Econ 502 Intro to New Keynesian School Week

<Econ 502> Intro. to New Keynesian School Week #12 Snowdon&Vane (2002, 2005) [SV] SV Blanchard (2017) [B] 2017 (Comp. by M. İ. )

NCs NC Vs NK The new Keynesian economics developed in response to the new classical macroeconomics Like the new Classicals (NCs), new Keynesians (NKs) build macroeconomics on -explicit microfoundations governing individual wage, price and expectation formation -they also typically share the NC view that these microfoundations should be based on an assumption of individual optimizing behaviour -expectation formation is generally rational! Despite these similarities, the NKs NK produce an analysis of the macroeconomy that revives Keynesian insights and so lends support to forms of government activism.

Recall the 'policy ineffectiveness proposition' When rational expectations were introduced, (early) Keynesian models could not explain long-lasting deviations of output from the natural (potential) level of output …

HOWEVER, NKs recognize some information problems which the NCs do not… Where the NCs assume that agents are price takers [in Perfectly Competitive Markets] and that prices move to clear markets, the NKs typically have agents that set prices and markets that fail to clear

Efficiency wage argument When a firm lacks information over the effort expended by its workers, it may set a wage above the market-clearing value even though the labour market is in other respects perfectly competitive. This is because a firm may respond to this lack of information by attempting to raise its wage relative to others in order to create a cost to shirking when there is at least some chance of a shirker being caught ex post and fired. But as each firm boosts its wage, the general wage is bid up above the market-clearing value and, when this happens sufficiently, the pressure to increase wage subsides because the prospect of involuntary unemployment, once fired, now supplies the incentive against shirking. This is one version of the efficiency wage argument

NKs switch to imperfectly competitive microfoundations There are many possible sources of this switch to imperfectly competitive microfoundations …

The switch to imperfect competition at the microfoundations is extremely important for at least two reasons. First, it alters the incentive of any firm to change price when there is an aggregate demand shock with the result that the adjustment of the general level of prices to the shock can be complex and slow, rather than instantaneous. Consider a deflationary monetary shock which requires an equiproportionate change in all prices to restore equilibrium at the initial real values. Each firm's demand curve shrinks, but what happens next? When the firm is a price taker and the individual firm demand curve is infinitely elastic at the market price, the question is easily answered: no firm can afford to do other than change price in line with the falling market price because it would lose all its customers. In comparison, when a firm faces a contracting but downwardsloping demand curve, the same cannot be said: the failure to lower price would not lead to a loss of all customers. Since there always some costs associated with changing prices (for example, menu costs), it therefore cannot be assumed that the gains from immediate price adjustment will necessarily outweigh

MENU COST (PAYM)

MENU COST (z)

In short, unlike the situation under perfect competition, prices will not adjust immediately to their new equilibrium values under conditions of imperfect competition. The adjustment process of prices may be long-drawn-out and in the meantime quantities will shoulder some of the burden with falling output and rising unemployment. In these circumstances, it is natural to wonder whether a judicious manipulation of aggregate demand in the first place to compensate for the shock might not be the better solution…

Other ideas… Staggering of wage and price decisions The fact that different wages are adjusted at different times, making it impossible to achieve a synchronized decrease in nominal wage inflation. The early Keynesian attempts to fortify their theoretical structure concentrated on nominal wage rigidities and the models developed by Fischer (1977) and Taylor (1980) introduced nominal inertia in the form of long-term wage contracts In developed economies wages are not determined in spot markets but tend to be set for an agreed period in the form of an explicit (or implicit) contract. The existence of these long-term contracts can generate sufficient nominal wage rigidity for monetary policy to regain its effectiveness. Following the contributions of Fischer (1977), Phelps and Taylor (1977), it was clear that the new classical conclusion that government demand management policy was ineffective did not depend on the assumption of rational expectations but rather on the assumption of instantaneous market clearing

To SUM Up! B (2017) The term new Keynesians denotes a loosely connected (heterogenous) heterogenous group of researchers who shared a common belief that the synthesis that emerged in response to the rational expectations critique was basically correct. But they also shared the belief that much remained to be learned about the nature of imperfections in different markets and about the implications of those imperfections for macroeconomic fluctuations. BROADLY SPEAKING; NK school represents a group of economists who believe in -the importance of nominal rigidities* in fluctuations, -and who are exploring the role of market imperfections in explaining fluctuations. WARNING! See SV (2005, Ch. 7) for more detail on the other important aspects (e. g. Theories) of NK School *Nominal rigidities-The slow adjustment of nominal wages and prices to changes in economic activity.

Policy Implications • There is no unified new Keynesian view on the extent of discretionary fiscal and monetary action that a government may take in response to aggregate fluctuations (see Solow and Taylor, 1998). • However, New Keynesians are not enthusiastic supporters of government not enthusiastic attempts to ‘fine-tune’ the macroeconomy. ‘fine-tune’ • Nevertheless, most new Keynesians do see a need for activist government most action of some form because of market failure, especially in the case of a deep recession. For example, Taylor (2000 a) argues that while fiscal policy should normally be used to achieve long-term objectives such as economic growth, there is a strong case for the explicit use of fiscal expansionary policy in ‘unusual situations such as when nominal interest rates hit a lower bound of zero’. • So, they generally favour “constrained” discretion

The New Neoclassical Synthesis The new synthesis 'inherits the spirit of the old in that it combines Keynesian and classical elements'. This can be seen by noting that the key elements in the new synthesis comprise intertemporal optimization, rational expectations, imperfect competition in goods, labour and credit markets, and nominal rigidities and costly price adjustment. In their analysis, Goodfriend and King conclude that the New Neoclassical Synthesis suggests several important conclusions about the role of monetary policy. First, monetary policy has real effects in the short run. Second, there is little by way of a long-run trade-off between inflation and real activity. Third, inflation is costly and it is important to eliminate it. Fourth, the credibility of policy actions has an important impact on monetary policy outcomes. Goodfriend and King argue that these conclusions point the way to a rules-based monetary policy framework with inflation targeting acting as the nominal anchor.