A New Keynesian Perspective on the Great Recession

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A NEW KEYNESIAN
PERSPECTIVE ON
THE GREAT
RECESSION
WRITTEN BY: PETER IRELAND
IN THE JOURNAL OF MONEY, CREDIT
AND BANKING,VOL. 43
Tyler Halberg, Dylan Adler, and Kevin
Reitz
THESIS
In terms of its macroeconomics, does the Great
Recession of 2007-2009 really stand apart from its
two immediate predecessors: the milder recessions
of 1990-1991 and 2001?
BACKGROUND
 Recession of 2007-2009
 New Keynesian Model
 Focus on post-1983 period
 Compare the Great Recession of 2007-2009 to:
 Milder Recessions of 1990-91 and 2001
 Monetary Policy Failed
 2007-09 recession had a combination of aggregate demand and supply
disturbances
 Difference
 Shocks lasted longer and more severe
MODEL
 Small-scale model that focuses on three main equations:
 The New Keynesian IS Curve

Behavior of a representative household
 The New Keynesian Phillips Curve

Optimizing Behavior of monopolistically competitive firms that face explicit costs of nominal price
adjustment
 Monetary Policy Rule

How the central bank adjusts the short-term nominal interest rate in response to movements in
output and inflation
 Empirical Analysis
 Output
 Inflation
 Short-term nominal interest rate
MODEL (REPRESENTATIVE HOUSEHOLD)
 Expected Utility Function
 𝐸0
∞
𝑡
𝑡=0 𝛽
𝑎𝑡 𝑙𝑛 𝐶𝑡 − 𝛾𝐶𝑡−1 + 𝑙𝑛 𝑀𝑡 𝑃𝑡 − ℎ𝑡
 Monetary policy affects:
 Money Supply
 Consumption
 Household’s Utility
MODEL (REPRESENTATIVE GOODSPRODUCING FIRM)
 Maximize Profits
 𝑃𝑡
1
𝑌
0 𝑡
𝑖
𝜃𝜃𝑡 −1 𝜃𝑡
 Firm’s Real Profits
𝑑𝑖
𝜃𝑡 𝜃𝑡 −1
−
1
𝑃
0 𝑡
𝑖 𝑌𝑡 𝑖 𝑑𝑖
MODEL (CENTRAL BANK)
 Variant of the Taylor Rule
 Output Growth or Inflation rise or fall below average
FIRST ORDER CONDITIONS
FIRST ORDER CONDITIONS
RESULTS
 All three recessions were the result of adverse preference and
technology shocks
 Lower bound zero interest rate
 Government had to implement a highly restrictive monetary policy
 The monetary policy prolonged and intensified the recession
CONCLUSION
 In terms of its macroeconomics, does the Great Recession
of 2007-2009 really stand apart from its two immediate
predecessors: the milder recessions of 1990-1991 and
2001?
 All three recessions were caused by a combination of aggregate demand
and supply disturbances
 The Great Recession had adverse shocks that lased much longer and were
much more severe
 Zero lower bound on short-term interest rate
 Need more complete and detailed assessment of monetary policymaking
strategy
THREE THINGS TO TAKE AWAY…
 Technology and preference shocks were the main causes of each
recession
 The zero lower bound nominal interest rates forced the Fed to
implement a strict monetary policy through the Taylor rule, which
prolonged and intensified the recession of 2007-2009
 Monetary policy is limited when helping the economy respond
efficiently to supply-side shocks
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