f   1  (1  ) f   f 
(20) y t  m t  E t 1m t    E t 2 m t    E t 1m t .
 1  (1  ) f   1  (1  ) f 
Since f – 1 + (1 – )f = – (1 – f) and 1 – (1 – )f – f = (1 – f), equation (20) can be rewritten as
(1  f )
(21) y t 
1  (1  ) f
 E t1m t  E t2 m t    m t  E t1m t  .
Equations (18) and (21) give equilibrium price and output for an even period.

The analysis for the case of t odd is identical to the preceding analysis, except that the roles of f and
(1 – f ) are reversed. Thus derivations analogous to those used to obtain (18) and (21) yield
(1  f )
(22) p t  E t 2 m t 
1  (1  )(1  f )
 E t1m t  E t2 m t  ,
and
 E t1m t  E t2 m t    m t  E t1m t  .
f
(23) y t 
1  (1  )(1  f )
Equations (22) and (23) give equilibrium price and output for an odd period.

Problem 7.2
We will deal first with firms that set price in odd periods. Suppose that period t is an even period. Then
pit is the price set for an even period by a firm that sets prices in odd periods and pit+1 is the price set for an
odd period by a firm that sets prices in odd periods. From equation (16) in the solution to Problem 7.1, pit
is given by
 Solutions to Chapter 7 7-3


(1) p it  E t 2 m t 
1  (1  ) f
 E t1m t  E t2 m t  .
With the assumption that m is a random walk, we have Et-2 mt = mt-2 and Et-1 mt = mt-1 . Thus

(2) p it  m t 2 
1  (1  ) f
 m t1  m t2  .
As usual, the optimal price for period t is given by
(3) pt* = mt + (1 – )pt .
From equation (18) in the solution to Problem 7.1, the aggregate price level in an even period is
f
(4) p t  E t 2 m t 
1  (1  ) f
 E t1m t  E t2 m t  .
Again, since m follows a random walk, this is equivalent to
f
(5) p t  m t 2 
1  (1  ) f
 m t1  m t2  .
Substituting equation (5) into equation (3) yields the optimal price in period t:
(1  )f
(6) p t *   m t  (1  )m t  2  m t 1  m t  2  .
1  (1  )f
Thus, the amount of profit a firm expects to lose in period t is proportional to E t [(pit  p*t ) 2 ] or
  (1  )f  
2
E t  m t 2  (m t 1  m t 2 )  m t  (1  )m t 2  m t 1  m t 2  
 1  (1  )f 1  (1  )f  

Collecting terms yields
 1  (1  )f 
2
(7) E t [(pit  p t *)2 ]  E t    m t  m t 1  m t  2    m t  2   .
 1  (1  )f  

Simplifying gives us
(8) Et [(pit – pt*)2 ]= Et [(-mt + mt-1 – mt-2 + mt-2 )2],
or
(9) Et [(pit – pt*)2 ]= 2 Et [(mt-1 – mt )2].

Now, the price set for an odd period by a firm that sets prices in odd periods is given by
(9) pit+1 = Et-1 mt+1 .
Since m follows a random walk, Et-1 mt+1 = mt-1 and thus
(10) pit+1 = mt-1 .
The optimal price for period t + 1 is given by
(11) pt+1* = mt+1 + (1 – )pt+1 .
From equation (22) in the solution to Problem 7.1, the aggregate price level in an odd period is
(1  f )
(12) p t 1  E t 1m t 1 
1  (1  )(1  f )
 E t m t1  E t1m t1  .
Since Et-1 mt+1 = mt-1 and Et mt+1 = mt , we have
(1  f )
(13) p t 1  m t 1 
1  (1  )(1  f )
 m t  m t1  .
Substituting equation (13) into equation (11) yields the optimal price in period t + 1:
(1  )  (1  f )
(14) p t 1*   m t 1  (1  )m t 1  m t  m t 1  .
1  (1  ) (1  f )
Thus the amount of profit a firm expects to lose in period t +1 is proportional to
7-4 Solutions to Chapter 7

 (1  )(1  f )  
2

(15) E t [(pit 1  p t 1*) ]  E t  m t 1  m t 1  (1  )m t 1 
2
m t  m t 1   .
 1  (1  )(1  f )  

Collecting terms gives us
      
2
(16) E t [(pit 1  p t 1*) ]  E t  (m t 1  m t 1 ) 
2 (1 ) (1 f )
m t 1  m t   .
 1  (1  ) (1  f )  

Expanding the right-hand side of equation (16) yields
2 (1  )  (1  f )
E t [(p it 1  p t 1*)2 ]   2 E t [(m t 1  m t 1 ) 2 ]  E t [(m t 1  m t 1 )(m t 1  m t )] 
1  (1  ) (1  f )
(17) 2
 (1  )  (1  f )  2
  E t [(m t 1  m t ) ].
 1  (1  ) (1  f ) 
Since m follows a random walk, we have Et [(mt-1 – mt+1 )(mt-1 – mt )] = Et [mt-1 – mt+1 ]Et [mt-1 – mt ] =
(mt-1 – mt )(mt-1 – mt-1 ) = 0. Thus, the second term on the right-hand side of equation (17) is equal to 0.
Using this fact, we can add equations (8) and (17). Thus, the total amount of profit a firm setting prices in
odd periods expects to lose is proportional to Et [(pit – pt*)2 ]+ Et [(pit+1 – pt+1*)2 ] or
(18) Exp. Lossodd =
2
 (1  )(1  f ) 
2 2 2 2
 E t [(m t 1  m t ) ]   E t [(m t 1  m t 1 ) ]    E t [m t 1  m t 2 ] .
1  (1  )(1  f ) 

Now we will deal with firms that set price in even periods. When period t is an odd period, analysis
parallel to that used to derive (8) shows that the amount of profit a firm expects to lose in period t + 1 is
proportional to
(19) Et (pit – pt*)2 = 2 Et (mt-1 – mt )2.

Analysis parallel to that used to derive (17) shows that the amount of profit a firm expects to lose in
period t + 1 is proportional to
2 (1  )  f
E t [(p it 1  p t 1*)2 ]   2 E t [(m t 1  m t 1 ) 2 ]  E t [(m t 1  m t 1 ) (m t 1  m t )] 
1  (1  ) f
(20) 2
 (1  )  f  2
  E t [(m t 1  m t ) ].
 1  (1  ) f 
Note that this is identical to (17) except that the roles of f and (1 – f ) are reversed. Proceeding as above,
since m follows a random walk, we have Et [(mt-1 – mt+1 )(mt-1 – mt )] = Et [mt-1 – mt+1 ]Et [mt-1 – mt ] =
(mt-1 – mt )(mt-1 – mt-1 ) = 0. Thus, the second term on the right-hand side of equation (20) is equal to 0.
Using this fact, we can add equations (19) and (20). Thus, the total amount of profit a firm setting prices
in even periods expects to lose is proportional to Et [(pit – pt*)2]+ Et [(pit+1 – pt+1*)2] or
2
 (1  )f 
 E t [m t 1  m t  ] .
2
(21) Exp. Losseven =  2 E t [(m t 1  m t ) 2 ]  2 E t [(m t 1  m t 1 ) 2 ]  
1  (1  )f 

We need to compare the right-hand sides of equations (18) and (21). Recall that f is the fraction of firms
that set prices in odd periods. Note that with f < 1/2 – more firms setting prices in even periods than in
odd periods – we have (1 – f) > f. Using this and the fact that  < 1, we can say that
 Solutions to Chapter 7 7-5

 (1  )(1  f )  2  (1  ) f  2
(22)     ,
 1  (1  )(1  f )   1  (1  ) f 
since (1 – )(1 – f) > (1 – )f and 1 – (1 – )(1 – f) < 1 – (1 – )f.

Thus the right-hand side of equation (18) is greater than the right-hand side of equation (21). This means
that the profit a firm expects to lose if it sets prices in odd periods exceeds the profit a firm expects to lose
if it sets prices in even periods. Thus it is not optimal to set prices in odd periods and firms would like to
switch to setting prices in even periods. This means that with  < 1, if we start with f < 1/2, we would
expect to see f go to zero; no firms will set price in odd periods.

By reasoning analogous to that above, we could show that if f > 1/2, the inequality in (22) is reversed.
Firms setting prices in even periods expect to lose more than firms setting prices in odd periods. Thus it is
not optimal to set price in even periods and firms would like to switch to setting prices in odd periods.
This means that with  < 1, if we start with f > 1/2, we would expect to see f go to one; all firms will set
price in odd periods.

Thus if  < 1, staggered price setting with f = 1/2 is not a stable equilibrium. If the economy starts with
anything other than f = 1/2, staggered price setting will not prevail. The economy will move to a situation
in which all firms set price in the same period.

Problem 7.3
(a) The representative individual will set her price equal to the average of the optimal price for t and the
expected optimal price for t + 1. Thus
(1) xt = (pt* + Et pt+1*)/2.
Since pt* = mt + (1 – )pt and this holds for all periods, we have
(2) xt = [(mt + (1 – )pt ) + (Et mt+1 + (1 – )Et pt+1 )]/2.

(b) With synchronization, pt = xt and pt+1 = xt and thus

(3) xt = [(mt + (1 – )xt ) + (Et mt+1 + (1 – )xt ]/2.
Simplifying yields
(4) xt = [2(1 – )xt + (mt + Et mt+1 )]/2.
Collecting the terms in xt yields
(5) [1 – (1 – )]xt = (mt + Et mt+1 )/2,
and thus
(6) xt = (mt + Et mt+1 )/2.
Firms set their price equal to the average of this period's value of m and the expected value of next
period's value of m.

(c) Substitute pt = xt = (mt + Et mt+1 )/2 into the aggregate demand equation to obtain
(7) yt = mt – (mt + Et mt+1 )/2.
Simplifying gives us
(8) yt = (mt – Et mt+1 )/2.
Assuming that m follows a random walk so that Et mt+1 = mt , we have
(9) yt = (mt – mt )/2,
or simply
(10) yt = 0.

Now, substituting pt+1 = xt = (mt + Et mt+1 )/2 into the aggregate demand equation for period t + 1 gives us
(11) yt+1 = mt+1 – [(mt + Et mt+1 )/2].
7-6 Solutions to Chapter 7

Assuming that m follows a random walk so that Et mt+1 = mt , we have

(12) yt+1 = mt+1 – (mt + mt )/2,
or simply
(13) yt+1 = mt+1 – mt .
The central result of the Taylor model does not continue to hold. Nominal disturbances that occur in
periods when firms are not setting prices feed through one-for-one into output; see equation (13).
However, once firms set prices again, output returns to its normal value of 0; see equation (10).

Intuitively, we have removed the mechanism by which the Taylor model generates long-lasting effects of
nominal disturbances. In the Taylor model, once firms get to adjust price, they do not adjust fully to a
nominal disturbance because they know that not all firms are adjusting at that time. Thus fully adjusting
will change their relative price, which they are reluctant to do. But here, firms know that all firms are also
adjusting their price at the same time. Thus firms' real prices will not change if they fully adjust and thus
they do so.

Problem 7.4
The price set by firms in period t is
(1) xt = (pt* + Et pt+1*)/2 = [(mt + (1 – )pt ) + (Et mt+1 + (1 – )Et pt+1 )]/2,
where we have used the fact that p* = m + (1 – )p. Since pt = (xt + xt-1 )/2 and Et mt+1 = 0, equation (1)
can be rewritten as
(1  )( x t  x t 1 )  (1  )( x t  E t x t 1 ) 2
(2) x t   m t   ,
2 2
which simplifies to
 m t (1  )( x t 1  2 x t  E t x t 1 )
(3) x t   .
2 4
Solving for xt yields
(4) xt = A(xt-1 + Et xt+1 ) + [(1 - 2A)/2]mt ,
1 1 
where A  .
2 1 

We need to eliminate Et xt+1 from the expression in (4). As in the text, it is reasonable to guess that xt is a
linear function of xt-1 and mt , or
(5) xt =  + xt-1 + mt .
We need to determine whether there are values of , , and  that solve the model. As explained in the
text, each price equals m in the flexible-price equilibrium. In light of this, consider a situation in which
xt-1 and mt both equal zero. If period-t price-setters also set their prices to mt = 0, the economy is at its
flexible-price equilibrium. In addition, since m is white noise, the period-t price-setters have no reason to
expect mt+1 to be on average either more or less than zero, and hence no reason to expect xt+1 to depart on
average from zero. Thus in this situation, pt* and Et pt+1* are both equal to zero and so price-setters
would choose xt = 0. In summary, it is reasonable to guess that when xt-1 = mt = 0, xt = 0. In terms of
equation (5), this condition is
(6) 0 =  + (0) + (0),
or simply  = 0. Thus equation (5) becomes
(7) xt = xt-1 + mt .

Our goal is to find values of  and  that solve the model. Since equation (7) holds each period, it implies
that xt+1 = xt + mt+1 . Thus the expectation as of time t of xt+1 is xt since Et mt+1 = 0. Using equation
(7) to substitute for xt yields
(8) Et xt+1 = 2 xt-1 + mt .
 Solutions to Chapter 7 7-7

Substituting equation (8) into equation (4) gives us

(9) xt = A(xt-1 + 2 xt-1 + mt ) + [(1 – 2A)/2]mt ,
which implies
(10) xt = (A + A2 )xt-1 + {A + [(1 – 2A)/2]}mt .
The coefficients on xt-1 and mt must be the same in equations (7) and (10). This requires
(11) A + A2 =  ,
and
(12) A + (1 – 2A)/2 = .
Equation (11) is the same as equation (7.38) in the text for the version of the model in which m follows a
random walk. The solution to this quadratic is thus given by
1 
(13)   .
1 

Solving for  in equation (12) yields

(14) (1 – A) = (1 – 2A)/2.
From equation (11), dividing through by  and rearranging, gives us 1 – A = A. Substituting this
expression into equation (14) gives us
1  2A 
(15)   .
2 A
Substituting equation (15) into equation (7) yields
1  2A 
(16) x t   x t 1  mt .
2 A
Thus equation (16) with  given by equation (13) solves the model.

We can now describe the behavior of output. Using the definitions of A and , some simple algebra
allows us to rewrite equation (16) as
2
(17) x t   x t 1  m t   x t 1  Cm t ,
(1   ) 2
2
where we have defined C  .
(1   ) 2

Since yt = mt – pt and pt = (xt + xt-1 )/2 we have

(18) yt = mt – [(xt + xt-1 )]/2.
Substituting equation (17), and equation (17) lagged one period, into equation (18) yields
(19) yt = mt – [(xt-1 + Cmt + xt-2 + Cmt-1 )/2],
or simply
(20) yt = mt – pt-1 – [(C/2)mt ] – [(C/2)mt-1 ],
where we have used the fact that pt-1 = (xt-1 + xt-2 )/2. Now since yt-1 = mt-1 – pt-1 , this implies
(21) yt = mt + yt-1 – mt-1 – (C/2)mt – (C/2)mt-1 .
Collecting terms yields
 C  C
(22) y t  1   m t      m t 1   y t 1 .
 2  2
Finally, since
C  1 2      1 2 
(23) 1   1  2
 2
 ,
2 (1   ) (1   ) (1   ) 2
and
7-8 Solutions to Chapter 7

C 1   (1   )(1   )   1    1
(24)     2
 2
 2
 .
2 1   (1   ) (1   ) (1   ) (1   ) 2
Using (23) and (24), equation (22) can be rewritten as
1 2  1
(25) y t  y t 1   
2 t
 t 1,
(1   ) (1   ) 2
where we have substituted for mt = t and mt-1 = t-1 . Thus if the money stock is white noise, output is an
ARMA(1,1) process rather than an AR(1) process.

Problem 7.5
We could proceed as in the text and obtain equation (7.50), which holds for a general process for m, and
which is given by
 1  2A
(7.50) x t  x t 1  [ m t  (1  )( E t m t 1  E t m t 2  2 E t m t 3  )] .
A 2
When the money stock is white noise, E t m t s  0 for all s > 0. Thus equation (7.50) simplifies to
 1  2A
(1) x t  x t 1  mt .
A 2
Note that equation (1) is identical to equation (16) in the solution to Problem 7.4. As in that solution, we
could now proceed to determine the behavior of output.

Problem 7.6
(a) This conjecture is reasonable. If λ is between 0 and 1, the price level will be positive. The price level
in this formula is proportional to the money supply. As t gets larger, 1 – λ t will increase if λ is between 0
and 1 and thus the price level will rise. As t → ∞, p t → m 1; i.e. the price level approaches the money
supply in the long run. The fact that price adjustment is Calvo, with a constant fraction of prices being
adjusted each period, makes it reasonable to conjecture that the form of adjustment of the price level
involves the price level moving a constant fraction of the remaining distance to its long-run value each
period.

(b) Our conjecture is that

(1) p t  (1  t )m1 .
Substituting equation (1) and the fact that mt = m1 into yt = mt – pt gives us
(2) y t  m1  (1  t )m1 ,
which simplifies to
(3) y t  t m1 .
Substituting equation (1) applied to periods t and t – 1 into the definition of inflation, πt = pt – pt – 1, yields
(4)  t  (1  t )m1  (1  t 1 )m1 ,
which simplifies to
(5)  t  t 1 (1  )m1 .

From equation (7.60) in the text, the new Keynesian Phillips curve is given by
(6)  t  y t  E t  t 1 ,
where   [1  (1  )] /(1  ) . Substituting equation (3) for yt and the expectation of πt + 1 , using
equation (5), gives us
(7)  t  t m1  t (1  )m1 .
Then we can set the right-hand sides of equations (5) and (7) equal to obtain
 Solutions to Chapter 7 7-9

(8) t 1 (1  )m1  t m1  t (1  )m1 .

Dividing both sides by t 1m1 gives us
(9) 1      (1  ) .
After rearranging the terms, we have the following quadratic in λ:
(10) 2  (1    )  1  0 .
The solutions to this quadratic equation are
(1    )  (1    ) 2  4
(11) 1 
2
and
(1    )  (1    ) 2  4
(12)  2  .
2
Only one of the two solutions produces reasonable results for the possible range of parameter values. For
example, consider α = 0.5, β = 1, and ϕ = 1. This implies that κ = 0.5, λ1 = 2, and λ2 = 0.5. The value of 2
for λ1 is not possible because it leads to a negative price, which we can see from equation (1). Thus, we
will choose λ2 as our solution.

(c) Taking the first derivative of λ2 with respect to α gives us

 
  2 1    1 2(1    )(  /  ) 
(13)   ,
  2    2 (1    ) 2  4 
 
which simplifies to
 
 2 1    1    .
(14)  1
  2    (1    )  4 
2

Note that 1     > (1    ) 2  4 and so the term in square brackets is negative. In addition,
1/2β > 0. Thus, we must determine the sign of   /   . We have
[1  (1  )]

(1  )
(15)

    .
1 
Taking the derivative with respect to α gives us
  (1  )  (1)
(16)    .
 1   2
Equation (16) simplifies to
 
  
  1   2
(17)
 1 
    .
 1   
2

Since α is between 0 and 1, 1/(1 – α)2 > 1. Then, since β is less than 1, the term in square brackets is
positive. Since ϕ > 0, the derivative   /   is positive. Thus, finally, we have
7-10 Solutions to Chapter 7

 
 2 1   1      0.
(18)  1
  2    (1    )  4 
2

An increase in the fraction of firms that set new prices each period is associated with a decrease in λ,
which implies faster adjustment of the price level to the change in the money supply, according to
equation (1).

Next, we first take the first derivative of λ2 with respect to β to yield

 
    1  1 2(1    )[(  /  )  1]  (2)  (1    )  (1    ) 2  4  (2)
 2   
 2  (1    ) 2  4 
(19)  ,
 42
which simplifies to
     (1    )

  (1    )  (1    ) 2  4 
  1 1   
   
 (1    )  4  
2
 2
(20)  .
 22
From equation (15), we have

(21)  1  1    0 .


As explained above, since 1     > (1    ) 2  4 , we know that

 
(1    )
(22) 1    0 , and
 (1    )  4 
2

(23) (1    )  (1    ) 2  4   0 .
 
Finally, since β is positive, we know that
     (1    )

  (1    )  (1    ) 2  4 
  1 1   
 2      (1    )  4  
2
(24)  0.
 22
An increase in households’ discount factor is associated with a decrease in λ, which implies faster
adjustment of the price level to the change in the money supply.

Finally, taking the derivative of λ2 with respect to ϕ gives us

 
  2 1    1 2(1    )(  /  ) 
(22)   ,
  2    2 (1    ) 2  4 
 
which simplifies to
 
 2 1   1    .
(23)  1
  2    (1    )  4 
2

As explained above, the term in square brackets is negative and 1/2β is positive. We therefore need to
determine the sign of   /   . Taking the derivative gives us
 Solutions to Chapter 7 7-11

 
  
  1 
(24)
 1 
    .
 1   
Since α is between 0 and 1, 1/(1 – α) > 1. Then, since β is less than 1, the term in square brackets is
positive. Since α is also positive, the derivative   /   is positive. Thus, finally, we have
 
 2 1    1    0.
(18)  1
  2    (1    )  4 
2

A decrease in ϕ is associated with an increase in λ. Since a decrease in ϕ means a higher degree of real
rigidity, this implies that greater real rigidity leads to slower price adjustment in response to the increase
in the money supply.

Problem 7.7
(a) We can visualize the distribution of pi – pt* as an “elevator” of height S in a “shaft” of height 2S. The
statement that pi – pt* continues to be distributed uniformly over some interval of width S means that
although the elevator may move up and down in the shaft, it remains of height S. To see this, suppose first
that the elevator is not at the top or bottom of the shaft. Now assume that the money supply rises by a
small (formally, infinitesimal) amount dm. Since pi – pt* does not equal S or -S for anyone, no prices
change. All the (pi – pt*)'s fall by dm. The elevator moves down the shaft by dm and stays of height S.
Similarly, if m falls, no prices change. The elevator moves up the shaft by dm and stays of height S.
S
Now suppose the elevator is at the bottom of the shaft.
Assume that the money supply rises by dm. Firms that
initially have pi – pt* "just above" -S reach the barrier. They
therefore raise their price so that pi – pt* = 0. Everyone else
moves down the shaft by dm. Since the height of the
elevator was S, the top of the elevator was initially at zero.
0
In the figure at right, the horizontal lines represent "slices" of
the elevator of infinitesimal height dm. Essentially, the
firms at the bottom of the elevator jump up to the top and
everyone else moves down by dm. So the elevator does not
move or change shape. Thus, with an infinitesimal change in
m, the distribution of pi – pt* is unchanged, just as in the -S
Caplin-Spulber model.

The situation in which the elevator is at the bottom of the shaft and m falls is like the case in which the
elevator is not at the top or bottom of the shaft. It simply moves up by dm.

Finally, the case in which the elevator is at the top of the shaft is the reverse of the case in which it starts
at the bottom. If m falls, the elevator does not move. If m rises, the elevator moves down by dm.

(b) For an increase in m, average price is unchanged except if the elevator is at the bottom of the shaft.
In this case, the average price rises exactly as much as m. Thus, on average, increases in the money
supply increase output.
7-12 Solutions to Chapter 7

Problem 7.8
(a) The price set by individuals at time t is
1 T 1 T
(1) x( t )   E t [ m( t   )]dt   ( t   )gd ,
T  0 T  0
where we have substituted for the fact that m(t) = gt and thus that Et [m(t + )] = g(t + ). Solving the
integral in (1) gives us
1  T 
 
T 1
 T
(2)  ( t   )gd  gt  0    2   gtT  gT 2 .
 0 2  0  2
Substituting equation (2) back into equation (1) gives us the price set by individuals at time t, which is
(3) x(t) = gt + (gT/2).

The aggregate price level is the average of the prices set over the last interval of length T. Thus
1 T
(4) p( t )   x( t   )d .
T  0
Substituting equation (3) into equation (4) yields
1 T  1 
(5) p( t )    g( t   )  gT d .
T  0  2 
Solving the integral in (5) gives us
T  T
 1   1 1  1 1
(6)   g( t   )  gT d   gt  g 2  gT   gtT  gT 2  gT 2  gtT .
 0
 2   2 2  2 2
 0
Substituting equation (6) back into equation (5) gives us the price level at time t, which is
(7) p(t) = gt.

Substituting m(t) = gt and p(t) = gt into y(t) = m(t) – p(t) gives us

(8) y(t) = 0.

(b) (i) Suppose that x(t) = gT/2 for all t > 0. Then for t > T, since p(t) is just the average of the x's set
over the last interval of length T, p(t) = gT/2. Now we know that for t > T, m(t) = gT/2. Thus for t > T,
we do have p(t) = m(t). From y(t) = m(t) – p(t), this means that for all t > T, y(t) = 0, which would have
been its value in the absence of the change in policy.

Now consider the situation for some time t between time 0 and time T. From time 0 to time t, we are
assuming that individuals set price equal to gT/2. From equation (3), we know that before time 0,
individuals set price equal to gt + (gT/2). The aggregate price at time t, which is the average of the prices
set by individuals over the past interval of length T, is therefore given by
1 0  gT  t  gT   1  0  gT  gTt 
(9) p( t )     g   d     d      g   d  .
T    t T  2     T    t T 
 0 2 2  2 
Solving the remaining integral in equation (9) gives us
 0
0  gT   g 2 gT  g( t  T) 2 gT( t  T)
(10)   g   d       .
  t T
 2   2 2  2 2
  t T
Substituting equation (10) back into equation (9) and expanding yields
1  g( t  T) 2 gT( t  T) gTt  1  gt 2  2gtT  gT 2  gTt  gT 2  gTt 
(11) p( t )        ,
T  2 2 2  T  2 
 Solutions to Chapter 7 7-13

which implies
gt 2  t 
(12) p( t )  gt   gt 1  .
2T  2T 
Thus p(t) = m(t) for t between 0 and T as well. Thus if x(t) = gT/2 for all t > 0, then p(t) = m(t) for all
t > 0, and thus output is the same as it would be without the change in policy.

(b) (ii) At time t, individuals set their prices equal to the average of the expected money supply over the
next interval of length T. We know that m(t) = gT/2 for t  T, but it is strictly less than gT/2 for t < T.
Thus individuals setting prices at some time t before T are going to set their prices less than gT/2. Why?
They will be averaging some m's equal to gT/2 with some m's less than gT/2 and so we must have
x(t) < gT/2 for 0 < t < T. For T  t < 2T, the money supply is expected to be constant at gT/2 and thus
individuals set prices equal to this constant money supply. Thus x(t) = gT/2 for T  t < 2T.

We have shown in part (b) (i), that if everyone sets prices to gT/2, p(t) = m(t) and thus y(t) = 0, which is
its value in the absence of the change in policy. But as we have just explained, individuals set prices less
than gT/2 for 0 < t < T. Thus the aggregate price level will be less than m(t) over the interval
0 < t < 2T. Since y(t) = m(t) – p(t), this means that output will be greater than zero during this interval.
Thus this steady reduction in money growth actually causes output to be higher than it would have been
in the absence of the policy change.

Problem 7.9
(a) From equation (7.76), the new Keynesian Phillips curve with indexation is
1 
(1)  t   t 1  E t  t 1  y t ,
1  1 
1 
where   [1  (1  )] . With perfect foresight and β = 1, equation (1) simplifies to
1  1 
1 1
(2)  t   t 1   t 1  y t .
2 2
Using the definition of inflation,  t  p t  p t 1 , and the usual aggregate demand equation,
y t  m t  p t , we can rewrite equation (2) as
1 1
(3) p t  p t 1  (p t 1  p t 2 )  (p t 1  p t )  (m t  p t ) .
2 2
After rearranging the terms, we have an expression for pt + 1 in terms of its lagged values and mt:
(4) p t 1  (3  2)p t  3p t 1  p t 2  2m t .

(b) Consider an anticipated, permanent, one-time increase in m: mt = 0 for t < 0 and mt = 1 for all t ≥ 0.
Using the lag operator, we can write equation (4) as
(5) p t 1  (3  2)Lp t 1  3L2 p t 1  L3 p t 1  2m t .
Collecting the pt+1 terms gives us
(6) [I  (3  2)L  3L2  L3 ]p t 1  2m t ,
or
(7) p t 1  [I  (3  2)L  3L2  L3 ]1 (2m t ) .
Then we can factor [I  (3  2)L  3L2  L3 ] as (I  a1L)(I  a 2 L)(I  a 3 L) and therefore write
(8) p t 1  [(I  a1L)(I  a 2 L)(I  a 3 L)]1 (2m t ) ,
or simply
7-14 Solutions to Chapter 7

(9) p t 1  (I  a1L) 1 (I  a 2 L) 1 (I  a 3 L) 1 (2m t ) .

Then we can express each of (I  a1L) 1 , (I  a 2 L) 1 , (I  a 3 L) 1 as an infinite sum of the form

1  a i L  a i 2 L2   for i = 1, 2, and 3. Thus, we can rewrite equation (9) as
(10) p t 1  (1  a1L  a12 L2  )(1  a 2 L  a 2 2 L2  )(1  a 3 L  a 3 2 L2  )(2m t ) .
Then after distributing the terms for multiplication and some simplification, we find the resulting path of
pt is given by
(11) p t 1  [1  (a1  a 2  a 3 )L  (a1a 2  a1a 3  a 2 a 3  a12  a 2 2  a 3 2 )L2  ](2m t ) .

Problem 7.10
We will first derive the hint given in the problem. With partial indexation, the average (log) price in
period t of firms that do not review their prices is p t 1  t 1 . Since fraction (1 – α) of firms do not
review their price and fraction α set their price equal to xt, the average price in period t is given by
(1) p t  x t  (1  )(p t 1  t 1 ) .
Subtracting pt -1 from both sides of equation (1) gives us
(2) p t  p t 1  (x t  p t 1 )  (1  )t 1 .
Adding and subtracting αpt to the right-hand-side of equation (2) yields
(3) p t  p t 1  [(x t  p t )  (p t  p t 1 )]  (1  )t 1 .
Since  t  p t  p t 1 , we can rewrite (3) as
(4)  t  (x t  p t )   t  (1  )t 1 .
Collecting the terms in πt gives us
(5) (x t  p t )  (1  ) t  (1  )t 1 .
Thus, finally, we arrive at the hint:
1 
(6) x t  p t   t  t 1 .


Equation (6) represents one key equation in our solution. The second key equation will be an expression
analogous to equation (7.75). Intuitively, from period t to period t + 1, the firm will adjust "γ for 1" to
inflation in period t. The firm would prefer not to adjust to πt at all, though, because given pt, πt has no
effect on the profit-maximizing price. Also, from t to t + 1, the firm will not adjust at all to expected
inflation in period t + 1. The firm would like to adjust one-for-one, though, because given pt , πt+1 moves
the proft-maximizing price one-for-one. Thus, we can conjecture that the analogue to equation (7.75) will
be:
(7) x t  p t  [1  (1  )]  y t  (1  )E t [x t 1  p t 1 ]  E t [ t 1 ]  t  .

To derive (7), we need to generalize equation (7.13) to discounting and to the fact that the price changes
between reviews. We will denote the price the firm sets as xt and allow zt+j(xt) to denote the price of a
firm setting xt at time t and not getting a chance to review before period t + j. Thus, the analogue to
equation (7.13) is
 1 
2 
 
2
(8) min   jq j E t  z t  j ( x t )  p*t  j  .

xt j0

Since fraction (1 – α) of firms get to review their price each period, q j  (1  ) j . With partial indexation,
we have
 Solutions to Chapter 7 7-15

x t for j  0

(9) z t  j ( x j )   j1
 t    t   for j  1.
x 
  0
The profit-maximizing price in period t + j is given by
p t   y t for j  0
* 
(10) p t  j   j
p
 t    t     y t  j for j  1.
 1
Thus, we can rewrite the minimization problem as
  j1 j  
2
(11) min
1
x t  (p t   y t )    (1  ) E t  x t     t   p t    t    y t  j   .
2 j j1 
xt 2 j1 2   0 1  

The first-order condition for xt is given by
  j1 j 
(12) x t  (p t   y t )    j (1  ) j E t  x t     t   p t    t    y t  j   0 .
j1   0 1 
We can collect the (xt – pt) terms and rewrite equation (12) as
   j1 j 
(13)   j (1  ) j (x t  p t )   y t    j (1  ) j E t     t      t     y t  j  .
j0 j1   0 1 
Since β(1 – α) < 1, the sum on the left-hand-side of equation (13) converges to {1 /[1  (1  )]}(x t  p t )
and so we can write

   j1 j 
(14) x t  p t  [1  (1  )]  y t    j (1  ) j E t     t      t     y t  j   .

 j1   0 1 

Equation (14) holds for all periods. Expressing it for period t + 1, multiplying both sides by β(1 – α), and
taking the expectation of the resulting expression as of period t gives us
(1  )E t [ x t 1  p t 1 ] 
(15) 
   j1 j 
[1  (1  )] (1  )  E t [ y t 1 ]   (1  ) j (1  ) j E t     t 1     t 1    y t 1 j  .

 j1  0 1 
Changing the subscripts on the summations allows us to write
(1  )E t [ x t 1  p t 1 ] 
(16) 
   j1 j 
[1  (1  )] (1  )  E t [ y t 1 ]    j (1  ) j E t     t      t     y t  j  .

 j2  1  2 

We now want to expand equation (14) so that we express xt – pt as several terms plus the expression given
by equation (16). That is, we can write equation (14) as

  0    0 
x t  p t  [1  (1  )] y t  (1  )E t     t       j (1  ) j E t     t    

   0  j2  0 
(17)
1  1 
(1  )   t      j (1  ) j E t    t      (1  )E t [ x t 1  p t 1 ].
1 j2 1 
Since β(1 – α) < 1, we can write equation (17) as
7-16 Solutions to Chapter 7

 (1  ) (1  ) 
(18) x t  p t  [1  (1  )] y t  (t )  E t [ t 1 ]  (1  )E t [ x t 1  p t 1 ].
 1  (1  ) 1  (1  ) 
Finally, equation (18) simplifies to equation (7), as desired:
(7) x t  p t  [1  (1  )]  y t  (1  )E t [x t 1  p t 1 ]  E t [ t 1 ]  t  .

We can now use equations (6) and (7) to solve the problem. Setting the right-hand sides of (6) and (7)
equal gives us
1 
(19)  t  t 1   [1  (1  )]  y t  (1  )E t [x t 1  p t 1 ]  E t [ t 1 ]  t  .

Expressing equation (6) for period t + 1 and taking the expectation as of period t gives us
1 
(20) E t [ x t 1  p t 1 ]  E t [ t 1 ]  t .

Substituting equation (20) into equation (19) yields
1 
(21)  t  t 1   [1  (1  )]  y t  (1  )1   E t [ t 1 ]  t   E t [ t 1 ]  t  .
   
Equation (21) simplifies to
(22)
1 
 t  t 1   [1  (1  )] y t  (1  ) E t [ t 1 ]  t  .
 
Multiplying both sides of equation (22) by α/(1 – α) and adding γπt+1 to both sides of the resulting
expression yields

(23)  t  t 1  [1  (1  )]  y t   E t [ t 1 ]  t  .
1 
Collecting terms in πt gives us

(24) (1  ) t  t 1  E t [ t 1 ]  [1  (1  )]  y t .
1 
Finally, the new Keynesian Phillips curve with partial indexation is given by
1  1 
(25)  t  t 1  E t [ t 1 ]  [1  (1  )]  y t .
1   1   1   1  

In the special case in which γ = 0, equation (25) simplifies to


(26)  t  E t [ t 1 ]  [1  (1  )]  y t ,
1 
which is equivalent to equation (7.60), the new Keynesian Phillips curve.

In the special case in which γ = 1, equation (25) simplifies to

1  1 
(27)  t   t 1  E t [ t 1 ]  [1  (1  )]  y t ,
1  1  1  1 
which is equivalent to equation (7.76), the new Keynesian Phillips curve with full indexation.

Problem 7.11
(a) Since e i is the probability that a price path set at time t is still being followed at time t + i, then we
can let (i)  1  e i be the probability that a firm has had an opportunity to change its price path
between t and t + i. Then similar to equation (7.80) we can write
(1) (i)[(1  )a(i)  ]  a (i) .
Solving for a(i) gives us
 Solutions to Chapter 7 7-17

 (i)
(2) a (i)  .
1  (1  )(i)
Substituting our expression for λ(i) into equation (2) yields
(1  e i )
(3) a (i)  .
1  (1  )(1  e i )

(b) (i) Reasoning analogous to that used to derive equation (7.83) gives us
(4) y(t )  [(1  a (t )](gt ) .
Substituting equation (3) for a(t) into equation (4) gives us
 (1  e t ) 
(5) y( t )  1   (gt ) .
 1  (1  )(1  e t ) 
Equation (5) simplifies to
e t
(6) y( t )   gt .
1  (1  )(1  e  t )

(b) (ii) We need to find an expression for inflation, p ( t ) , for t ≥ 0. Our usual aggregate demand equation
(7) y(t) = m(t) – p(t) ,
can be rewritten in terms of the price level as
(8) p(t) = m(t) – y(t).
Because of the assumption that all firms expect m(t) = 0 for t > 0, this simplifies to
(9) p(t) = -y(t).
Taking the time derivative of both sides of equation (9) implies
(10) p (t )  y (t ) .

We need to take the time derivative of output, which is given by equation (6). Using the quotient rule, we
have
t t

 (e gt  ge )[1  (1  )(1  e t )]  e t gt[(1  )e t ] 

(11) p ( t )   .
  t 2 
 [1  (1  )(1  e )] 

After rearranging the terms and simplifying, we arrive at the following expression for inflation:
ge t [(1   t )  (1  )(1  e t )]
(12) p ( t )  .
[1  (1  )(1  e t )]2
Since ge t and [1  (1  )(1  e t )]2 are both positive, inflation will be negative if
[(1   t )  (1  )(1  e t )] is negative. Since 0    1 , then (1  e t )  0 for large enough t. In
addition, since (1  )  0 , then (1  )(1  e t ) > 0 for large t, or equivalently,  (1  )(1  e t )  0
for large t. Since (1   t )  0 for t  1 /  , the answer to this question is yes and inflation during the
transition to the new steady state will be negative for large enough t.

(b) (iii) With the assumption that ϕ = 1, equation (6) becomes

(13) y(t )  e t gt .
To find the time at which output reaches its lowest level, we need to set dy(t)/dt = 0 and solve for t. Thus,
we have
7-18 Solutions to Chapter 7

dy ( t )
(14)  e t gt  e t g  0 ,
dt
which implies
(15) ge t (t  1)  0 .
Because ge t is nonzero, our solution is
1
(16) t*  .

To check whether this is a minimum, we take the second derivative

d 2 y( t )
(17)    2 e t gt  e t g  e t g 1 ,
dt 2 1 t
t 

which simplifies to
d 2 y( t )
(18)  e t g(2  t ) t  1 ,
2
dt t
1 

and, finally
d 2 y( t )
(19)  e 1g  0 .
2
dt t
1

Thus, output does reach a minimum at t* = 1/α.

To determine the time at which inflation reaches its lowest level, we need to take the first derivative of
expression (10) with respect to time, set it to zero, and solve for t. That is, we need to solve
dp ( t ) dy ( t )
(20)  0.
dt dt
From equation (18), we already know that dy (t ) / dt  e t g(2  t ) and so we must solve
(21)  e t g(2  t )  0 .
Because e t g is nonzero, our solution is
2
(22) t*  .

To check whether this is a minimum, we know from equation (21) that
dp ( t )
(22)  e t g(2  t ) ,
dt
which we can rewrite as
dp ( t )
(23)  2e t g   2 e t gt .
dt
Taking the second derivative of p ( t ) with respect to time gives us

d 2 p ( t )
(24)  2 2 e t g   2 ge t   2 gt ()e t 2 ,
dt 2 2 t
t 

which simplifies to
 Solutions to Chapter 7 7-19

d 2 p ( t )
(25)   2 ge t (3  t ) 2 .
dt 2 2 t
t 

Thus, we have
d 2 p ( t )
(26)   2 ge 2  0 .
2
dt t
2

Thus, inflation does reach a minimum at t* = 2/α.

Problem 7.12
(a) For the case of white-noise disturbances, to find expressions analogous to (7.92) – (7.94), we start
with the three core equations given by
1
(1) y t  E t [ y t 1 ]  rt  u IS
t ,   0,

and
(2) t  E t [t 1]  y t  u t , 0    1,   0,
and
(3) rt     t   y y t  u MP
t ,    0,  y  0 .

First, we substitute equation (3) for rt into equation (1) to yield

1
(4) y t  E t [ y t 1 ]  (   t   y y t  u MPt )  ut .
IS

Substituting equation (2) for πt into equation (4) gives us
1


(5) y t  E t [ y t 1]  E t [t 1]   y t  u t   y y t  u MP t  u IS
t .

We need to solve for yt. Collecting terms gives us

     y 
(6) 1 

1
 

MP IS
 y t  E t [ y t 1 ]  E t [ t 1 ]  u t  u t  u t .

 
Multiplying both sides of equation (6) by  /(     y ) gives us

(7) y t 

      y
E t [ y t 1] 
1
      y
 t
E t [ t 1 ]  u t  u MP 

      y
u IS
t ,

which we can rewrite as

(8) y t 
1
      y

 E t [ y t 1 ]  E t [ t 1 ]  u t  u MP
t   u IS
t .
Next, we incorporate the fundamental solution of E t [ y t 1 ]  0 and E t [ t 1 ]  0 , giving us

(9) y t 
1
      y
 u IS   MP
t   u t  u t . 
Now substitute equation (8) for yt into equation (2) to yield the following expression for inflation:
(10) t  E t [t 1] 

      y

 E t [ y t 1]  E t [t 1]  u t  u MP IS 
t  ut  ut .
Collecting the terms in Et[πt+1] and u t gives us
7-20 Solutions to Chapter 7


(11)  t  1 
  
E t [ t 1 ] 
       y 

      y

 E t [ y t 1 ]  u MP
t 
  u IS

t  1 
   
u t .
       y 
Since
      y
(12) 1   ,
       y        y
we can rewrite equation (11) as
(13)  t 
1
      y

  E t [ y t 1 ]   u MP
t    u IS 

t  (   y )(E t [ t 1 ]  u t ) .

Substituting the fundamental solution of E t [ y t 1 ]  0 and E t [ t 1 ]  0 into equation (13) yields

(14) t 
1
      y

  u IS  MP
t  (   y ) u t   u t . 
Next, we can substitute equations (9) and (14) for output and inflation into equation (3) to obtain an
expression for the real interest rate, given by

(15) rt 

     y

  u IS  MP
t  (   y ) u t   u t   y
     y
 u IS  MP
t   u t  u t  u MP
t . 
Collecting terms gives us
(16) rt 
1
     y

(     y )u IS  MP
t  (   y   y )u t  (     y     y   )u t , 
which simplifies to
(17) rt 
1
     y

 (     y )u IS  MP
t    u t   u t . 
Equations (9), (14), and (17) are analogous to (7.92)-(7.94).

Because we are assuming that all constants are positive, we obtain the following signs on the impacts of
the unfavorable inflation shock:
 yt 
(18) 
 0;
 ut      y
 t   y
(19)   0;
 u t      y
and
 rt  
(20)   0.
 u t      y
Thus, an unfavorable inflation shock reduces output and increases both inflation and the real interest rate.

(b) The shocks follow independent AR-1 processes:

(21) u IS IS IS
t  ISu t 1  e t ,  1  IS  1 ;
(22) u t  u t 1  et ,  1    1 ;
and
(23) u MP
t  MP u MP MP
t 1  e t ,  1  MP  1 ,
 Solutions to Chapter 7 7-21

where eIS, eπ, and eMP are white-noise disturbances that are uncorrelated with one another. To solve the
model using the method of undetermined coefficients, we guess that the endogenous variables are linear
functions of the disturbances. We can therefore write output and inflation as

(24) y t  a ISu IS MP
t  a u t  a MP u t ,
and

(25) t  bISu IS MP
t  b u t  b MP u t .

Since (24) and (25) hold for all t, we can express output and inflation in period t + 1 as

(26) y t 1  a ISu IS MP
t 1  a u t 1  a MP u t 1 ,
and

(27) t 1  b ISu IS MP
t 1  b u t 1  b MP u t 1 .
Now substitute equations (21) through (23), expressed in period t + 1, into equations (26) and (27) and
take the expectation of the resulting expressions as of period t to yield

(28) E t [ y t 1]  a ISISu IS MP
t  a u t  a MPMP u t ,
and

(29) E t [t 1]  bISISu IS MP
t  b u t  bMPMP u t .

We can now substitute the expressions for E t [ y t 1 ] and E t [ t 1 ] , along with equations (24) and (25)
into equations (8) and (13). We obtain the following expression from equation (8):
  
a ISu IS MP
t  a  u t  a MP u t  (a ISISu IS MP
t  a  u t  a MPMP u t )
      y

 
(30)
  1 
 (b ISISu IS MP
t  b  u t  b MPMP u t )   u IS MP
t   u t  u t .
      y       y
We also obtain the following expression from equation (13):
  
b ISu IS MP
t  b  u t  b MP u t  (a ISISu IS MP
t  a  u t  a MPMP u t ) 
      y
(31)
(   y )
      y
(b ISISu IS  MP
t  b  u t  b MPMP u t ) 
1
      y
  u IS  MP
t  (   y ) u t   u t .


The two sides of (30) must be equal for all values of u IS MP IS
t , u t , and u t . Thus the coefficients on u t ,
u t , and u MP
t on the two sides must be equal. The same reasoning applies to equation (31). Once we
have solved for the “a”s and “b”s, equations (24) and (25) tell us the behavior of output and inflation. We
can then substitute those solutions for πt and yt into equation (3) to solve for the real interest rate.