New Keynesian Economics
Reading: Romer Ch 6
Recap:
- Aggregate supply behaves very differently in the short run than in the
long run
- Economists disagree about how best to explain AS in the SR
- A common conclusion is that the SRAS curve is upward sloping due
to frictions of macroeconomics
All three models imply
Theories of SRAS
- Traditional Keynes: advocated sticky wages
- Phillips curve: prices and wages slowly adjusted to excess demand
- Friedman-Phelps critique and the expectations augmented Phillips
curve
- Lucas supply function: only unanticipated changes in money matter
(monetary policy ineffectiveness)
New Keynesian Economics
- Keynesians found the assumption of perfect market clearing in
Lucas’s model unreasonable.
- New Keynesians accept IS-LM model as the theory of AD and try
to develop more fully the Keynesian approach to AS which
preserves the desirable analytical features of Lucas’s model (RE)
but incorporated wage or price stickiness
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- Provides the microeconomics behind SR price adjustment with
rational expectations while maintaining the Keynesian policy result
- What precisely are the market imperfections that make wages and
price sticky? (This stickiness makes the SRAS upward sloping)
Two main ways in which nominal rigidities are modeled:
o Menu costs
o Staggering wages and prices
Market structure and price adjustment in New Keynesian models:
- Sluggish price adjustment cannot occur in a world of perfect
information.
- The market structure that is usually chosen in New Keynesian
models is a simple version of monopolistic competition.
Compared to the Lucas model:
- There is now a competitive labor market, rather than each
household producing output using its own labor.
- There is now also no product specific demand shock.
In the Lucas model this shock was needed to generate confusion in the mind
of agents between aggregate and relative price changes. The imperfect
information model does not rely on confusing price signals so it does not
need a product-specific demand shock.
- In the Lucas model, each producer was a monopolist as each island
produced different goods that were not substitutes. In monopolistic
competition, each agent is the sole producer of her particular good
which is an imperfect substitute for the products of others.
Some terminology:
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Nominal rigidity
Real rigidity
Modeling rigidities in the New Keynesian framework
(1) Staggered Prices/Wages
- All wages and prices do not adjust at the same time (nonsynchronized)
- Staggering makes the overall level of wages and prices adjust
gradually, even when individual wages and prices changes frequently.
General idea1:
Suppose there are two main sectors in the economy, A and B. Suppose that
workers in sector A set their wage at the beginning of period t (for example
by bargaining with firms in that sector) and this wage lasts for two periods,
period t and period t+1. This means that once the wage is set it remains fixed
in period t and t+1.
Now consider sector B and suppose that workers in that sector set their wage
at the beginning of period t+1 (one period after sector A) and again that
wage remains fixed for two periods (t+1 and t+2).
Suppose that the government decides to increase the level of money supply
at the end of period t. What is the implication of this non-synchronization?
Suppose that the monetary policy is known, meaning that it is announced to
the public and so the public expects higher prices after that policy. In this
case, the workers in sector A cannot change their wage since it is fixed for
two periods (t and t+1).
Reading: Ball, Mankiw and Romer (1988), “The New Keynesian Economics and the
Output Inflation Trade-off”, Brookings Papers on Economic Activity.
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Workers in sector B can change their wage at the beginning of period t+1.
This means that in sector A, even if the policy is known and there are
rational expectations, nominal wages cannot change. In sector B workers can
change their nominal wage in order to keep the same real wage after the
policy and not lose purchasing power.
The same idea applies to the case where there are staggered prices. The
idea is exactly the same, the only difference is that now firms in different
sectors set their prices at different periods and their prices must be constant
for some periods.
Suppose first that every firm adjusts its price on the first of each month and
the new price lasts one month, so that price setting is synchronized.
If the money supply falls on June 10, output is reduced from June 10 to July
1, because nominal prices are fixed during this period. But on July 1 all
prices adjust in proportion to the fall in money, and the recession ends.
Now suppose that half of all firms set prices on the first of each month and
half on the fifteenth. If the money supply falls on June 10, then on June 15
half the firms have an opportunity to adjust their prices. But in this case they
may choose to make little adjustment. Because half of all nominal prices
remain fixed, adjustment of the other prices implies changes in relative
prices, which firms may not want. (In contrast, if all prices change
simultaneously, full nominal adjustment does not affect relative prices).
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If the June 15 price setters make little adjustment, then the other firms make
little adjustment when their turn comes on July 1
And so on. The price level declines slowly as the result of small decreases
every first and fifteenth, and the real effects of the fall in money die out
slowly.
Main critique:
The main critique at this kind of models is that the nominal rigidities are
imposed exogenously to the model. We have assumed that prices/wages are
staggered and once they are set they last for some periods. Even if this may
be a realistic assumption it does not come from the optimal behaviour of
firms and workers.
Why it is optimal for workers to keep their wage fixed for some periods and
why they should set wages in a non-synchronised way?
One possible explanation on why it may be optimal for firms to keep
constant their prices is because there may be costs in changing prices 
menu costs.
(2) Menu costs:
- Menu costs are FIXED costs of changing prices
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- Menu costs are small (small - especially compared to the cost of
operating a firm) so New Keynesians have explored “amplification
mechanisms” that can cause small nominal rigidities at the micro
level to lead to large aggregate price stickiness and significant nonneutralities.
General idea:
- Firms set prices according to MR = MC in a monopolistic competition
environment to maximize profits.
- After prices are set, aggregate demand is determined, and each firm
can change its price by paying a menu cost.
- Suppose there is a decline in the money supply that reduces aggregate
demand. Each firm will see this as a decline in its demand curve.
- Since the economy is large, each firm takes other firm’s actions as
given.
- However, the magnitude of the decline in any firm’s demand curve
depends on what its rival firms do. If its rivals lower their prices, this
will cause the overall price level to fall (slightly) which raises real
money balances and increases aggregate demand, benefiting other
firms.
- If rival firms hold prices fixed, the firm will not change its price given
that
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o The firms produce at point A, where MR = MC
o A fall in aggregate demand with other prices unchanged
reduces aggregate output and shifts the demand curve to the left
to D’. MR shifts in accordingly.
o If firms do not change prices, it produces at B, where MR >
MC, so the firms have some incentive to lower price and raise
output
o If firms change prices, it produces at C, so the area in the
triangle is the additional profits that can be gained from
reducing price and increasing quantity.
- Therefore, in the presence of menu cost, firms may not change prices
given that rivals do not adjust
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Why small menu costs can have a big impact in the economy? The
Aggregate Demand Externality
The macroeconomic effects of nominal rigidity differ from the private costs
because rigidity has an aggregate demand externality.
- Suppose that there is a decrease in the demand faced by firm i, and
due to menu costs, the firm does not adjust prices (i.e. it does not
decrease).
- The price of firm i is part of the aggregate price level P and therefore
contributes to the rigidity of P.
- If all firms are similar, all firms will not change prices when aggregate
demand changes and we have stickiness at the aggregate level.
- This is what we call aggregate demand externality. There is
externality because adjustment of all prices would prevent a fall in
real aggregate demand but each firm is a small part of the economy
and thus ignores this macroeconomic benefit.
With aggregate demand externality, small menu costs can have a big impact
on the overall economy.
Main critique to Menu costs
- Menu costs are normally small costs. If the change in aggregate
demand is particularly large, then it may be possible that the loss in
profits by not adjusting prices can be larger than the menu cost. In this
case it is optimal for firms to pay the menu cost and to adjust prices
and so this change in aggregate demand will simply affect prices and
not real production.
- Given plausible parameter values (eg. relatively inelastic labor
supply), no plausible cost of price adjustment can prevent firms from
changing prices.
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The role of real rigidities
- Nominal rigidities such as menu costs are not sufficient to explain
price rigidity in response to sizable aggregate demand shocks if there
are no other rigidities in the system.
- Consider a recession where aggregate demand declines, pushing the
demand curve of each firm downward. The profit function of the firm
shifts down.
- In this case, firms will either
Distance AB is the firm’s incentive to pay the menu cost, which depends on:
1) How the profit maximizing price depends on aggregate output
If other firms do not change prices, a change in the firm’s nominal price is a
change in real price as well. CD is therefore determined how the profit
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maximizing real price depends on aggregate output. If less responsive, then
the incentive to adjust prices are smaller and there is greater real rigidity.
2) Curvature of the profit function
If profits are less sensitive to departures from the optimum,
Coordination Failure
Following an aggregate demand shock:
Option 1: If the firm chooses to cut prices, all firms will (since they are
identical) and we have neutrality
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Option 2: Firms choose to keep prices fixed. Prices remain high and
recession continue (inferior outcome)
If there are real rigidities, this option could be less costly. If firms are close
substitutes, each firm wants its price to stay close to its competitors. This
makes option 1 unattractive if other firms are not expected to change prices.
Given that real price rigidities are sufficiently important, who is going to be
the first to change prices? Without an effective coordination mechanism, no
individual firm or worker would be willing to cut his price without knowing
that others will cut their prices
- Note: We have here a case of multiple alternative equilbria. There is a
close connection between multiple equilibria and real rigidity.
- There is both an “adjustment equilibrium” and a “non-adjustment
equilibrium”.
- Either is an equilibrium: if everyone adjusts then there is no incentive
for any individual to change her decision but if everyone does not
adjust there is also no incentive for the individual to change.
- The adjustment equilibrium may have higher profit and general
welfare than the non-adjustment equilibrium, but without any
coordination mechanism there may not be signals and incentives to
move the economy from the inefficient one to the efficient one. This
is the coordination failure.
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- Fundamental outcomes do not determine outcomes in multiple
equilbria. It is rather animal spirits, sunspots self-fulfilling prophecies
that affect aggregate outcomes. If the economy expects to be at A it
will end up there, if they expect it to be at C, it will end up there.
- Strategic complementaries lie at the heart of the possibility of multiple
equilbria. They occur when one person taking an action makes that
action more attractive for others. The application to price rigidity is
A far less important case for our purposes is strategic substitutability, which
occurs when one person acting makes it less desirable for others to act in the
same way. For example, if someone else closes the window, you do not have
to do so.
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