1. Keynesian Coordination Failure Strategic Complementarities Production and Supply Goods Market Cycles and Policy

2. Keynesian theory has traditionally emphasized (i)Non-market clearing (fixed wages/prices) (ii)Market Failures (i) and (ii) are not necessarily the same. Coordination Failure (CF) model assumes market-clearing and failure. Some policy conclusions are similar to traditional Keynesian theory.

3. Strategic Complementarities Pioneered by P. Diamond (1982) and R. Cooper- A. John (1988). Strategic complementarities (SC) – an individual’s willingness to participate in an activity depends upon the number of others engaged in that activity. *Social interactions (party!), Software- hardware industry, labor markets. SC implies that aggregate production function can have increasing returns.

4. Example Suppose the labor in one industry directly affects the productivity of another: Each industry has (i) Diminishing returns. (ii) Downward sloping ND curve. But aggregate ND curve will be upward sloping: Aggregate production function has increasing returns:

5. Increasing returns: (1)Aggregate production function is convex (2)MPN increases with more labor. (3)ND curve is upward sloping! (4)Output supply curve (Y s ) downward sloping.

6. Goods Market Equilibrium Both Y s and Y d are downward sloping. (1)There maybe just one equilibrium (2)There maybe multiple (two) equilibria.

7. Two Equilibria: (1)Business cycles are fluctuations between Y L and Y H. (2)BC are caused by coordination failures and self-fulfilling expectations. (3)Importance of non-fundamental (speculative/human) factors affecting consumer-business sentiment (“sunspots” – variables that matter just because it is believed to matter).

8. Business Cycle Facts (i)C,I are procyclical (ii)N is procyclical (iii)(Y/N) is procyclical (iv)P is countercyclical (?)

9. Policy and BC Monetary Policy * In general M s is neutral. * However, if M s is a sunspot variable: High M s  consumer optimism  Y H Low M s  consumer optimism  Y L *Notice that r decreases with high M and P maybe fixed or “sticky”. *Monetary policy can be used to coordinate economy.

10. Fiscal Policy/Government Purchases * An increase in G shifts Y d right but Y s left! (negative income effect  increases N s, creates excess labor supply, decreases  * and N*) *Can create more instability. Low G may eliminate BC. *The Y H equilibrium may lead to higher household welfare if r is low enough.

11. Table 11.3 Data Versus Predictions of the Coordination Failure Model

12. Shortcomings: *Evidence of increasing returns to scale in aggregate production function is mixed. Weak at best. *Difficulty measuring expectations makes it difficult to implement model in practice.