What is New Keynesian economics?

History

            New Keynesian economics is a school of macroeconomic thought that found its beginnings in the late 1970s in the writings of those economists that dissented from the New Classical revolution fronted by Robert Lucas. Lucas, often regarded as the central figure in New Classical economics, became famous for his incorporation of the theory of rational expectations into macroeconomic models as a result of several papers, including: “Econometric Testing of the Natural Rate Hypothesis” (1972), “Expectations and the Neutrality of Money” (1972), and “An Equilibrium Model of Business Cycles.” In 1976, Lucas published his paper “Econometric Policy Evaluation,” which would eventually become known as the “Lucas Critique.” By the end of the 1970s, many economists were wondering if Lucas had “killed” Keynesian economics; and in 1980, Lucas published his paper “The Death of Keynesian Economics: Issues and Ideas.” Lucas ultimately placed Keynes in the history of economic thought, believing Keynesian models to be archaic as they lacked the microfoundations that he emphasized throughout his essays in the 1970s.

Rather than be deterred from their study, so-called “Old” Keynesian economists such as James Tobin responded to Lucas with a kind of furor. In 1977, Tobin asked a question in his essay “How Dead is Keynes?” which he would answer later, in his 1987 essay “The Future of Keynesian Economics.” In this essay, he said:

One reason that Keynesian economics has a future is that rival theories of economic fluctuations do not… I hazard to say the prediction that neither of the two species of Business Cycle Theory offered by New Classical economists will be regarded as serious and credible explanations of economic fluctuations a few years from now. Whatever cycle theory emerges in a new synthesis will have important Keynesian elements… Yes, Keynesian economics has a future because it is essential to the explanation and understanding of a host of observations and experiences past and present, that alternative macroeconomic approaches do not illuminate.

According to Tobin, the primary difference between New Keynesian and New Classical thought is that New Keynesians believe that deadweight losses and market failures (caused by the concept of sticky prices) are possible on a macroeconomic scale and can cause serious damage to the economy. Because of those phenomena, New Keynesian economists believe that government instigated demand management policies can help the economy return to equilibrium at a faster rate than is naturally possible.

But where did New Keynesian economics come from? The term was first coined in 1982 by Robin Bade and Michael Parkin in their Macroeconomics textbook—though it is possible that the term Neo-Keynesian was used a little bit earlier on; ultimately, the two terms are interchangeable. Much of the foundational elements of the school were developed during the late 1970s through the mid/late 1990s, with James Tobin doing some of the most well-known research in this field throughout the 1980s. In 1991, Gregory Mankiw and David Romer published an essay collection titled New Keynesian Economics. These essays helped shape the identity of New Keynesian economics, and Gregory Mankiw would ultimately become the “show-runner” of sorts for the school of thought.

Ultimately, New Keynesian economics is a response to the New Classical economist critiques of Keynesianism. New Keynesians believe that the New Classical economists had some valuable critiques, and incorporated elements of New Classical theory into their own New Keynesian models. It’s not so much a reinterpretation of Keynes as it is—as Mankiw says—“a reincarnation of Keynes;” one that includes elements from both New Classical economics and Monetarism.  Mankiw has also, interestingly enough, said that New Keynesian economics could have just as easily been called “New Monetarism.”

And now, knowing that, we can ask what exactly IS New Keynesian economics?  Simply put, it is:

  • Economic theory that incorporates the Micro-Foundations that Lucas found to be so important when trying to illustrate the macroeconomy.
  • An acceptance of the theory of Rational Expectations.
  • A belief that firms are not perfectly competitive rather, they are monopolistically competitive.
  • A belief that, wages and prices are “sticky;” therefore, market failures and involuntary unemployment are possible, and government intervention is able to (and should) hasten the markets return to equilibrium.

 New Keynesian Macroeconomic Models

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

The above model illustrate’s Stanley Fischer’s concept of nominal wage contracts, rational expectations, and monetary policy. In this model, the economy begins in equilibrium at point A. Then, we are asked to suppose that the economy suffers an unexpected demand shock that results in the economy’s aggregate demand curve shifting downwards from AD0 to AD1. At point B, New Classical economists would say that wages adjust, and that the economy’s W0 curve would shift down to W1. New Keynesians economists however, say that due to sticky wages, this down shift is unlikely because—by the definition of sticky wages—employees are not very likely to take pay cuts. New Keynesian economists believe that in this situation, the central bank would increase the money supply, and the economy’s AD1 curve would shift up back to AD0. According to Snowdon and Vane, “the monetary authorities can react to nominal demand shocks more quickly than the private sector can renegotiate nominal wages.”

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

The above model illustrates price adjustments under monopolistic competition. This model assumes that the firm begins at the profit maximizing point of Y. Then, there is a decline in demand, from D0 to D1. If the firm was a perfect monopoly, it would then adjust its price to the profit maximizing point of W. However, due to the concept of menu costs—the cost of changing prices—a monopolistic firm will opt to not lower its price (to P1) but rather keep the price at (P0), or at point J. At point J, the firm is technically not maximizing profit, but it is likely preventing losses The firm can do this because it is a price maker, and can choose whether or not to reduce price to the new profit-maximizing of W. The ultimate point here, is that a firm will set a price lower than the profit maximizing price if the menu cost associated with changing the price would result in a greater loss than simply not changing the price at all.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

This model incorporates both sticky wages and sticky prices, and shows an aggregate demand shock in the New Keynesian model. In this model, the economy begins at equilibrium, at point E0 on graph a. Due to a shift in the AD curve (from AD0 to AD1), the economy’s new equilibrium as at point E1. The SRAS (P0) curve is elastic due to menu cost and real rigidities, price remains at (P0). Output then declines from point E0, to point E1 on graph b. The demand for labor then declines from E0 to E1 on graph c. On graph D, we can see that if the labor supply declines, the rigid wages prevent wages from declining.

 

According to Snowdon and Vane:

 

Eventually downward pressure on prices and wages would move the economy from point E1 to E2 in [graph] a, but this process may take an unacceptably long period of time. Therefore, New Keynesian economists… advocate measures which will push the aggregate demand curve back towards E0. In the new Keynesian model, monetary shocks clearly have non-neutral effects in the short run, although money remains neutral in the long run, as indicated by the vertical the [LRAS] curve…

Ultimately, New Keynesian economists argue that while the economy will eventually return to equilibrium (from E1 on graph a to E2), effective monetary policy can hasten the return to equilibrium (from E1 back to E0).

The Taylor model was used by John Taylor to look at the consequences of using gradualist stabilization rules that were being suggested by monetarist economists. The model consists of two equations, one to measure deviation from trend of GDP, or in other words, the GDP gap, and the other to measure the rate of inflation defined as Pt+1-Pt (Log of the price level in the past minus the log of the price level in the present time). Both π^t and y^t are set in period t-1 because prices are set and there is a one period lag.

  • Yt0 + β1 yt-1 + β2 yt-2 + β3 (mt – Pt) + β4 (mt-1 – Pt-1) + β5 π^t + β6t
  • Πt = πt-1 + γ1y^ + γ0

Taylor makes two key assumptions in his model, that prices are predetermined since they were set in the previous period and that money stock in period t is equal to what had been anticipated in the period before. The second assumption comes from the idea that monetary authorities follow stable rules that are known by the private sector, so there will be no monetary surprises to impact anything. These assumptions make it possible for monetary authorities to  effect the probability distribution of output. The main issue with these two equations as of now is that they both contain two unobservable variables; expectations of inflation and expenditure. Fortunately, we can use the rational expectations hypothesis to eliminate these unobservable variables. To do this, all that needs to be done is to take conditional expectations of both sides of the equations. Price level and money stock in the time t are previously determined in tim t-1—in other words, the price level and money stock in the present are determined in the past. This leads to two simultaneous equations that can be solved for.

  • Yt= a{B0 + B1Yt-1 + B2Yt-2 + B3 (mt – Pt) + B4 (mt-1 – Pt-1) + B5πt-1 + B6t}
  • Πt= a{γ1 [B1yt-1 + B2yt-2 + B3 (mt – Pt) + B4 (mt-1 – Pt-1)] + πt-1 + γ1B6t + γ1B0 + γ0}

a= 1/(1-B5γ1)

These equations contain only observable variables and can be estimated; expectations are rational and policy evaluation is possible. Unfortunately, they don’t completely avoid complaints raised by Lucas in that the expectations are rational, but the coefficients are assumed to be invariant to changes in policies. In other words, policy will not overtly change prices, because they are determined in the past period, and are thus, “sticky.” Ultimately, this model illustrates the New Keynesian concept of sticky prices.

Policy Implications

                One important aspect of New Keynesian economic thinking is that not everyone in the economy sets prices at the same time and this fact must be kept in mind when creating policies. Any adjustment of prices is going to be staggered which complicates the setting of prices because firms care about prices relative to other firms. This leads to the belief that recessions may result from a failure in coordination between firms because those setting wages/prices must anticipate the actions of other firms when setting prices. New Keynesians do accept the view of neoclassical synthesis which states that the economy can deviate in the short run from equilibrium and that monetary and fiscal policy has influence upon real economic activity. New Keynesians by and large believe that government intervention should not be used to boost the economy in the short run, and thus leaving it open to disaster in the long run; rather that it should be used as a stabilizing tool focused on keeping the economy at a steady equilibrium. While the economy and employment can be strengthened temporarily by government policies, this is a risky proposal and can lead to higher inflationary expectations which will hurt the economy in the long term.

New Keynesian DSGE Models

            Dynamic Stochastic General Equilibrium (DSGE) models attempt to explain aggregate economic problems. According to Wikipedia, they are Dynamic in the sense that they show how the economy grows over time, and they are Stochastic in the sense that they take into account the fact that the economy is affected by random shocks. Ultimately, these models are used to show how an interaction of supply, demand, and prices will reach an equilibrium. This makes them extremely important for modern-day modeling of macroeconomic theory.  The DSGE models use microfoundations in order to explain the preferences of the decision-makers in the model. This makes it less vulnerable to the Lucas critique, which states that the effect of economic policy based on aggregated historical data does not properly analyze the complexity of microeconomic systems.

The DSGE model use a structure similar to the Real Business Cycle models, but instead assume that prices are set by monopolistically competitive firms, and cannot be adjusted without cost and instantaneously. In other words, New Keynesian DSGE models differ from real business cycles DSGE models because they take into account various financial frictions—price and wage stickiness.

DSGE models aim to describe the behavior of the economy as a whole by looking at the many microeconomic decisions made in the economy. The decisions considered in most DSGE models are consumption, saving, investment, and labor demand. The decision-makers in the model includes households, business firms, and perhaps the government or central banks.
The European Central Bank (ECB) has developed a DSGE model called the Smets–Wouters model, which it uses to analyze the economy of the Eurozone. The model is an alternative to the Area-Wide Model (AWM). The equations in the Smets-Wouters model describe the choices of three types of decision-makers: households, who choose consumption and hours worked optimally, under a budget constraint; firms, who decide how much labor and capital to employ; and the central bank, which controls monetary policy. The model approximately describes the dynamics of GDP, consumption, investment, prices, wages, employment, and interest rates in the Eurozone economy. In order to accurately reproduce the sluggish behavior of some of these variables, the model incorporates several types of frictions that slow down adjustment to shocks, including sticky wages and prices, and adjustment costs in investment.
Given the difficulty of constructing accurate DSGE models, most central banks still rely on traditional macroeconometric models for short-term forecasting. However, the effects of alternative policies are increasingly studied using DSGE methods.

References

Brian Snowdon’s and Howard R. Vane’s Modern Macroeconomics

Steven M. Sheffrin’s Rational Expectations

Brian Snowdon’s and Howard R. Vane’s A Modern Macroeconomics Reader

Arjo Klamer’s Conversations with Economists

One Response to What is New Keynesian economics?

  1. Pingback: Noah Smith Fumbles Argument, Endorses Post-Keynesian Endogenous Money Theory | Fixing the Economists

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