ECON 364 - Topic Eight

New Keynesian Economics

The label New Keynesian describes those economists who, in the eighties, responded to a new classical critique with adjustments to the original Keynesian ideas.

Primary Disagreement:  how quickly wages and prices adjust

    New Classical – markets clear because wages and prices are flexible.

    New Keynesians – market clearing prices cannot explain short run fluctuations.

Sticky Wages and Prices lead to Involuntary Unemployment and we need monetary policy to influence economic activity.

Long tradition (both NK and Monetarists) is that monetary policy affects employment and production in the short run because prices respond sluggishly to changes in the money supply. 

If the money supply falls, people spend less, and the demand for good falls.  Because (input) prices and wages are inflexible and don’t fall immediately, the decreased spending causes a drop in production and layoffs of workers.

Graph:

New Classical criticized this tradition because it lacked a coherent theoretical explanation for the sluggish behavior of prices.

So the New Keynesians set out to explain:

Menu Costs:  changing prices can be costly – printing new catalogs, menus, etc.

 So firms adjust prices intermittently rather than continuously.

 But how big are these costs?  Controversial.

 The idea is that even though menu costs might be small for an individual firm, they could have large effects on the economy as a whole.  In other words, if prices were adjusted, things would be better – if they aren’t adjusted, the benefits don’t come.

Aggregate Demand Externalities:

When a firm lowers its price, that lowers the average price level slightly and thereby raises real income. 

The stimulus from higher income, in turn, raises the demand for the products of all firms.  This is an aggregate demand externality.

 So small menu costs hamper this positive externality.

 If GM failed to pay a menu cost and didn’t cut pieces, wouldn’t get the “socially desirable” result.

The Staggering of Prices:

Not everyone sets prices in the economy at the same time.  This also slows the changing of prices.

Example:  if everyone adjusted their prices on the first of every month.  If there is an increase in the MS and aggregate demand on May 10 – then prices remain constant until then.  When the prices are raised, the boom is over.

Now suppose that half set prices on the first and half on the 15^th.  But they know they will lose customers to those who don’t change prices, so they don’t change them very much.

 When the first comes, these guys don’t change much either.

 All are avoiding relative price changes.

This staggering makes the price level sluggish.

But why do we assume that some people in an industry must change prices on May 1 and some on May 15?  It’s more like, the first to raise prices does so slightly, this leads others to slightly, etc.

Coordination Failure:

Some new Keynesian economists suggest that recessions result from a failure of coordination.

Coordination problems arise in the setting of wages and prices because those who set them must anticipate the actions of other wage and price setters.  Via Nash.

 Firms watch other firms.  Unions watch other unions.

Example:  the economy is made up of two firms.  After a fall in the money supply, each form must decide whether to cut its price.  Each firm wants to maximize its profit, but its profit depends not only on its pricing decision but also on the decision made by the other firm.

 If neither cuts price, real income remains low, AD low, a recession comes, and each firm makes $15 in profit.

 If both cut process, real income increases, AD remains high, a recession is avoided, and each firm makes $30 in profit.

So what will happen?

If both expect the other to cut prices, both will.

If both expect the other not to cut prices, both won’t. 

Either of these outcomes is possible.

The first is called a coordination failure.  The firms fail to coordinate price cuts.

 If they coordinate, they would both cut prices and the economy would remain happy.

Moral of the story:  even though sticky prices are in no one’s interest, prices can be sticky simply because people expect them to be.

Efficiency Wages:

Normally, an excess supply of labor would lead to cut in wages, thereby increasing the quantity of labor demanded and reducing unemployment.

Graph:

According to the NK, market clearing mechanisms might fail.

High wages make workers more productive – so firms don’t want to cut wages even with an excess supply of labor.  The firm is afraid it will lose productivity.  It will then pay above market wages.

So the lower productivity would be greater than the savings on the wage bill.

Why do higher wages increase productivity?

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Policy Implications:

At the broadest level new Keynesian economics suggests that recessions do not represent the efficient functioning of markets.

Markets fail according to the NK.  Thus, new Keynesian economics provides a rationale for government intervention in the economy, such as countercyclical monetary policy or fiscal policy.