HET_New+Classical+and+New+Keynesian (1)

New Classical and New Keynesian

Walter Bazn Fall 2014

Economics Department

Rutgers University

Walter Bazn - Rutgers University

The important of money

The only times that major economic contractions occurred were when the absolute value of the money stock fell.

From evidences, changes in money cause changes in money income.

Monetarists believe that money is a substitute for a wide range of real and financial assets, but not single asset could be a close substitute for money. So interest rate affect money demand.

Recall Monetarist


Monetarists thought that LM is flatter and IS is steeper than in Keynesians.

Fiscal policy would lead to a large amount of crowding out of investment and have little impact on total output.

There is no liquidity trap.

Recall Monetarist


Phillips Curve

The Phillips curve has been a central topic in Macroeconomics since the 1950s and its successes and failures have been a major element in the evolution over time of the discipline.

The idea that there should be some sort of positive relationship between inflation and output has been around almost as long as economics itself


Phillips Curve

The Phillips Curve provided a menu of tradeoffs for policy-makers: They could use demand management policies to increase output and decrease unemployment, but this could only be done at the expense of higher inflation.

The Keynesian model implicitly relied on the idea that low unemployment could be sustained by allowing high inflation to erode real wages and thus boost labour demand.


The second wave of monetarism deal with Philips curve.

Philip curve is published in 1958 using UK data. It shows the inverse relationship between money wage and the rate of unemployment.

The Keynesians draw the conclusion of this finding to support their idea of a permanent trade-off between inflation and unemployment.

Phillips Curve and Monetarism


Phillips Curve and Monetarism

To justify Keynesian policy, the workers must have money illusion.

Friedman argued that money illusion occurs in the short run only. In the long run, there is no trade-off between unemployment and inflation and the evidences seem to confirm this point of view.


PC, Monetarism and Implications

Implications of monetarist

Monetary policy is more effective than fiscal policy.

No long-run trade-off between inflation and unemployment.

The market system was not perfect, the government would only make things worse.

Fiscal policy could only influence the distribution of income and the allocation of resources (crowding out effect).

The only way to increase output permanently is to make market work better.

Adaptive expectation.


New Classical School



Rutgers University


Robert E. Lucas Jr.

1937

University of Chicago

Leading personality of New Classical Revolution

Economist, but originally studied history

Nobel prize 1995


Thomas J. Sargent

1943 Teacher at several US Universities,

namely Minnesota, Chicago, Stanford and New York (currently), essential advanced macroeconomic theory textbooks

Rational expectations Impact on (namely) monetary

policies, statistical operationality of RE, models of Phillips curve, demand for money in hyperinflations, intertemporal coordination of monetary and fiscal policies, etc.

Nobel prize in 2011 (with Christopher Sims)



Initiated by

Lucas

Wallace

Sargent

Barro

Initiated because of:

Theoretical : introduce microeconomic foundation in macroeconomics instead of AD-AS model.

Empirical: inconsistencies between Keynesian and Monetarist and what actually happened in 1970s from oil price shocks, Stagflation.


In search of macroeconomic theory, rooted in micro foundations and Walrasian general equilibrium approach

All economic agents optimize continuously, i.e. subject to their constraints, firms maximize profits and households maximize utility

In taking optimizing decisions, agents take into account only relative prices (do not suffer from money illusion)

Agents able to exhaust all profitable opportunities, wages and prices are flexible and markets continuously clear

Assumptions


Both Keynesian and monetary framework insufficient

Consequently - see assumptions above - return to classical model, i.e. money neutral, AS and LRPC vertical

But, reality (data) not consistent with classical assumptions either, namely short-run correlations

positive: price and output (upward sloping AS) positive: nominal money supply and real GDP (non-

neutral money)



negative: inflation and unemployment (downward sloping PC)

New Classical solution: existence of non-neutralities given by imperfect information, agents have

A novelty, indeed: classical, pre-WWI model, always assumed perfect information



Three basics building blocks

Rational expectations

Continuous market learning

New concept of aggregate supply



New Classical School: RE

Rational Expectation Stagflation is inconsistent with adaptive expectation

(backward-looking).

John Muth developed rational expectation, which is forward looking expectation.

It features: - people would look to the future.

- people use information wisely.

- people would not make systematic errors.


Incorporating rational expectations in the AS-AD model

1. Imperfect information : Household may not know the price level at the time they make decision.

2. Parameterization of AS, Ls and Ld curve: The curves are parameterized by expectations of the values of the exogenous variable.




Implications of new classical economics

Expectations are formed normally. They may form wrong expectations, but once they have learnt their mistake, they will no longer make mistakes.

Only unanticipated policies have an effect on the output and employment.

SR AS is upward sloping from imperfect information.

LR AS is vertical.

Self-correcting economy.



Economic decisions: action today to receive uncertain return in the future Quality of expectations crucial, most famous example:

expected inflation in wage negotiations

Expectation: not only one predicted value, but a probability distribution of all possible outcomes

Two crucial issues How people get, process and use information to form

expectations?

What type of expectations hypothesis is most suitable for application in macroeconomics?


P

Y

LRAS

Y1

P1

A

AD1

AS1

AD2

Y2

P2

AS3

B

C

Y3=

P3




All previous models, be it neoclassical synthesis, monetarism - either explicitly or implicitly used

expectations

So far, PFH or AEH and - in the long run - return to potential output and other natural values

Even when adjustment to past errors takes place (AEH), the errors are all the time systematically

biased



Why Rational?

See assumptions above - all agents are optimizers they are also using all available information in an optimal way (best use of info)

Weak version: in forming the expectations, agents perform cost-benefit analysis regarding how much information to obtain

Compared to AEH, agents use all available info AEH: learning from the past mistakes in predicting only the

same variable

REH: taking into account all information, about all other variables and about all other relevant facts



People DO make errors in forecast

It is NOT perfect foresight

The errors are due to the incomplete information

The errors are independent on the information set -1

On average, agents expectations are correct, i.e. equal to the true values

Expectations are NOT systematically wrong over time (are not biased)


New Classical School: CCM

Continuous Clearing Market

Agents either perform an optimal search for all available

information (weak version)

or just have all information from period -1 (strong version)

In both cases they are (a) rational, (b) optimizing their behavior the resulting prices and quantities are consistent with general equilibrium outcomes

Consequently: all markets clear


New Classical School: CCM

Lucas Aggregate Supply

If both firms and households have complete information, than assuming rational expectations the forecast is always perfect

Rational expectations with PFH, i.e. with classical model

Reality

Firms: usually have complete information, including the price

Households: do not have complete information


New Classical School: CCM -Labor

Start with the classical case, i.e. full employment N* (and Y *).

In next period actual price P>P-1, known to firms, but unknown to households

They can make only expectations, assume

Firms: know that real wage is lower at any nominal wage shift of ND

Households: dont know that real wage is for any nominal wage lower do not shift NS

Increase in equilibrium employment


Pe =P-1

N

W

P-1.NS

P-1.ND

P.ND

N*

W*

N1

W1

Two comments: if price has decreased, there would be shift of ND to the left and new employment would be lower than original one. If households knew the actual price, they would shift NS properly and the model is classical.

New Classical School: CCM -Labor


Y

P

AS

Y*

P=Pe

New Classical School: Aggregate Supply


Equilibrium model with rational expectations just on ADxAS level

Suppose an exogenous change People form expectations of price changes as a

consequence of change in M

Rational expectation: if people anticipate the monetary policy and there is no other random shock, than they will make a proper forecast of price, because They have full information They dont make systematic errors

In this case, given the price changes, both AD and AS shift

M>0

New Classical School: Anticipated


Anticipated monetary change

P

Y

LRAS

Y1

P1

A

AD1

AS1

AD2

Y2

P2

AS3

B

C

Y3=

P3


New Classical School: Un-Anticipated

Suppose, that the change in monetary policy is not anticipated by the households and/or some random shocks appear

Then households will not properly forecast the price level, but firms will only AD shifts, but AS does not

There is a new equilibrium level of employment and output as a consequence of change in the monetary policy


Pe =P-1

Un-anticipated monetary change P

Y

LRAS

Y1

P1

A

AD1

AS1

AD2

Y2

P2 B


Anticipated: households immediately adjust expectations (and behavior) Market clearing

Vertical, classical AS

Un-anticipated: households make mistake from the shock Equilibrium moves along the positively sloped Lucas

AS

New equilibrium output (and employment)

However, given the rational expectation proposition, this is not the end of the story in the next period, households learn their mistake and will adjust return to Y* anyway

New Classical School: Policy


New Classical Macroeconomics Allows for short term fluctuations from natural values

Based on completely different theory than the Keynesian one

Consistent with microeconomic assumptions

Limited effects of governmental policies: If policies anticipated, than quick adjustment and no effect on

output (and other variables)

If un-anticipated policy (or some random, exogenous shock), than after some short term fluctuations adjustment to natural values anyway

Policy impotence proposition PIP

New Classical School: Policy


New Classical Economics - a great leap forward, but a lot of criticism

Rational expectations:

Costs to obtain information

What is the correct model of the economy?

Risk vs. uncertainty

Continuous clearing:

Sluggish adjustment of prices and wages

Involuntary unemployment

Empirical studies

There is an empirical support for non-neutrality of the money (anticipated nominal money change has an impact on real output)

New Classical School: Critics


Lucas: A Positive Program for Business Cycles

Continuous market-clearing, dynamic equilibrium against Keyness involuntary unemployment involuntary unemployment is not a fact or a phenomenon

which it is the task of the theorist to explain. It is, on the contrary, a theoretical construct which Keynes . . . hope[d] would be helpful in discovering a correct explanation for a genuine phenomenon: large-scale fluctuations in measured, total unemployment. Is it the task of modern theoretical economics to explain the theoretical constructs of our predecessors, whether or not they have proved fruitful?

Business cycle phenomena: not objects, but patterns of covariation picked up by Kydland and Prescott surprising respect for Burns and Mitchell


The Transition to the Real Business Cycle Model

Lucass 1975 Business Cycle Model growth, capital, and the propagation mechanism

the last gasp of the monetary surprises

alternative rationales for money

Kydland and Prescott, Time to Build and Aggregate Fluctuations technology shocks

the absence of monetary shocks

the irrelevance of time-to-build


Real Business cycle

New classical fails to explain the important empirical fact, deviations from capacity output tended to be prolonged and correlated.


Real Business cycle

Important summary

1. Random walks : shocks to US output is random walk so it did not revert back to its trend.

2. Intertemporal substition : Instead of AS-AD model, RBC tried to use intertemporal substitution to explain how shocks are transmitted into the economy.

3. RBC still uses rational expectation.


Real Business cycle

Important summary (cont)

4. Market are always clearing.

5. Money is neutral.

6. Economic fluctuations are due to supply side such as technological changes, natural disaster, tax, input prices, etc.


New Keynesian School



Rutgers University


New Keynesian Economics: Basics

The name New Keynesian Theory was introduced by Michael Parkin (1982).

One of the earliest uses of the term new-Keynesian Economics was in an article by Ball, Mankiw, and Romer (1988).

New is used instead of neo to distinguish from Neoclassical Synthesis Keynesian Economics (a term used by Samuelson and others), and also to show it is the counter-argument to the New Classical Economics.


New Keynesian Economics: Basics

According to Gordon, sticky prices implies that real GDP is a residual, and is not determined by agents in the economy.

If this is the case, then firms optimize by setting prices, and accept quantities (production levels) as given.

In the neoclassical and new classical theories, the firms are price takers and optimize by setting quantities (production levels).


New Keynesian Economics

There are 4 main problems with new classical

1. Unhappy / involuntary workers.

2. 1982 US recession.

3. Intertemporal substitution of labor does not seem to be as large as RBC suggested.

4. Hysteresis of unemployment.



New Keynesian uses the new classical model but introduces:

Union models

Contracts and staggering of price and wage changes

Menu cost and imperfect competition



Implications of New Keynesian Economics

Market may not adjust quickly even with rational expectation.

Strong recession warrants government intervention.

Government should ensure that market works smoothly as possible via microeconomic policies.



They use the micro foundations approach as used by the New Classical school.

They argue that the Keynesian conclusions about the effectiveness of fiscal and monetary policy are still valid because goods and labour market do not clear quickly because of imperfections in these markets. Prices and wages are sticky.


Market fails and prices and wages are sticky

menu cost

long period sales and purchase agreements and

imperfect competitions in goods markets and

wage contracts between unions and employers,

insider-outsider behaviour of unions,

efficiency wage behaviour in the labour market.


Old Question:Why is the AS Curve Upward Sloping? New answer: Mark Ups in Wage Rate and Prices

Why is the aggregate demand upward sloping? Why increasing demand can increase

output in the short run?

Price Classical Supply New Classical Supply

p1

Keynesian supply

p0

AD1

AD

O yn Output

Write equations for each of these supply lines


Menu Cost and Impact of an Increase in Aggregate Demand

Profit maximising price and output of a monopolist Impact of an increase in aggregate demand (Ne >N)

Price

And cost

P0 ?

?

A C

pm pm

? ? B

k k

q q1 q



If the expected aggregate demand in

greater than the actual NeN then mpp 0

and if NeN then mpp 0.

Firms should change their price whenever

demand changes.

But there is a menu cost z of changing the

prices because menus have to be printed

again and sent to the customers.


New Keynesian Economics: Final Issues

The authors claim that Keynesians, new and old, can be identified viz a viz members of other schools by their belief in three propositions: An excess supply of labor may exist, sometimes for prolonged periods,

at the prevailing level of real wages.

The aggregate level of economic activity fluctuates widelymore widely than can be explained by short-run changes in technology, tastes, or demographics.

Money matters, at least most of the time, although monetary policy may be ineffective at times.

A lot of this boils down to the proposition that at times quantities adjust rather than prices to bring about cash-flow equilibria.



1. Nominal price rigidities are the fundamental ways in which real-world economies differ from Walrasian Arrow-Debreu economies. Most of the work here focuses on explaining sources of rigidity.

- Because of these rigidities, the classical dichotomy breaks down, and policy can be effective.

2. Even if prices and wages were perfectly flexible, output would still be volatile. This flexibility is not the central problem. In fact, more flexibility might make things worse. This approach focuses on market failures.

- Thus monetary policy has real effects even when prices and wages are perfectly flexible.



The flex-price NK school argues that: Natural economic forces can magnify shocks that seems

small, and

Sticky prices and wages may actually reduce the magnitude of the fluctuations (as Keynes argued).

This makes this group less interested in the source of the shocks (unlike the RBC theorists), and more interested in the mechanisms by which they propagate, are magnified or diminished.


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HET_New+Classical+and+New+Keynesian (1)