In-Depth Notes on Shocks in the New Keynesian Model

Shocks in the New Keynesian Model

Overview of the Course

  • Course Structure:
    • Review of concepts
    • Neoclassical Model
    • Money, Inflation, Interest Rates
    • Midterm Exam

The New Keynesian Model

  • Topics Covered:
    • Previous Classes: IS-LM-AD Framework (Ch. 24), Supply Side Investigations (Ch. 25)
    • Current Class Focus: Shocks in the New Keynesian Model (Ch. 26)
    • Future Classes: Dynamics from Short Run to Medium Run (Ch. 27), Monetary Policy (Ch. 28), Recent Events, Financial Factors, Unemployment

Shocks in the New Keynesian Model: Approach

  • Foundation:
    • Micro-founded Neoclassical Model
    • Household and firm behavior is consistent with Neoclassical Model
  • Price Flexibility:
    • Assumes sticky prices in short run
    • This leads to different equilibrium reactions to shocks

Demand and Supply Framework

  • Demand Side Equations:
    • Consumption: C_d(Y - G, Y' - G', r)
    • Investment: I_d(r, A', K)
  • Nominal Aspects:
    • Similar to Neoclassical Model: M = PMd(r + πe, Y)
    • Where: r = i - π_e (nominal interest rate)
  • Supply Side Characteristics:
    • Prices can be fully or partially sticky
    • Market serves demand with flat or upward-sloping AS curve (not vertical)
    • Leads to greater effects from demand shocks

Simple Sticky Price Model

  • Key Differences from Neoclassical Model:
    • AS curve is horizontal - meaning output is determined by demand
    • Wages are influenced solely by labor supply
Impact of Various Shocks

  1. Increase in Money Supply (M ↑):

    • Leads to increase in AD with constant P (AS horizontal)
    • Outcome: Y ↑, r decreases, N and wages increase, leading to higher C and I due to lower r
    • Non- neutrality of money in this model

  2. Increase in Government Spending (G ↑):

    • Y ↑, P constant, leading to an increase in employment and wages, but a decrease in C and I due to higher r
    • Positive government spending multiplier, counter to Neoclassical expectations

  3. Increase in Productivity (A ↑):

    • Fixed P, with a demand-determined Y means AS does not shift; output remains constant while employment and wages decrease

  4. Increase in Price Level (P̅ ↑):

    • Shifts AS upwards, leading to lower Y and higher r, which decreases N and wages

Partial Sticky Price Model

  • Model Characteristics:
    • Upward-sloping AS curve
    • Flexible price output (AS_f) determined through labor market clearing
    • Output remains demand determined
Effects of Shocks in the Partial Sticky Price Model

  1. Increase in Money Supply (M ↑):

    • Increase in AD results in Y rising and prices mildly increasing
    • Y increases less than under fixed P conditions, leading to partially back shift of LM curve

  2. Increase in Government Spending (G ↑):

    • Similar effects as in Simple Sticky Price Model, but with less Y increase and a slight rise in price leading to adjustments of C and I

  3. Increase in Productivity (A ↑):

    • Y increases while prices decrease; unclear effect on employment due to lower Y increase than anticipated

  4. Cost-Push Shock (P̅ ↑):

    • Y decreases while prices increase, leading to decreased C, I, and employment

Summary of Results

  • Monetary Non-neutrality:
    • Short run implications include the non-neutral characteristics of money in the New Keynesian context
  • Comparison with Neoclassical Model:
    • New Keynesian model exhibits a stronger reaction to demand shocks and a weaker response to real supply shocks compared to its Neoclassical counterpart
  • Key Takeaways:
    • Notable differences in how changes in monetary policy or external shocks impact outcomes in the economy across models.