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Selected Aspects of Macroeconomics:

Module on Monetary Policy
New Keynesian Monetary Policy

Lectures 4
Partha Ray
29 July 2016

Who are New-Keynesians?

IN THE LATE 1970s it appeared that the U. S. macroeconomic landscape was
being swept by a new-classical tide, and that Keynesian economics had
become an isolated backwater. In fact there is still a widespread impression
that the best and brightest young macroeconomists almost uniformly
marched under the new-classical banner as the decade of the 1980s began.
Yet it is now apparent that the rumours of the death of Keynesian economics
were greatly exaggerated. Building on foundations laid in the late 1970s by
Stanley Fischer (1977a) and Edmund Phelps and John Taylor (1977), a large
number of authors, young and middle-aged alike, in the past decade have
produced an outpouring of research within the Keynesian tradition that
attempts to build the microeconomic foundations of wage and price
stickiness. The adjective new-Keynesian nicely juxtaposes this body of
research with its arch-opposite, the new-classical approach
- Robert Gordon (1990)
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Policymaking and Implementation Lags

Data lag
Recognition lag
Legislative lag

Implementation lag
Impact lag

Some Basics

By definition, the log of nominal GNP (X) must be divided between the log of
the GNP deflator (P) and the log of real GNP (Q)
X = P + Q.
or, in % term, x = p + q
which states that any change in nominal GNP must be divided between a change in
the aggregate price level and a change in real GNP.

Next, we subtract from both sides of the above expression, the long-run
equilibrium or natural growth rate of real GNP (q*),:
x- q*= p + (q - q*)
This states that an excess of nominal GNP growth over the long-run growth rate
of real output (x) must be accompanied by some combination of inflation (p) and
a deviation of real output from that same long-run growth rate (q).

If the rate of change of prices over the business cycle is always equal to some
constant fraction () of the excess nominal GNP movement, then businesscycle movements in real output (q) must soak up the remaining fraction (1 - ):
p = (x- q*)
q-q*= (1- ) (x- q*)
Thus, an economy with relatively sticky prices (a small ) must exhibit
correspondingly large fluctuations in real output, as long as fluctuations in
nominal demand (x - q*) are independent of the price stickiness parameter ()
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Tracking Money and Output

Movements in the Short Run
Through the business cycle, money and output
fluctuate.
Movements in the growth rate of the money supply
are procyclical.
Monetary expansions (contractions) tend to precede
business cycle peaks (troughs).
Economists debate whether money causes output
changes or vice versa.

Money Supply Growth and the

Business Cycle in the US: 1950-2002

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Basic Tenets of RE
(1) Rational Expectation: yte = E(yt| It-1)

(2) Markets (i.e., commodity,

Money or Bond) Clear
(3) The relationships are derived
from underlying micro-foundation of
agents behavior
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Three Features of a Keynesian

An excess supply of labor may exist,
sometimes for prolonged periods, at the
prevailing level of real wages.
The aggregate level of economic activity
fluctuates widelymore widely than can
be explained by short-run changes in
technology, tastes, or demographics.
Money matters, at least most of the
time, although monetary policy may be
ineffective at times.
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NCE Critique of Keynesian

Macroeconomics
Failure on a grand scale.
Made up of ad hoc assumptions, not built on a
strong foundation of rational agents.
Must assume rational, optimizing agents.
Must assume that markets clear.
Keynesians do not explicitly handle expectations,
and expectations have been shown to be critically
important.
Have not given explicit structural explanations of
wage stickiness.
How can you explain persistence in business
cycles?
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Basic Tenets of New Keynesian

Hypothesis
Retains (1) and (3) of RE
But relaxes (2), i,e., markets do not clear.
With (1), (3) and relaxed (2) monetary policy
can have real effect.
NKs make model with micro-foundation where
markets do not clear.

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New Keynesians
Rational expectations + microfoundations
But real / nominal wage / price rigidity
Offer theoretical support at the firm profit
maximization level for Keynesian features in the
economy

Contracting models
Menu/transactions costs
Efficiency wages
Insider-Outsider theory

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The Name of NKE

The name New Keynesian Theory was
introduced by Michael Parkin (1982).
One of the earliest uses of the term newKeynesian Economics was in an article by
Ball, Mankiw, and Romer (1988).
New is used instead of neo to distinguish
from Neoclassical Synthesis Keynesian
Economics (a term used by Samuelson and
others), and also to show it is the counterargument to the New Classical Economics.
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Who are New Keynesians?

New KEYNESIAN ECONOMICS is the school
of thought in modern macroeconomics
that evolved from the ideas of JOHN
MAYNARD KEYNES. Keynes wrote The

General Theory of Employment, Interest,

and Money in the 1930s, and his influence

among academics and policymakers

increased through the 1960s. In the 1970s,
however, new classical economists such
as ROBERT LUCAS, Thomas J. Sargent, and
Robert Barro called into question many of
the precepts of the Keynesian revolution.
The label new Keynesian describes those
economists who, in the 1980s, responded
to this new classical critique with
adjustments to the original Keynesian
tenets N. Gregory Mankiw

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New Keynesians

In the new classical model, all wages and prices are completely
flexible with respect to expected changes in the price level.

In other words, a rise in the expected price level results in an

immediate and equal rise in wages and prices.

Many economists who accept rational expectations do not accept

the assumption of wage and price flexibility in the new classical
model.

These critics of the new classical model, called new Keynesians,

object to complete wage and price flexibility and identify factors in
the economy that prevent some wages and prices from rising fully
with a rise in the expected price level.

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Reasons for Wage Price Rigidity

Menu Costs and Aggregate-Demand Externalities
- Akerlof and Yellen (1985), Mankiw (1985)
The Staggering of Prices Fischer (1977); Taylor
(1980); Calvo (1983).
Coordination Failure - Cooper and John (1988)
Efficiency Wages Akerlof and Yellen (1984)
Monopolistic Competition Blanchard & Kiyotaki
(1987)

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Long-term Labour Contracts

Long-term labor contracts are one source of rigidity that prevents

wages and prices from responding fully to changes in the expected
price level (called wage-price stickiness).

For example, workers might find themselves at the end of the first
year of a three-year wage contract that specifies the wage rate for
the coming two years. Even if new information appeared that would
make them raise their expectations of the inflation rate and the
future price level, they could not do anything about it because they
are locked into a wage agreement. Even with a high expectation
about the price level, the wage rate will not adjust.

In two years, when the contract is renegotiated, both workers and

firms may build the expected inflation rate into their agreement, but
they cannot do so immediately
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Reluctance to Change Wages

Another source of rigidity is that firms may be reluctant to change wages
frequently even when there are no explicit wage contracts, because such
changes may affect the work effort of the labor force.
For example, a firm may not want to lower workers' wages when
unemployment is high, because this might result in poorer worker
performance.
Price stickiness may also occur because firms engage in fixed-price contracts
with their suppliers or because it is costly for firms to change prices
frequently.
All of these rigidities (which diminish wage and price flexibility), even if they
are not present in all wage and price arrangements, suggest that an increase
in the expected price level might not translate into an immediate and
complete adjustment of wages and prices.

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Rational Expectations and the New Keynesian

Model

Although the new Keynesians do not agree with the complete wage and
price flexibility of the new classical macroeconomics, they nevertheless
recognize the importance of expectations to the determination of short-run
aggregate supply and are willing to accept rational expectations theory as a
reasonable characterization of how expectations are formed.

The model they have developed, the new Keynesian model, assumes that
expectations are rational but does not assume complete wage and price
flexibility; instead, it assumes that wages and prices are sticky.

Its basic conclusion is that unanticipated policy has a larger effect on

aggregate output than anticipated policy (as in the new classical model).

However, in contrast to the new classical model, the policy ineffectiveness

proposition does not hold in the new Keynesian model:

Anticipated policy does affect aggregate output and the business cycle

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Difference between three models

In the new classical model, the short-run aggregate supply curve shifts leftward to
AS2 when policy is anticipated, because when expectations of the higher price
level are realized, aggregate output will be at the natural rate level.
The economy moves to point 2, aggregate
output does not rise, but prices rise to P2. This
outcome is different from the move to point l'
when policy is unanticipated.
The new classical model distinguishes between
the short-run effects of anticipated and
unanticipated policies:
Anticipated policy has no effect on
output, but unanticipated policy does.
However, anticipated policy has a bigger
impact than unanticipated policy on price
level movements.
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NKE is in an Intermediate Position

The new Keynesian model is an intermediate position between the traditional and
new classical models. It recognizes that anticipated policy affects the aggregate
supply curve, but due to rigidities such as long-term contracts, wage and price
adjustment is not as complete as in the new classical model.
The short-run aggregate supply curve shifts
only to AS2, in response to anticipated policy,
and the economy moves to point 2', where
output at Y2' is lower than the YI' level
reached when the expansionary policy is
unanticipated. But the price level at P2' is
higher than the level P1' that resulted from
the unanticipated policy .
Like the new classical model, the new
Keynesian model distinguishes between the
effects of anticipated and unanticipated
policies:
Anticipated policy has a smaller effect on
output than unanticipated policy does but a
larger effect on the price level.
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Micro-Foundation
of Wage and Price
Rigidity

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(1) Long Term Contracts

The initial equilibrium occurs at point A.
LAS

SAS(W0)
P0
P1

SAS(W1)

A
B
C

AD0
AD1

Y1

YN

An unexpected nominal demand shock

such as a drop in velocity causes
aggregate demand to shift from AD0 to
AD1.
If prices are flexible but nominal wages
equal W0 and are set by contract in
the previous period, the economy moves
to point B.
Output falls from YN to Y1.
If nominal wages were flexible, SAS(W0)
would shift to SAS(W1) to re-establish
the natural rate of output at point C.
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(1) Long Term Contracts

Summary:
The existence of long term contracts prevents the
rapid establishment of equilibrium at point C and
provides the monetary authority with an
opportunity to expand the money supply, which,
even if anticipated, shifts the AD curve to the right
and re-establishes equilibrium at point A.
If the central bank is free to act while workers are
not, there is room for demand management,
because the fixed nominal wage gives the central
bank influence over the real wage and hence
employment and output.
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(1) Long Term Contracts

Why are long term contracts formed if they
increase macroeconomic instability?
There are private advantages to both firms and
workers:
Wage negotiations are costly in time for both
workers and firms.
The potential for wage negotiations to break down
always exists, increasing the risk of a strike.
Decreasing wages following a negative shock may
reduce the firms wage relative to other firms and
increase labor turnover.
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(2) Nominal Rigidities: Real Goods Market

When firms face a downward sloping demand curve,
price reductions increase sales but also result in less
revenue per unit sold.
However, if the drop in profits is not substantive
compared to the cost of changing prices, the
presence of even small costs to price adjustment can
generate considerable aggregate nominal price
rigidity.
The presence of frictions or barriers to price
adjustment are known as menu costs.
Examples of menu costs include the physical costs of
resetting prices and expensive management time used in
the supervision and renegotiation of purchase and sales
contracts with suppliers and customers.

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(2) Menu Costs

The key insight of this model is that the
private cost of nominal rigidities to the
individual firm is much smaller than the
macroeconomic consequences of such
rigidities.

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(2) Background: Definitions

Profit maximization rule:
Produce where marginal cost equals marginal
revenue.
Marginal revenue is the revenue received from
producing the next unit of output.
Marginal cost is the cost associated with producing the
next unit of output.

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(2) Background: MR = MC
When a firm produces at the point where marginal
revenue equals marginal cost, every unit of output
that contributes to profit has been produced.
When a firm produces at a point where marginal
revenue exceeds marginal cost, units of output that
contribute to profit are not produced.
When a firm produces at a point where marginal
revenue is less that marginal cost, units of output
that decrease profit are produced.
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(2) Background: TR, TC, Profits

P

TR = ?
TC = ?
Profits = ?

MC

MR
0

D
Q
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(2) Menu Costs

In imperfectly competitive markets, a firms
demand curve depends on:
The relative price of its good
Aggregate demand

The firm decides how much to produce by

setting marginal cost equal to marginal
revenue unless menu costs are significant.

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(2) Menu Costs

Given the demand curve D0, the firm maximizes profits
by setting price equal to P0 and selling Q0.
P

A drop in aggregate demand causes the demand curve

facing the firm to shift to the left to D1.

P0

Y
W

P1

Given the demand curve D1, the firm maximizes profits

by setting price equal to P1 and selling Q1.

If the firm chooses to continue to charge P0 when its

demand curve is D1, it sells the amount Q* and no longer
maximizes profits.
MC

D0
MR1 MR0
0

Q* Q1

D1
Q

Q0

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(2) Menu Costs

Profits equal total revenues minus total
costs.

P0

Y
W

P1

On demand curve D0, before the decline

in aggregate demand, the firms total
revenue equals the area 0P0YQ0 and the
firms total costs equal 0SXQ0.

Its profits equal the area SP0YX.

MC

D0
MR1 MR0
0

Q* Q1

Q0

D1
Q
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(2) Menu Costs

Profits equal total revenues minus total
costs.

P0

Y
W

P1

After the decline in aggregate demand,

on demand curve D1, the firms total
revenue equals the area 0P1WQ1 and the
firms total costs equal 0SVQ1.

Its profits equal the area SP1WV.

MC

D0
MR1 MR0
0

Q* Q1

D1
Q

Q0

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Menu Costs
Profits equal total revenues minus total
costs.

P0

After the decline in aggregate demand, if

the firm does not decrease price from P0,
the firms total revenue equals the area
0P0JQ* and the firms total costs equal
0STQ*.

Y
W

P1

Its profits equal the area SP0JT.

S

MC

D0
MR1 MR0
0

Q* Q1

Q0

D1
Q
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(2) Menu Costs

The firm must decide whether or not to
reduce price to the new profit maximizing
point, W on the new demand curve, D1.
With no adjustment costs, the firm makes a profit
equal to SP1WV and would reduce output to Q1.
But, if the firm faces non-trivial menu costs of z,
the firm may decide to leave the price at P0,
thereby moving from point Y to point J.

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(2) Menu Costs

By reducing price from P0 to P1, the firm would
increase its profits by B A, but there is no incentive
for the firm to reduce price if z > B A.

If z > B A, the firm would to charge P0 and sell Q*.

J

P0
A

P1

B
S

The loss to society of producing Q* rather than Q1 is

the amount B + C, which equals the loss of total
surplus.

Q* Q1

D1

Q0

MC

If B + C > z >B A, then the firm

will not cut its price even though
doing so would be socially
optimal

Q
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(2) Summary: Menu Costs

If the presence of menu costs causes nominal
price rigidity, shocks to nominal aggregate
demand will cause fluctuations in output and
welfare.
Such fluctuations are inefficient, indicating the
need for stabilization policy.
In addition if nominal wages are rigid because of
contracts, the marginal cost curve will be sticky,
thus reinforcing the impact of menu costs in
producing price rigidities.
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(3) The Efficiency Wage Model

The efficiency wage model can explain why real wages
might be rigid, why unemployment can be persistent, and why
labor is willing to supply added hours in response to a
demand increase from firms.
The main idea underlying the efficiency wage model is that if
firms pay higher real wages (than a market clearing level),
workers may be more productive, because of added effort
The gift exchange motive
The shirking control motive

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(3) Efficiency Wage Model

An alternative model of unemployment
Key assumption: workers effort
depends on their wage
To induce workers to work harder, a firm
may be willing to pay a real wage higher
than the competitive market wage
This higher efficiency wage thus creates
unemployment
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(3) Effort of the Worker

A workers effort increases with the
wage

e(w), e '(w) 0

Effective labor input is working hours N

multiplied by effort

EN e(w) N
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(3) Why e(w) increases with w?

Adverse Selection: Firm does not
know the productivity of workers. Higher
wage will more likely attract high-ability
workers

More Hazard: Firm has difficulty in

monitoring the on-the-job effort of its
workers. Higher efficiency wage means
the opportunity cost of shirking
increases
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(3) Effort and Optimal Wage Setting

Suppose that effort is a
function of the real wage paid.
Further, suppose that effort
measures the increase in labor
forthcoming from a worker
That is, if effort doubles, the
output gained from an extra
hour of labor doubles
Given this, a firm will wish to set
the real wage so that it gets the
maximum effort per dollar spent
on labor

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(3) The Labor Market in the Efficiency

Wage Model

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To Sum up.
Monetary Policy can influence both output
and inflation as long as there is some real /
nominal rigidities in the system even with
rational expectation.

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