The New Keynesian Synthesis
By David Romer
Presented by:
Matt Sheahan, Matt Rudquist,
Dan Becker
Background
• Departure from Keynesian macroeconomics
– Widespread involuntary unemployment
– Aggregate demand was a central source of shortrun aggregate economic activity
• Neoclassical Synthesis
– Blamed sluggish nominal wage
– Classical dichotomy failed
– Remainder was Walrasian
Background
• Split into two schools of thought
• Real Business Cycle Theory
– Deny involuntary unemployment and failure of
classical dichotomy
• New Keynesian Macroeconomics
– Aimed to correctly define the microeconomy to better
understand the macroeconomy
– Looked for small departures from prevailing beliefs
that had large effects
Nominal Frictions
• Barriers to full price flexibility
• It is costly to inform customers about nominal
price changes because they are usually left
unchanged
• Firms choose to leave prices unchanged
What are the Frictions?
•
•
•
•
Expressing price nominally
Firms choose nominally ridged pricing policies
Menu Costs
Price-setters deciding to change price
Frictions / Inflation
• High Inflation
– Prices adjusted often
– Optimal price-setters
– Consumers put less importance on nominal prices
• Low Inflation
– Adjust Slower
• Nominal Shocks are smaller with high inflation
Real Rigidities
• Issue: can small frictions cause nominal
disturbances to have large effects on the
aggregate economy?
• If incentive is small, firms may not adjust
prices to reduction in output
• If incentive is high, all firms will adjust prices
due to reduction in output
Real Rigidities
• Function of 2 factors: impact of profit
maximizing real price and cost to firm of
departure from it real maximizing price
• Real rigidity is low when incentive to change
price is high, and high when incentive to
change price is high
Sources of Real Rigidity
1. Thick Market Externalities
2. Capital Market Imperfections form Imperfect
Information
3. Cyclical Behavior of Demand Elasticity in
Goods Market
4. No Evidence of Real Wages being Procyclical
Welfare (New Keynesian Model)
• There is asymmetry between demand driven
booms and recessions.
• Economy is operating below social optimum
as MC is below price.
• Therefore, an increase in output increases
welfare and a decrease in output decreases
welfare.
Welfare (New Keynesian Model)
• A firms decision to raise price above the normal
price level impacts aggregate price and aggregate
demand.
• If all firms cut Prices to respond to the decreased
aggregate demand output does not fall.
• However firms incentive to reduce price is often
low.
• A fall in aggregate demand could lead to a
recession if prices remain unchanged.
Welfare (New Keynesian Model)
• Other similar inefficiencies can also to a
recession. Example- efficiency wages
• Firms can also create externalities that impact
the volatility of output. Example- holding
prices stable during demand shifts.
Coordination Failure
• Coordination Failure occurs when firms fail to
coordinate decision making and must,
therefore, settle for a less efficient equilibrium
• Example- Real rigidity might be so strong that
a negative demand shock could cause a firm
to raise its price and cut output even more.
Coordination Failure
If government wishes
to intervene to
prevent coordination
failure they must aim
to push output to a
point above A.
Directions of Research
• Frictions themselves
– Pricing policies of firms
– Timing of change in prices (fixed time rather than
change in aggregate demand)
– Barriers to price adjustment
• Real Rigidities
– existence of factors that affect employment hours and
changes in real wages, not only prices
• Examine the macroeconomic evidence
concerning the effects of monetary and other
aggregate demand disturbances.
Questions?