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The New
Keynesians
Intermediate Macroeconomics
ECON-305 Spring 2013
Professor Dalton
Boise State University
The Death of Keynesianism
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Orthodox Keynesianism suffered
attacks in 1950s and 1960s from
Monetarism
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Weathered storm
Incorporated ideas into the neo-classical
synthesis
New Classical attacks of 1970s more
damaging
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Poor performance of stable Phillips Curve
Theoretical inconsistencies
The Death of Keynesianism
Lucas and Sargent, “After Keynesian
Macroeconomics,” in After The Phillips
Curve… (1978)
Fundamental Problems of Orthodox
Keynesianism
(1) Inadequate micro-foundations which assume
markets don’t clear
(2) Use of expectations inconsistent with maximizing
behavior (adaptive rather than rational)
After Keynes and Lucas
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New Classical and RBC
macroeconomics resolved tension
between neoclassical micro and
Keynesian macro by abandoning
latter.
Alternative Approach – rebuild
micro foundations of Keynesian
macroeconomics
New Keynesian Economics

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New Classical and RBC models,
despite their theoretical elegance, fail
to “square” with fundamental
observations concerning business
cycles
Orthodox Keynesian models, adapted
for supply shocks, do pretty well in
accounting for most (not all) business
cycle facts, but lack micro-reasoning
to help understanding
Essential Task of Macro
“The co-ordination question, simply stated, is
this: Will the market system ‘automatically’
co-ordinate economic activities? Always?
Never? Sometimes very well but sometimes
pretty badly? If the latter, under what
conditions, and with what institutional
structures, will it do well or do badly? I
regard these questions as the central and
basic ones in macroeconomics.”
- Leijonhufvud, “Keynesian Economics: Past Confusions,
Future Prospects,” in Vercelli and Dmitri, eds.,
Macroeconomics: A Survey of Recent Strategies
NK Research Program
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The Difference
In classical models, the world is
characterized by continuous marketclearing
In Keynesian models, there is an
absence of continuous market-clearing
NK Research Program

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If do away with CMC, better have good
reasons.
New Keynesians attempt to provide microfoundations for absence of CMC, rather
than just assume it.
CMC fails when prices and wages are
rigid.
Therefore, New Keynesians attempts a
microeconomics of price and wage
stickiness.
NK Research Program
Central Aspects
(1) Construction of a theory of AS
based upon wage and price
rigidities.
(2) Construction of models of wage
and price rigidities based on
maximizing behavior and rational
expectations.
However…
New Keynesian School?
“Genuine school in our sense: There
was one master, one doctrine,
personal coherence; there was a
core; there were zones of
influence; there were fringe ends.”
-
Schumpeter, History of Economic Analysis, p. 95.
New Keynesian School?
“a school … is a collection of affiliated
scientist who display a considerably
higher agreement upon a particular
set of views than the science as a
whole displays.”
“A school must have a leader …[and]
consensus upon substantive scientific
views.”
- Stigler, “Does Economics Have a Useful past?” The
Economist as Preacher, p. 116.
New Keynesian School?
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New Keynesian economists are an
extremely heterogeneous group
New Keynesian economists hold a wide
diversity of views regarding policy
There is no single, unified, new
Keynesian Model
Even disagreement over the importance
of wage and price rigidities!!!
Leading New Keynesians
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Gregory Mankiw (Harvard)
Lawrence Summers (Harvard)
Olivier Blanchard (MIT)
Stanley Fischer (MIT)
Joseph Stiglitz (Columbia)
Ben Bernanke (Princeton, Federal Reserve)
George Akerlof (Cal-Berkeley)
Janet Yellen (Cal-Berkeley)
David Romer (Cal-Berkeley)
John Taylor (Stanford)
Core Propositions
Mankiw and Romer, New Keynesian
Economics (1991)
(1) Is money non-neutral?
(2) Are real market imperfections
crucial for understanding economic
fluctuations?
Only New Keynesians (among
mainstream) answer Yes to both.
Core Propositions
Summary View of New Keynesianism
“Economic fluctuations arise from
monetary non-neutrality occurring
because of [sticky prices arising from]
real market imperfections.”
Core Propositions
(1) Firms
are price-makers
(2) Rational expectations (usually)
(3) Both demand and supply
shocks are sources of
instability
(4) Incomplete markets and
asymmetric information
Nominal and Real Rigidities

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Nominal rigidity occurs when
something prevents nominal prices or
wages from adjusting to meet changes
in demand or supply
Real rigidity occurs when something
prevents real wages, real prices, or
relative prices from adjusting to meet
changes in demand or supply
Nominal Rigidities
 Nominal
wage rigidity
 Nominal price rigidity
Nominal Wage Rigidity

Long-term labor contracts
Agents Ratex
 Money supply changes more frequent
than contracts negotiated
 Monetary Policy can have real effects

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Micro rationale for long-term labor
contracts

Wage negotiations costly for both
workers and firms
Nominal Wage Rigidity
Potential costs from strikes due to
negotiation breakdowns
 Not optimal to change W immediately; if
other firms don’t follow, increased labor
turnover
 Why not COLAs?
 In world of imperfect info firms can gain
vital information by observing wage/price
changes of other firms

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PROBLEM: counter-cyclical real wages
predicted
Nominal Price Rigidity

PAYM insight
Parkin, Akerlof, Yellen and Mankiw
 “In price-maker markets, small costs to
price adjustment can generate aggregate
nominal price rigidity.”

Akerlof and Yellen, “A Near-Rational Model of the
Business Cycle, with Wage and Price Inertia,” (1985)
Mankiw, “Small Menu Costs and Large Business
Cycles: A Macroeconomic Model of Monopoly,”
(1985)
Parkin, “The Output-Inflation Tradeoff When Prices
Are Costly to Change,” (1986)
Nominal Price Rigidity

Menu Costs Idea
Physical costs of resetting prices and
management expense in supervising and
renegotiatiing purchase and sales
contracts
 Profit-maximizing firms and Menu costs
 When D falls, should price-maker cut
price or not?

Nominal Price Rigidity
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Macro Consequences of Answer
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w/out Menu costs
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Profit-maximization results in all firms
reducing prices and therefore costs of inputs
fall. MC decline, leading to further P declines
and real money balances increase. Real
interest rate falls, AD increases, and full
employment is re-established.
With Menu costs

Costs of inputs don’t decline and economy
remains stuck in underemployment
equilibrium
Nominal Price Rigidity

Micro rationale for long-term price
agreements (set menu prices)
Economize on firm’s resources
 Reduce uncertainty of potential
transactors
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PROBLEMS:

Ignores costs of output adjustment; Fails
to explain why some prices are more
flexible;To get large aggregate effects
requires implausible values for demand
elasticity and marginal cost elasticity
Nominal Rigidity and AD/AS
P
W
LRAS
SL
SRAS
W0
DL
AD1
L1
L0
Y
L
Y
AD0
Y
Y=Y
DLe
L
Y
Real Price Rigidity
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Implicit oligopolistic collusion
“Thick market” externalities
“Customer” markets
Asymmetric information in capital
markets
Price-Quality Judgments
Imperfect Information and InputOutput Complexity
Real Wage Rigidity
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Implicit Labor Contracts
“Efficiency Wages”
Adverse Selection
 Labor Turnover
 Shirking
 Fairness
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“Insider-Outsider” Theory
NK Business Cycle Theory
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Demand and Supply shocks combine
with frictions and imperfections within
economy to produce non-neutralities
that amplify shocks resulting in large
output and employment fluctuations
Predominant approach focuses on
rigidities
Hysteresis and Unemployment
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Hysteresis: path-dependency
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Idea that the natural-rate of unemployment at
any given point in time depends upon the path
of past unemployment rates
If actual unemployment rate exceeds the natural
rate, the natural rate rises (and vice versa)
Why?
Duration Theories (Structural) and InsiderOutsider Theories (Wage Rigidity)
Policy Implication: the sacrifice-ratio is
much larger than suggested by original
Phillips Curve literature
NK and Stylized Facts
(1)
(2)
(3)
(4)
Consistent with pro-cyclical L, C, I, G,
and Y/L
Non-neutrality of money consistent
with leading pro-cyclical money
NK predicts inflation pro-cyclical and
lagging
With sticky nominal prices, real wage
can be pro-cyclical or acyclical
Policy Implications
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Sticky prices and monetary nonneutrality re-establishes policy
effectiveness
Eclectic Nature of New Keynesian
Policy Prescriptions
Criticisms of New Keynesianism
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Lack of empirical support
Numerous theories
Doubt on importance of menu costs
Denial that efforts accurately portray
Keynes
Acceptance of rational expectations
Continued reliance in IS-LM to
understand AD
Distinguishing Beliefs
1.
2.
Economy subject to irregular and
unpredictable shocks from both
demand and supply, and economy
slow to adjust due to nominal price
and wage rigidity
Equilibrium consistent with
involuntary unemployment is due to
real price and wage rigidity that itself
is result of rational maximizing
behavior
Distinguishing Beliefs
3.
4.
Short-run tradeoff exists between
unemployment and inflation due to
the non-neutrality of money in a
world of price and wage rigidity
In principle, activist Monetary and
Fiscal policy can return economy to
full-employment output, but policy
should be aimed at offsetting major
rather than minor problems
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“Coarse-tuning” rather than “fine-tuning”