In that case, however, a monetary disturbance has large effects on relative prices and induces different responses of output in different sectors of the economy. Monetary shocks, in this way, may contribute to sectoral shifts in the economy. Nominal price sluggishness also affects the short-run response of the economy to real disturbances (e.g., to changes in technology), even in sectors of the economy with flexible prices.
We begin with a simple flexible-price equilibrium model that we have also examined in Ohanian and Stockman (1994) and (in a two-country framework) in Stockman and Ohanian (1993). The model has two consumption goods, X and Y, and labour. We introduce money through a cash-in-advance constraint, intended to stand in for a more general transactions model of money. We assume, for simplicity, that there are complete asset markets. The representative household maximizes utility:
each period. Equation (2) is a budget constraint for period t asset markets and is the cash-in-advance constraint which applies to period t product markets (which immediately follow period t asset markets as in Lucas ). ...
The terms x and y refer to consumption of goods X and Y, LX and Ly refer to labour hours producing goods X and Y, 0 is less than or equal to delta < 1 is a parameter of the production function, kX and kY are exogenous productivity parameters, nt-1 refers to the household's money holdings at the end of period (t - 1) product markets (which is the slack in inequality from the previous period and equals zero in our equilibrium), tau refers to a lump-sum transfer of money to the household from the government, Px and P[sub. Y] are nominal prices, Mt is the nominal money the household chooses as it leaves period t asset markets and enters period t product markets, and vt is a vector of other assets the household owns at the beginning of period t, with dividend vector d and ex-dividend price-vector q.
First, alpha is a parameter describing tastes. Because Alpha helps determine the equilibrium share of good X in total output, we will vary it in "The Size of the Sticky-Price Sector" subsection of Section 2 to discuss changes in the relative sizes of the X and Y industries. Next, p is the inverse of the intertemporal elasticity of substitution; an increase in p means households are less willing to trade current consumption for future consumption (that is, they are willing to pay more for a more constant consumption stream). The subsection "The Size of Intertemporal Substitution" explains how the size of p affects our results. Third, Sigma is the elasticity of substitution between goods X and Y; a larger sigma means the goods are better substitutes. The impact of the size of sigma on our results is the subject of the subsection "The Size of Intratemporal Substitution." Finally, delta determines the curvature of the production function, with