The New Keynesians

The New The New KeynesiansKeynesiansIntermediate MacroeconomicsIntermediate Macroeconomics

ECON-305 Spring 2013ECON-305 Spring 2013Professor DaltonProfessor Dalton

Boise State UniversityBoise State University

The Death of The Death of KeynesianismKeynesianism

Orthodox Keynesianism suffered Orthodox Keynesianism suffered attacks in 1950s and 1960s from attacks in 1950s and 1960s from MonetarismMonetarism Weathered stormWeathered storm Incorporated ideas into the neo-classical Incorporated ideas into the neo-classical

synthesissynthesis New Classical attacks of 1970s more New Classical attacks of 1970s more

damagingdamaging Poor performance of stable Phillips CurvePoor performance of stable Phillips Curve Theoretical inconsistenciesTheoretical inconsistencies

The Death of The Death of KeynesianismKeynesianism

Lucas and Sargent, “After Keynesian Lucas and Sargent, “After Keynesian Macroeconomics,” in Macroeconomics,” in After The After The Phillips Curve…Phillips Curve… (1978) (1978)

Fundamental Problems of Orthodox Fundamental Problems of Orthodox KeynesianismKeynesianism

(1)(1) Inadequate micro-foundations which assume Inadequate micro-foundations which assume markets don’t clearmarkets don’t clear

(2)(2)Use of expectations inconsistent with maximizing Use of expectations inconsistent with maximizing behavior (adaptive rather than rational)behavior (adaptive rather than rational)

After Keynes and LucasAfter Keynes and Lucas New Classical and RBC New Classical and RBC

macroeconomics resolved macroeconomics resolved tension between neoclassical tension between neoclassical micro and Keynesian macro by micro and Keynesian macro by abandoning latter.abandoning latter.

Alternative Approach – rebuild Alternative Approach – rebuild micro foundations of Keynesian micro foundations of Keynesian macroeconomicsmacroeconomics

New Keynesian EconomicsNew Keynesian Economics New Classical and RBC models, despite New Classical and RBC models, despite

their theoretical elegance, fail to their theoretical elegance, fail to “square” with fundamental “square” with fundamental observations concerning business observations concerning business cyclescycles

Orthodox Keynesian models, adapted Orthodox Keynesian models, adapted for supply shocks, do pretty well in for supply shocks, do pretty well in accounting for most (not all) business accounting for most (not all) business cycle facts, but lack micro-reasoning to cycle facts, but lack micro-reasoning to help understandinghelp understanding

Essential Task of MacroEssential Task of Macro““The co-ordination question, simply stated, is The co-ordination question, simply stated, is

this: Will the market system ‘automatically’ this: Will the market system ‘automatically’ co-ordinate economic activities? Always? co-ordinate economic activities? Always? Never? Sometimes very well but sometimes Never? Sometimes very well but sometimes pretty badly? If the latter, under what pretty badly? If the latter, under what conditions, and with what institutional conditions, and with what institutional structures, will it do well or do badly? I structures, will it do well or do badly? I regard these questions as the central and regard these questions as the central and basic ones in macroeconomics.”basic ones in macroeconomics.”

- Leijonhufvud, “Keynesian Economics: Past Confusions, - Leijonhufvud, “Keynesian Economics: Past Confusions, Future Prospects,” in Vercelli and Dmitri, eds., Future Prospects,” in Vercelli and Dmitri, eds., Macroeconomics: A Survey of Recent StrategiesMacroeconomics: A Survey of Recent Strategies

NK Research ProgramNK Research Program

TheThe Difference Difference In classical models, the world is In classical models, the world is

characterized by continuous market-characterized by continuous market-clearingclearing

In Keynesian models, there is an In Keynesian models, there is an absenceabsence of continuous market- of continuous market-clearingclearing


If do away with CMC, better have good If do away with CMC, better have good reasons.reasons.

New Keynesians attempt to provide micro-New Keynesians attempt to provide micro-foundations for absence of CMC, rather foundations for absence of CMC, rather than just assume it.than just assume it.

CMC fails when prices and wages are rigid.CMC fails when prices and wages are rigid. Therefore, New Keynesians attempts a Therefore, New Keynesians attempts a

microeconomics of price and wage microeconomics of price and wage stickiness.stickiness.


Central AspectsCentral Aspects

(1)(1)Construction of a theory of AS Construction of a theory of AS based upon wage and price based upon wage and price rigidities.rigidities.

(2)(2)Construction of models of wage Construction of models of wage and price rigidities based on and price rigidities based on maximizing behavior and rational maximizing behavior and rational expectations.expectations.

However…However…

New Keynesian School?New Keynesian School?

““Genuine school in our sense: Genuine school in our sense: There was one master, one There was one master, one doctrine, personal coherence; doctrine, personal coherence; there was a core; there were there was a core; there were zones of influence; there were zones of influence; there were fringe ends.”fringe ends.”

- Schumpeter, Schumpeter, History of Economic AnalysisHistory of Economic Analysis, p. 95., p. 95.


““a school … is a collection of affiliated a school … is a collection of affiliated scientist who display a considerably scientist who display a considerably higher agreement upon a particular higher agreement upon a particular set of views than the science as a set of views than the science as a whole displays.”whole displays.”

““A school must have a leader …[and] A school must have a leader …[and] consensus upon substantive scientific consensus upon substantive scientific views.”views.”

- Stigler, “Does Economics Have a Useful past?” - Stigler, “Does Economics Have a Useful past?” The The Economist as PreacherEconomist as Preacher, p. 116., p. 116.


New Keynesian economists are an New Keynesian economists are an extremely heterogeneous groupextremely heterogeneous group

New Keynesian economists hold a wide New Keynesian economists hold a wide diversity of views regarding policydiversity of views regarding policy

There is no single, unified, new There is no single, unified, new Keynesian ModelKeynesian Model

Even disagreement over the importance Even disagreement over the importance of wage and price rigidities!!!of wage and price rigidities!!!

Leading New KeynesiansLeading New Keynesians Gregory Mankiw (Harvard)Gregory Mankiw (Harvard) Lawrence Summers (Harvard)Lawrence Summers (Harvard) Olivier Blanchard (MIT)Olivier Blanchard (MIT) Stanley Fischer (MIT)Stanley Fischer (MIT) Joseph Stiglitz (Columbia)Joseph Stiglitz (Columbia) Ben Bernanke (Princeton, Federal Reserve)Ben Bernanke (Princeton, Federal Reserve) George Akerlof (Cal-Berkeley)George Akerlof (Cal-Berkeley) Janet Yellen (Cal-Berkeley)Janet Yellen (Cal-Berkeley) David Romer (Cal-Berkeley)David Romer (Cal-Berkeley) John Taylor (Stanford)John Taylor (Stanford)

Core PropositionsCore Propositions

Mankiw and Romer, Mankiw and Romer, New Keynesian New Keynesian EconomicsEconomics (1991) (1991)

(1)(1) Is money non-neutral?Is money non-neutral?

(2)(2) Are real market imperfections Are real market imperfections crucial for understanding economic crucial for understanding economic fluctuations?fluctuations?

Only New Keynesians (among Only New Keynesians (among mainstream) answer mainstream) answer YesYes to to bothboth..


Summary View of New KeynesianismSummary View of New Keynesianism

““Economic fluctuations arise from Economic fluctuations arise from monetary non-neutrality occurring monetary non-neutrality occurring because of [sticky prices arising because of [sticky prices arising

from] real market imperfections.”from] real market imperfections.”


(1)(1)Firms are price-makersFirms are price-makers

(2)(2)Rational expectations (usually)Rational expectations (usually)

(3)(3)Both demand and supply Both demand and supply shocks are sources of instabilityshocks are sources of instability

(4)(4)Incomplete markets and Incomplete markets and asymmetric informationasymmetric information

Nominal and Real Nominal and Real RigiditiesRigidities

Nominal rigidity Nominal rigidity occurs when occurs when something prevents nominal prices something prevents nominal prices or wages from adjusting to meet or wages from adjusting to meet changes in demand or supplychanges in demand or supply

Real rigidity Real rigidity occurs when something occurs when something prevents real wages, real prices, or prevents real wages, real prices, or relative prices from adjusting to relative prices from adjusting to meet changes in demand or supplymeet changes in demand or supply

Nominal RigiditiesNominal Rigidities

Nominal wage rigidityNominal wage rigidityNominal price rigidityNominal price rigidity

Nominal Wage RigidityNominal Wage Rigidity Long-term labor contractsLong-term labor contracts

Agents RatexAgents Ratex Money supply changes more frequent Money supply changes more frequent

than contracts negotiatedthan contracts negotiated Monetary Policy can have real effects Monetary Policy can have real effects

Micro rationale for long-term labor Micro rationale for long-term labor contractscontracts Wage negotiations costly for both Wage negotiations costly for both

workers and firmsworkers and firms

Nominal Wage RigidityNominal Wage Rigidity Potential costs from strikes due to Potential costs from strikes due to

negotiation breakdownsnegotiation breakdowns Not optimal to change W immediately; if Not optimal to change W immediately; if

other firms don’t follow, increased labor other firms don’t follow, increased labor turnoverturnover

Why not COLAs?Why not COLAs? In world of imperfect info firms can gain vital In world of imperfect info firms can gain vital

information by observing wage/price information by observing wage/price changes of other firmschanges of other firms

PROBLEM: counter-cyclical real wages PROBLEM: counter-cyclical real wages predictedpredicted

Nominal Price RigidityNominal Price Rigidity PAYM insightPAYM insight

Parkin, Akerlof, Yellen and MankiwParkin, Akerlof, Yellen and Mankiw ““In price-maker markets, small costs to In price-maker markets, small costs to

price adjustment can generate aggregate price adjustment can generate aggregate nominal price rigidity.”nominal price rigidity.”

Akerlof and Yellen, “A Near-Rational Model of the Akerlof and Yellen, “A Near-Rational Model of the Business Cycle, with Wage and Price Inertia,” (1985)Business Cycle, with Wage and Price Inertia,” (1985)

Mankiw, “Small Menu Costs and Large Business Mankiw, “Small Menu Costs and Large Business Cycles: A Macroeconomic Model of Monopoly,” Cycles: A Macroeconomic Model of Monopoly,” (1985)(1985)

Parkin, “The Output-Inflation Tradeoff When Prices Parkin, “The Output-Inflation Tradeoff When Prices Are Costly to Change,” (1986)Are Costly to Change,” (1986)

Nominal Price RigidityNominal Price Rigidity Menu Costs IdeaMenu Costs Idea

Physical costs of resetting prices and Physical costs of resetting prices and management expense in supervising management expense in supervising and renegotiatiing purchase and sales and renegotiatiing purchase and sales contractscontracts

Profit-maximizing firms and Menu costsProfit-maximizing firms and Menu costs When D falls, should price-maker cut When D falls, should price-maker cut

price or not?price or not?

Nominal Price RigidityNominal Price Rigidity Macro Consequences of AnswerMacro Consequences of Answer

w/out Menu costsw/out Menu costs Profit-maximization results in all firms Profit-maximization results in all firms

reducing prices and therefore costs of inputs reducing prices and therefore costs of inputs fall. MC decline, leading to further P declines fall. MC decline, leading to further P declines and real money balances increase. Real and real money balances increase. Real interest rate falls, AD increases, and full interest rate falls, AD increases, and full employment is re-established.employment is re-established.

With Menu costsWith Menu costs Costs of inputs don’t decline and economy Costs of inputs don’t decline and economy

remains stuck in underemployment remains stuck in underemployment equilibriumequilibrium

Nominal Price RigidityNominal Price Rigidity Micro rationale for long-term price Micro rationale for long-term price

agreements (set menu prices)agreements (set menu prices) Economize on firm’s resourcesEconomize on firm’s resources Reduce uncertainty of potential transactorsReduce uncertainty of potential transactors

PROBLEMS:PROBLEMS: Ignores costs of output adjustment; Fails to Ignores costs of output adjustment; Fails to

explain why some prices are more explain why some prices are more flexible;To get large aggregate effects flexible;To get large aggregate effects requires implausible values for demand requires implausible values for demand elasticity and marginal cost elasticityelasticity and marginal cost elasticity

Nominal Rigidity and Nominal Rigidity and AD/ASAD/AS

Y=Y

LRAS

SRAS

DLe

DL

SL

AD0AD1

W

L0

L

Y

Y

Y

Y

P

W0

LL1

Real Price RigidityReal Price Rigidity

Implicit oligopolistic collusionImplicit oligopolistic collusion ““Thick market” externalitiesThick market” externalities ““Customer” marketsCustomer” markets Asymmetric information in capital Asymmetric information in capital

marketsmarkets Price-Quality JudgmentsPrice-Quality Judgments Imperfect Information and Input-Imperfect Information and Input-

Output ComplexityOutput Complexity

Real Wage RigidityReal Wage Rigidity

Implicit Labor ContractsImplicit Labor Contracts ““Efficiency Wages”Efficiency Wages”

Adverse SelectionAdverse Selection Labor TurnoverLabor Turnover ShirkingShirking FairnessFairness

““Insider-Outsider” TheoryInsider-Outsider” Theory

NK Business Cycle NK Business Cycle TheoryTheory

Demand and Supply shocks combine Demand and Supply shocks combine with frictions and imperfections with frictions and imperfections within economy to produce non-within economy to produce non-neutralities that amplify shocks neutralities that amplify shocks resulting in large output and resulting in large output and employment fluctuationsemployment fluctuations

Predominant approach focuses on Predominant approach focuses on rigiditiesrigidities

Hysteresis and Hysteresis and UnemploymentUnemployment

Hysteresis: path-dependencyHysteresis: path-dependency Idea that the natural-rate of unemployment at any given point in time depends upon the path of Idea that the natural-rate of unemployment at any given point in time depends upon the path of

past unemployment ratespast unemployment rates If actual unemployment rate exceeds the natural rate, the natural rate rises (and vice versa)If actual unemployment rate exceeds the natural rate, the natural rate rises (and vice versa) Why?Why? Duration Theories (Structural) and Insider-Outsider Theories (Wage Rigidity) Duration Theories (Structural) and Insider-Outsider Theories (Wage Rigidity)

Policy Implication: the sacrifice-ratio is much larger than suggested by original Phillips Policy Implication: the sacrifice-ratio is much larger than suggested by original Phillips Curve literatureCurve literature

NK and Stylized FactsNK and Stylized Facts

(1)(1) Consistent with pro-cyclical L, C, I, Consistent with pro-cyclical L, C, I, G, and Y/LG, and Y/L

(2)(2) Non-neutrality of money consistent Non-neutrality of money consistent with leading pro-cyclical moneywith leading pro-cyclical money

(3)(3) NK predicts inflation pro-cyclical and NK predicts inflation pro-cyclical and lagginglagging

(4)(4) With sticky nominal prices, real With sticky nominal prices, real wage can be pro-cyclical or acyclicalwage can be pro-cyclical or acyclical

Policy ImplicationsPolicy Implications

Sticky prices and monetary non-Sticky prices and monetary non-neutrality re-establishes policy neutrality re-establishes policy effectivenesseffectiveness

Eclectic Nature of New Keynesian Eclectic Nature of New Keynesian Policy PrescriptionsPolicy Prescriptions

Criticisms of New Criticisms of New KeynesianismKeynesianism

Lack of empirical supportLack of empirical support Numerous theoriesNumerous theories Doubt on importance of menu costsDoubt on importance of menu costs Denial that efforts accurately portray Denial that efforts accurately portray

KeynesKeynes Acceptance of rational expectationsAcceptance of rational expectations Continued reliance in IS-LM to Continued reliance in IS-LM to

understand ADunderstand AD

Distinguishing BeliefsDistinguishing Beliefs

1.1. Economy subject to irregular and Economy subject to irregular and unpredictable shocks from both unpredictable shocks from both demand and supply, and economy demand and supply, and economy slow to adjust due to nominal price slow to adjust due to nominal price and wage rigidityand wage rigidity

2.2. Equilibrium consistent with involuntary Equilibrium consistent with involuntary unemployment is due to real price and unemployment is due to real price and wage rigidity that itself is result of wage rigidity that itself is result of rational maximizing behaviorrational maximizing behavior

Distinguishing BeliefsDistinguishing Beliefs3.3. Short-run tradeoff exists between Short-run tradeoff exists between

unemployment and inflation due to unemployment and inflation due to the non-neutrality of money in a world the non-neutrality of money in a world of price and wage rigidityof price and wage rigidity

4.4. In principle, activist Monetary and In principle, activist Monetary and Fiscal policy can return economy to Fiscal policy can return economy to full-employment output, but policy full-employment output, but policy should be aimed at offsetting major should be aimed at offsetting major rather than minor problemsrather than minor problems

““Coarse-tuning” rather than “fine-tuning”Coarse-tuning” rather than “fine-tuning”

Documents

The New Keynesians