XVII. New Keynesian Economics

XVII.1 AD – AS model once again Agregate demand : both in long and short term decreasing function of price Agregate supply –In the long run – vertical at potential product –In the short term – horizontal at the level of fixed price Shifts of AD (because of monetary or fiscal policy) –In the long run does not change product, but a price level –In the short run changes product (and employment), but price remains constant

AD shifts – short run P Y SRAS

AD shifts - long run P Y LRAS

P Y SRAS AD Long term equilibrium E

From short to long run (1) Short run equilibrium: –AD equals AS, quantity adjustment, AS adjusts to AD –Price fixed, equilibrium as state of rest, on the labor market an excess supply might exist (unemployment) –Product might be lower than potential (natural) Long run equilibrium: –AD equals AS –Prices adjusted, so that on all markets supply equals demand –Product on potential (natural) level

From short to long run (2) Intuitive interpretation: Fixed price: either depression (Keynes) or a very short run, when prices (wages) are sluggish in any economy and (almost) in any situation (except e.g. hyperinflation) Long term equilibrium – prices and wages had to react to changes in demand and supply on various markets (including labor market) and cleared the markets through its adjustment

Aggregate supply in short to medium run Adjustment process (from short to long run) takes some time  question –How is the aggregate supply specified in this transition period?  increasing function of price No unified theory till today –Neoclassical synthesis: downward wage and price rigidities (no market clearing) –Phillips curve: adaptive expectations hypothesis –New Classical Economics: market clearing, rational expectations, Lucas’ AS –End of 1980s – revival of Keynes: “The New Keynesian Economics” (NKE)

Another view on the same problem … In the very long run: economy always at natural levels, AS vertical If AS positively sloped → money is not neutral, i.e. increase of money supply increases output (and price) and vice-versa Beginning of 1990s: NKE, 2 questions: –Is money non-neutral? Do we build the theory that denies classical dichotomy? –Do real market imperfections determine economic fluctuations The second question defines NKE: theoretical explanation of market imperfections and the link to deviations from natural values –Prices are not fixed (adjust slowly, etc.) because of short run, but because of market imperfections –Not unified theory, rather many different models and in next parts, Mankiw’s textbook is followed (see Literature)

XVII.2 Nominal wage rigidity Originally: F.Modigliani (1944) – downward wage rigidity In general: wages rigid in both directions, reasons: –Long term wage contracts, eventually implicit contracts, power of the unions Intuitively: if wages rigid, then price increase lowers real wage  firms increase employment  product increases and supply increasing function of the price

Wage: targeted and actual Wage negotiations: Always negotiated nominal wage at the expected price P e, so both firms and workers have in mind targeted real wage, so w T a W = w T. P e Employment given by demand  firms then decide according price P - (W/P) = w T. (P e /P) –if P = P e, then (W/P) = w T –if P > P e, then (W/P) < w T –if P w T –Unexpected growth of price means fall of real wage  higher employment  higher product; conversely, fall of price  lower product Higher price  higher AS (and vice versa)

N W/P A N Y Y P AS A B B

From wage to AS Difference between actual and expected price reflects price movements –One possible interpretation – if in moment t, expectation equals price, than actual price, determining real wage, is price in moment t+1 Generalization: Counter cyclical movement of real wage

XVII.3 Wrong perception of price level by workers Starting assumption – firms always know prices, workers only expect them and will know real price only with a time lag Demand for labor Supply of labor Always and ratio reflects a degree of wrong perception of price level by workers

Model (1) Demand for labor: decreasing function of real wage Supply of labor: increasing function of expected real wage, can be written as –Labor supply curve shifts according the ratio Model assumes simultaneous clearing of all markets

Wrong price perception: price increase Demand – decreasing function od real wage Supply – increasing function of initial supply Unexpected price increase  labor supply shifts to the right  real wage fall  new equilibrium with higher employment N W/P

Model (2) Price increase  employment increase AD – increasing function of price In general again P Y AS

XVII.4 Incomplete price information Assumptions: No difference between firms and workers On the markets, agents know –Very well the price of goods they produce –Not so well the price of most other goods Agents produce one good and consume many goods

Basic idea Unexpected increase of overall price level, then each agent –As producer perceives the increase of the price of “its” product and feel incentives to increase production –As a consumer doesn’t perceive the price increase as an overall one, as he doesn’t know all other prices In general – at change of absolute price level agent wrongly assumes the change of only relative prices (of “his” product)  increases supply because of increase of price Formally again

XVII.5 Sticky-Price Model Starting point: no perfect competition, different reasons for prices being sticky → firms are able to set their prices (at least to some extent) –i.e., firms have some degree of monopoly Two prices: overall level P, individual price of the firm p p determined by P and by deviation of output form natural level –higher output → higher marginal costs → higher p p = P + a(Y – Y f ), a>0

Sticky and flexible prices Firms are price setters and some of them face sticky prices, some of them face flexible prices, i.e. they must react to change in demand, but can set their price (do not take it from the market) Flexible prices: p = P + a(Y – Y f ) Sticky prices: p = P e, i.e. firms, when setting a price that will remain sticky, set the price to the expected overall level

Price level determination Suppose that s – fraction of firms with sticky prices (0<s<1) Overall price level – weighted average of prices, set by the different groups of firms: P = sP e + (1-s)[P + s(Y-Y f )] Subtracting (1-s)P from both sides and dividing by s: P = P e + [(1-s)a/s](Y-Y f )

Interpretation P e high → P high: when firms with sticky prices expect high prices, they set their price high and contribute to the high overall price level Output high → demand high → firms with flexible prices set them high, again high overall level P Pro-cyclical movements of real wage

XVII.6 Summary Particular models of short term aggregate supply differ, but do not exclude each other exclusively All models generate AS that – in the short run – is increasing function of price

Interpretation Variations from potential (natural) product are proportional to variations of actual price from expected one Actual price higher than expected  product higher than potential; and vice versa In graphical terms: short term AS is increasing, slope Expected price becomes a model parameter –When actual and expected price equal, product on potential level –Change of expected price shifts AS curve Dynamics

AS in long and short term Y P LRAS AS

Literature to Ch. XVIII Mankiw, Macroeconomics, Ch.13 Snowdon, Vane, Modern Macroeconomics, Ch.7 Read parts 7.1 – 7.4. In subsequent parts the NKE is discussed in much more detail and from a slightly different angle See references in Snowdon and Vane