Overhead 3a New Keynesian Macroeconomics

Introduction to New Keynesian Macroeconomics

  • The Keynesian view of business cycles began to lose favor in the early 1980s.

  • Keynesian framework heavily relied on strong assumptions:

    • Fluctuations in output due to fluctuations in aggregate demand.

    • Changes in demand were believed to have real effects due to price- and wage rigidity.

    • Nominal rigidities were taken as given without explanation.

  • A critical question arose: Why assume prices and wages are fixed in the short run when it is in the interests of economic agents to eliminate these rigidities?

  • During the 1970s and early 1980s, many economists shifted focus from Keynesian theories to new classical models which emphasized flexible wages and prices.

  • In previous discussions, it was noted that with rational expectations and fully flexible prices, systematic policy changes would not have real effects.

  • New Keynesian theory emerged as a blend:

    • Maintains rational expectations while introducing nominal rigidities.

    • Rigidities are not assumed but microfounded.

    • As a result, policies (including systematic policies) can have real effects on output, at least in the short term.

Comparison: New Classical vs. New Keynesian Theory

New Keynesian:

  • Rational Expectations: Economic agents form expectations of the future based on all available information.

  • Microfoundations: Economic theories built from the behavior of individual agents.

  • Price Rigidities: Some prices do not adjust quickly to changes in demand or supply.

  • Monopolistic Competition: Market structure where firms have some power to set prices above marginal cost.

New Classical:

  • Rational Expectations: Similar to New Keynesian.

  • Microfoundations: Also similar; based on individual behaviors.

  • Fully Flexible Prices: Prices adjust instantly to clear markets.

  • Perfect Competition: All firms are price takers, no market power.

Price Rigidities in New Keynesian Models

  • Two primary mechanisms for modeling price rigidities:

    1. Staggered Price or Wage Setting:

      • Not all firms or workers set prices at the same time.

      • Example scenarios include laws that limit how often prices can be changed or contracts that stipulate wage negotiations only at certain times (like once a year).

    2. Menu Costs:

      • Costs incurred by firms when changing prices.

      • This can refer to literal costs (like printing new menus) or broader implications (such as risking customer alienation or the effort required for constant reoptimization).

Visual Aids

  • Additional details on staggered pricing and menu costs are presented with projector aids in subsequent pages.