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Surviving the Theoretical Storm: The HurriKeynes Strike RBC Theory

RBC Theory vs. Keynesian Theory
Cleo Dan
May 8, 2013

















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OVERVIEW: This is an excerpt from a paper arguing that the Keynesian macroeconomic
theory more aptly explains business cycle fluctuations, particularly through price rigidity, and
also offered constructive advice on how the government can best manage the economy through
an active role by way of policymaking decisions.

The Keynesian theory also correctly predicts the decrease in inflation during and directly
after recessions due to the decline in aggregate demand during periods of economic hardship,
which is a generally accepted concept. This part of the Keynesian theory more aptly describes
the actual procyclical nature of inflation than the Classical theory which shows that a negative
productivity shock will induce prices to increase, a hypothesis that is entirely contrary to the data
(Figure 4 and 5) (Abel, Bernanke and Croushore, 2011).
In a working paper, Alan Blinder (1991) provides initial findings on the stickiness of
prices. Through an innovative research design of structured, controlled interviews, Blinder
(1991) systematically collects pricing strategies from firm executives. Verbal responses provided
evidence that the change in prices of the firms most important products infrequently changed on
an annual basis. Results showed that the majority of the companies in the study only changed
their pricing one time per year (Figure 6) (Blinder, 1991). Abel, Bernanke, and Croushore (2011)
state that the profit-maximizing behavior of monopolistically competitive firms that face menu
costs drive price stickiness due to price control strategies. In relation to Blinders study, firms
would infrequently readjust their price levels as a calculated response to changes in aggregate
demand, which further supports why price rigidities affect economic fluctuations.
A seemingly great deal of literature on price stickiness cites Stephen Cecchetis 1986 study
of the newsstand prices of magazines over a period of 26 years. Cecchetis study concludes that
the prices of magazines rarely changed- in fact, only half the magazines in the sample change
price in any one year (Figure 7) (Wynne, 1995). While it can be argued that Cecchetis research
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examines a very small sector of the market, his findings still hold that prices stickiness exists.
Finally, MacDonald and Aaronson (2001) also support the notion that prices are rigid by
using price data from the Bureau of Labor Statistics to analyze how prices have changed within
certain restaurants. The study determines that after a ten-month period, only half of the food
pricing had changed and overall, only minor fluctuations had occurred (Figure 8) (MacDonald
and Aaronson, 2001).
Leduc and Liu construct an argument supporting the Keynesian notion that changes in
aggregate demand affect the macro economy, by offering empirical evidence suggesting that
uncertainty shocks have the effects of aggregate demand shocks (Leduc and Liu, 2013). The
model that Leduc and Liu (2013) employ examines the role that nominal rigidities have on
economic activity, and conclude that this factor augment fluctuations through shocks. Leduc and
Liu (2013) employ data collection by the Michigan Survey, which asks American household
interviewees about their expectations of future prices (Leduc and Liu, 2013). The graph in Figure
9 shows the relationship between consumers uncertainty about future prices and documented
recessions by NBER. Keynes promoted the idea of animal spirits, or the changes in pessimism
and optimism embraced by consumers and investors in times of economic uncertainty (Abel,
Bernanke and Croushore, 2011). The graph clearly shows a correlation between higher levels of
uncertainty, which behave like aggregate demand shocks, with periods of recessions. This
research provides empirical evidence that supports the Keynesian notion that aggregate demand,
even in the 2000s, should be considered as an important factor that influences the business cycles
because the significance of aggregate demand stimulating cycles is a foundation of the
Keynesian theory.
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Inflation plays a significant role in short-run macroeconomic fluctuations (Brissimis and
Magginas, 2008). The Phillips curve traditionally assumes an inverse relationship between
inflation and unemployment rates. When inflation is high, unemployment is low and when
inflation is low, unemployment is high. Historically, Keynesians have harnessed the Phillips
Curve as a macroeconomic aid to policy formulation in deciding how to control two politically
contentious issues. A study published in 2012 by Roeger and Herz examined the Phillips Curve
in the paradigm of New Keynesian parameters and conclude that the empirical evidence on the
cumulated output effects of money are accurately shown in their forward-looking New
Keynesian model (Roeger and Herz, 2012). Brissimis and Magginas (2008) state that the
forward-looking behavior (future expectations) of the NKPC most closely resembles data by
reflecting actual inflation patterns in the United States from 1968:Q4 to 2006:Q4. The empirical
evidence presents inflation-forecast data, taken from quarterly U.S. data collected from the
Survey of Professional Forecasters and the Federal Reserves Greenbooks forecast work
(Brissimis and Magginas, 2008).
In conclusion, both the Classical and Keynesian theoretical models provide a useful
framework for economists and policymakers alike to evaluate economic activity. This paper
works to support the Keynesian theory, despite many criticisms that question its contemporary
applicability. Through a survey of literature, the existing research on nominal price rigidities and
aggregate demands influence on economic cycles point towards the Keynesian theory as
appropriate in explaining market fluctuations. Specifically, because Keynesian thought
emphasizes a larger government to control issues that negatively affect civilians, such as
inflation and unemployment, the Keynesian model appeals to those with politically left-leaning
tendencies. This politicized element to economic theory can be applied to the 2007-09 recession
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where unemployment rates. The goal of Keynesian policies aims to mitigate the effects of
business cycles. Therefore, this theory is attractive during a recession because proponents
advocate for an active role of exogenous institutions to either increase the money supply or
government spending to aim to push the economy back into equilibrium. During recessions,
fiscal policy often reflects Keynesian thought because citizens expect their government to work
to smooth recessions as quickly as possible when they personally suffer economic hardship,
hence the government employs taxation and government spending to theoretically spur aggregate
demand. The government may receive negative press if leaders were to virtually ignore their
constituents in time of need. Despite the many merits of the Keynesian theory, literature disputes
pieces of the framework that do not closely track real-time data as compared to other
macroeconomic models. One such criticism of the Keynesian theory is the idea of labor hoarding
to explain the procyclicality of marginal product of labor, as seen in the data. This theory has
been challenged by a lack of data and therefore should be the focus of future scholarship.










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APPENDIX


Figure 4



This graph depicts the Classical representation of a negative productivity shock, illustrating that
according to the Classical model; prices will rise from P1 to P2 as a result of this shock, showing
that inflation rises during a recession, which is contrary to the data.












10 0 1 2 3 4 5 6 7 8 9
10
0
1
2
3
4
5
6
7
8
9
Y
P
AD
AS
FE
FE
P1
P2
(


Figure 5




This graph portrays the effects of an economic recession through a Keynesian perspective with
the decrease in aggregate demand, which pushes the price level down. This theoretical effect is
generally accepted- prices decrease during recessions.


Figure 6

Source: Blinder, 1991.
10 0 1 2 3 4 5 6 7 8 9
10
0
1
2
3
4
5
6
7
8
9
Y
P
AS
AD
FE
AD'
P1
P2
)

Figure 7



Source: Wynne, 2005.















*

Figure 8

Percent of Items with Unchanged Price, Full (FS) and Limited (FS) Service Outlets

Source: MacDonald and Aaronson (2001)


















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Figure 9
Source: Leduc and Liu (2013)






















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Works Cited

Abel, Andrew B., Bernanke, Ben S., and Dean Croushore. Macroeconomics. Boston:
Pearson Education Inc., 2011.

Blinder, Alan S., "Why Are Prices Sticky? Preliminary Results from an Interview Study",
NBER Working Paper Series, no 3646, (March, 1991), pp. 1-25.

Brissimis, Sophocles and Nicholas Magginas, "Inflation Forecasts and the New Keynesian
Phillips Curve", International Journal of Central Banking, vol 4 no 2 (June, 2008),
pp. 1-22.

Colander, David, "New Keynesian Economics in Perspective", Eastern Economic Journal, vol
18, no 4 (Fall, 1992), pp. 437-448

Leduc, Sylvain and Zheng Liu, "Uncertainty Shocks are Aggregate Demand Shocks",
Federal Reserve Bank of San Francisco: Working Paper Series, (January, 2013), pp. 1-
44.

MacDonald, James M. and Daniel Aaronson, "How Do Retail Prices React to Minimum
Wage Increases?", Federal Reserve Bank of Chicago, (December, 2000), pp. 2- 40.

Mankiw, Gregory N, "A Quick Refresher Course in Macroeconomics", NBER Working Paper
Series no 3256 (1990), pp. 1-40.

Mankiw, N. Gregory, Symposium on Keynesian Economics Today, The Journal of
Economic Perspectives, vol 7, no 1 (Winter, 1993), pp 3-4.

Plosser, Charles, Understanding Real Business Cycles, The Journal of Economic
Perspectives, vol 3, no 5 (Summer, 1989), pp 52.

Roeger, Werner and Bernhard Herz, "Traditional versus New Keynesian Phillips Curves:
Evidence from Output Effects", International Journal of Central Banking, vol 8, no 2
(June, 2012), pp. 87-109.

Wynne, Mark A. "Sticky Prices: What is the Evidence?", Federal Reserve Bank of Dallas
Economic Review, (1995), pp. 1-12.