New Keynesian TheoryNew Classical View of Keynesian EconomicsNew Keynesian Response (1)New Keynesian Response (2)New Keynesian EconomicsNew Keynesian Models (1)New Keynesian Models (2)New Keynesian Models (3)New Keynesian Models (4)New Keynesian Response (5)New Keynesian Response (6)The NameFounding Researchers“What is New Keynesian Economics”, Gordon (1990)Basic Principles (1)Basic Principles (2)Demand-side contributionsWhat are Keynesians?Greenwald and Stiglitz, JEP 1993Two Strands of NK ResearchTwo Strands (Continued)Three Ingredients to the Flex-price ApproachRisk-aversivenessRisk-aversiveness (2)How does risk-aversiveness affect the firm?Risk-averse firmsAnother exampleNew Keynesian TheoryNew Keynesian TheoryGraduate Macroeconomics IECON 309 – Cunningham2New Classical View New Classical View of Keynesian Economicsof Keynesian Economicsz “Failure on a grand scale.”z Made up of ad hoc assumptions, not built on a strong foundation of rational agents.z Must assume rational, optimizing agents.z Must assume that markets clear.z Keynesians do not explicitly handle expectations, and expectations have been shown to be critically important.z Have not given explicit structural explanations of wage stickiness.z How can you explain persistence in business cycles?3New Keynesian Response (1)New Keynesian Response (1)z Persistence:– There have been and are persistent and substantial deviations from full employment. There is nothing to the persistence question.• Unemployment in Great Britain was greater than or equal to 10% from 1923-1939.• U.S. Great Depression, unemployment was greater than or equal to 14% for 10 years.4New Keynesian Response (2)New Keynesian Response (2)z Extreme Informational Assumptions– NK’s accept that adaptive expectations are ad hoc and unrealistic– Unconstrained REH implies unrealistically sophisticated agents– Bounded rationality– Structural impediments5New Keynesian EconomicsNew Keynesian Economicsz Attempts to build Keynesian arguments based upon rational expectations and microeconomic foundations.z Examples:– Contracting models– Sticky price models based upon transactions cost or menu costs– Efficiency wage models6New Keynesian Models (1)New Keynesian Models (1)z Sticky Prices – Menu costs and other transactions costs: • It costs to change prices.– A firm might hold prices constant even if demand fell if the firm faced a cost to the price change.• Costs: loss of customer good will• Potential price war• Menu costs7New Keynesian Models (2)New Keynesian Models (2)z Efficiency Wage Models– Firms wish to buy worker effort, not their “attendance”.– Instead of Y = F(K,N), the firm really operates according to Y = F(K,eN), where N is the number of workers or worker-hours, and e is the effort per worker.– The firm does not seek to minimize the cost of labor, but rather seeks to minimize the cost per efficiency unit.8New Keynesian Models (3)New Keynesian Models (3)z Efficiency Wages, continued– By paying the worker more than the equilibrium wage for labor, the firm may reduce the cost per efficiency unit by reducing the costs associated with:• Paying supervisors (monitoring costs)• Hiring replacement workers when the current workers leave (turnover costs)• Poor worker morale.– This leads to:• Shirking models,• Turnover cost models, and• Gift exchange models.9New Keynesian Models (4)New Keynesian Models (4)z Efficiency wage models identify a market failure:$eNsNsNdNs >NdN, eN10New Keynesian Response (5)New Keynesian Response (5)z Sticky Prices – Menu costs and other transactions costs– A firm might hold prices constant even if demand fell if the firm faced a cost to the price change.• Costs: loss of customer good will• Potential price war• Menu costs11New Keynesian Response (6)New Keynesian Response (6)z Insider-Outsider Models and Hysteresis– Hysteresis: present unemployment is highly related to past unemployment.– Past unemployment causes current unemployment by turning insiders into outsiders.– Outsiders cannot exert downward force on real wages.12The NameThe Namez The name “New Keynesian Theory” was introduced by Michael Parkin (1982).z One of the earliest uses of the term “new-Keynesian Economics” was in an article by Ball, Mankiw, and Romer (1988).z “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.13Founding ResearchersFounding Researchers“What is New Keynesian Economics”, Gordon (1990)“What is New Keynesian Economics”, Gordon (1990)z The foundations of New Keynesian Economics are usually attributed to Stanley Fischer, Edmund Phelps, and John Taylor. z The focus has been on demonstrating the microfoundations of price and wage stickiness.14Basic Principles (1)Basic Principles (1)z According to Gordon, sticky prices implies that real GDP is a residual, and is not determined by agents in the economy.z If this is the case, then firms optimize by setting prices, and accept quantities (production levels) as given. z In the neoclassical and new classical theories, the firms are price takers and optimize by setting quantities (production levels).15Basic Principles (2)Basic Principles (2)z Price and wage stickiness emerges from microeconomics:– Technology of transactions– Heterogeneity of goods and factor inputs– Imperfect competition– Imperfect information– Imperfect capital marketsz These core elements remove any incentive for individual agents to focus on nominal demand in price-setting.z New Keynesian Economics is about macroeconomic externalities of individual decisions and coordination failures inherent in free market economies.z Note that Gordon omits any topics that are not at the heart of the debate between the New Keynesian and New Classical economists.16DemandDemand--side contributionsside contributionsz Credit rationing as a source of fluctuations in commodity demand and as a channel for monetary policy. (Blanchard and Fischer, 1989)z Feedback from price stickiness to aggregate nominal demand. (Taylor, Summers)z How the monetary system interferes with the coordination of intertemporal choices.17What are Keynesians?What are Keynesians?Greenwald and Greenwald and StiglitzStiglitz, JEP 1993, JEP 1993z The authors claim that Keynesians, new and old, can be identified viz a viz members