11. Sensitivity of the Results to the Specification of the Price Equation
Prices in the model respond only modestly to changes in the unemployment rate. This seems to be what the data are telling us, but many may feel that prices are likely to respond more than the model indicates. It is easy to change the model to make it more price sensitive to unemployment changes. This is done by making the coefficient of the unemployment rate in equation 10 larger in absolute value. This is what Experiment 11.1 does.

Experiment 11.1: Experiment 5.1 with a more Unemployment Sensitive Price Equation

  • Change the fifth coefficient in equation 10 to be twice its size in absolute value. Solve the model. Call this dataset BASEA. Take BASEA as your base dataset, and change COG by -20 each quarter. Solve the model. Call this dataset NEWA. Answer the following questions by comparing NEWA to BASEA.
  1. The price index PF falls more in this experiment than it does in Experiment 5.1. Why? Do you think the price response should be even larger?
  2. Why was the decrease in real GDP slightly less here than in Experiment 5.1? Be sure to trace through the effects.
  3. How did the Fed behave here as compared to Experiment 5.1?

The sensitivity of prices to changes in demand is one of the key questions in macroeconomics, and experiments like 11.1 help to examine it.