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New Keynesian economics is a school of contemporary macroeconomics that strives to provide microeconomic foundations for Keynesian economics. Macroeconomics is a branch of Economics that deals with the performance structure and behavior of a national or regional Economy as a whole In economics the term microfoundations refers to the microeconomic analysis of the behavior of individual agents such as households or firms that underpins a In Economics Keynesian economics (ˈkeɪnziən also Keynesianism and Keynesian Theory) is based on the ideas of twentieth-century British economist It developed partly in response to the New Classical school's criticisms of earlier versions of Keynesian macroeconomics. New classical macroeconomics emerged as a school in Macroeconomics during the 1970s Both New Classical economics and New Keynesian economics usually assume that households and firms have rational expectations. Rational expectations is an assumption used in many contemporary macroeconomic models, and also in other areas of contemporary Economics and Game theory The main difference between these schools is that the New Keynesians assume wages and prices cannot be adjusted instantly, which implies that the economy may fail to attain full employment. In Macroeconomics, full employment is when all people looking for employment can find a job Because of this market failure, and other market imperfections considered in their models, New Keynesian economists argue that demand management by the government or its central bank can lead to more efficient macroeconomic outcomes than laissez faire policy would. A central bank, reserve bank, or monetary authority is the entity responsible for the Monetary policy of a country or of a group of member states Laissez-faire ( pronunciation: French,; English,) is a French phrase literally meaning Let do (“allow to do” However, New Keynesian economics is somewhat more skeptical of the benefits of activist policies than traditional Keynesian economics was. In Economics Keynesian economics (ˈkeɪnziən also Keynesianism and Keynesian Theory) is based on the ideas of twentieth-century British economist

Key early contributions to New Keynesian theory were compiled in 1991 by editors N. Gregory Mankiw and David Romer in New Keynesian Economics, volumes 1 and 2. Nicholas Gregory "Greg" Mankiw (mæŋˈkjuː (born February 3, 1958) is an American macroeconomist. [1] The papers in these volumes focused mostly on microfoundations, that is, microeconomic ingredients that could produce Keynesian macroeconomic effects, and did not yet attempt to construct complete macroeconomic models. In economics the term microfoundations refers to the microeconomic analysis of the behavior of individual agents such as households or firms that underpins a A model in Macroeconomics is a logical mathematical and/or computational framework designed to describe the operation of a national or regional economy and especially the Since that time, macroeconomists have begun to study complete dynamic stochastic general equilibrium (DSGE) models with Keynesian features. Dynamic stochastic general equilibrium modeling (abbreviated DSGE or sometimes DGE) is a branch of applied General equilibrium theory that is increasingly The New Keynesian DSGE modeling methodology is explained in Michael Woodford's textbook Interest and Prices: Foundations of a Theory of Monetary Policy. Michael Dean Woodford is an American macroeconomist who currently teaches at Columbia University [2] Economists are now actively estimating quantitative models of this type for use in studying optimal monetary and fiscal policy.

Contents

Microfoundations of price stickiness

A commonly used explanation that New Keynesians use to explain why prices adjust slowly is “menu costs”. In Economics, menu costs are the costs to firms of updating menus price lists brochures and other materials when prices change in an economy This is saying that the reason firms do not change their prices immediately is due to the costs that they must incur in order to do so. For instance, the cost of making a new catalog, price list, or menu is considered menu costs. Even though such a cost seems minor, New Keynesians explain how it can cause short-run fluctuations. Not only do the firms have to pay to change the price, but also, according to N. Gregory Mankiw, there are also externalities that go along with changing prices. Nicholas Gregory "Greg" Mankiw (mæŋˈkjuː (born February 3, 1958) is an American macroeconomist. [3] As Mankiw describes, a firm that lowers its prices because of a decrease in the money supply will be raising the real income of the customers of that product. This will allow the buyers to purchase more, which will not necessarily be from the firm that lowered their prices. As firms do not receive the full benefit from reducing their prices their incentive to adjust prices in response to macroeconomic events is reduced.


Recent studies (e. g. Golosov and Lucas)[4] find that the size of the menu cost needed to match the micro-data of price adjustment is implausibily large to justify the menu-cost argument.

Other microeconomic ingredients

Besides sticky prices, another market imperfection built into most New Keynesian models is the assumption that firms are monopolistic competitors. Monopolistic competition is a common Market form. Many markets can be considered monopolistically competitive often including the markets for Restaurants, Cereal [5] In fact, without some monopoly power it would make no sense to assume sticky prices, because under perfect competition, any firm with a price slightly higher than the others would be unable to sell anything, and any firm with a price slightly lower than the others would be obliged to sell much more than they can profitably produce. In Neoclassical economics and Microeconomics, perfect competition describes a market in which no buyer or seller has Market power. Therefore, New Keynesian models assume instead that firms use their market power to maintain their prices above marginal cost, so that even if they fail to set prices optimally they will remain profitable. In Economics, market power is the ability of a firm to alter the Market price of a good or service In Economics and Finance, marginal cost is the change in Total cost that arises when the quantity produced changes by one unit Many macroeconomic studies have estimated typical firms' degree of market power, so this information can be used in parameterizing New Keynesian models.

Other microeconomic elements that appear in some New Keynesian models (though not so commonly as sticky prices and imperfect competition) include the following.

New Keynesian DSGE models

After the pioneering work, surveyed in the Mankiw and Romer volumes, on what types of microeconomic ingredients might produce Keynesian macroeconomic effects, economists began putting these pieces together to construct macroeconomic models. Moral hazard is the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk In Economics, search theory (or just search) is the study of an individual's optimal strategy when choosing from a series of potential opportunities A model in Macroeconomics is a logical mathematical and/or computational framework designed to describe the operation of a national or regional economy and especially the These models describe the decisions of households, monopolistically competitive firms, the government or central bank, and sometimes other economic agents. In Economics, an agent is an actor in a model that (generally solves an optimization problem The monopolistic firms are assumed to face some type of price stickiness, so each time firms adjust their prices, they must bear in mind that those prices are likely to remain fixed longer than they would like. Many models assume wages are rigid too. Total output is determined by households' purchases, which depend on the prices of the firms. Since macroeconomic behavior is derived from the interaction of the decisions of all these players, acting over time, in the face of uncertainty about future conditions, these models are classified as dynamic stochastic general equilibrium (DSGE) models. Dynamic stochastic general equilibrium modeling (abbreviated DSGE or sometimes DGE) is a branch of applied General equilibrium theory that is increasingly The parameters of the model are usually estimated or chosen to make the model's dynamics resemble the actual macroeconomic data from the country or region under study. This modeling methodology is surveyed in Woodford (2003), op. cit.

Policy implications

New Keynesian economists fully agree with New Classical economists that in the long run, changes in the money supply are neutral. New classical macroeconomics emerged as a school in Macroeconomics during the 1970s In Economics, money supply, or money stock, is the total amount of money available in an Economy at a particular point in time In Economics, neutrality of money is the idea that a change in the stock of Money affects only nominal variables in the economy such as Prices However, because prices are sticky in the New Keynesian model, an increase in the money supply (or equivalently, a decrease in the interest rate) does increase output and lower unemployment in the short run.

Nonetheless, New Keynesian economists do not advocate using expansive monetary policy just for short run gains in output and employment, because doing so would raise inflationary expectations and thus store up problems for the future. Instead, they advocate using monetary policy for stabilization. A stabilization policy is a package or set of measures introduced to stabilise a financial system or economy. That is, suddenly increasing the money supply just to produce a temporary economic boom is a bad idea (because eliminating the increased inflationary expectations will be impossible without producing a recession). But when the economy is hit by some unexpected external shock, it may be a good idea to offset the macroeconomic effects of the shock with monetary policy. This is especially true if the unexpected shock is one (like a fall in consumer confidence) which tends to lower both output and inflation; in that case, expanding the money supply (lowering interest rates) helps by increasing output while stabilizing inflation and inflationary expectations.

Studies of optimal monetary policy in New Keynesian DSGE models have focused on interest rate rules (especially 'Taylor rules'), specifying how the central bank should adjust the nominal interest rate in response to changes in inflation and output. The Taylor rule is a modern Monetary policy rule proposed by Economist John B In finance and economics nominal interest rate or nominal rate of interest refers to the rate of Interest before adjustment for inflation (in contrast with the In economics inflation or price inflation is a rise in the general level of prices of goods and services over a period of time (More precisely, optimal rules usually react to changes in the output gap, rather than changes in output per se. The GDP gap or the Output gap is the difference between Potential GDP and Actual GDP or actual output ) In some simple New Keynesian DSGE models, it turns out that stabilizing inflation suffices, because maintaining perfectly stable inflation also stabilizes output and employment to the maximum degree desirable. Blanchard and Galí have called this property the 'divine coincidence'. [11] However, they also show that in models with more than one market imperfection (for example, frictions in adjusting the employment level, as well as sticky prices), there is no longer a 'divine coincidence', and instead there is a tradeoff between stabilizing inflation and stabilizing employment. [10]

Relation to other macroeconomic schools

Over the years, a sequence of 'new' macroeconomic theories related to Keynesianism have been influential. In Economics Keynesian economics (ˈkeɪnziən also Keynesianism and Keynesian Theory) is based on the ideas of twentieth-century British economist After World War II, Paul Samuelson used the term neoclassical synthesis to refer to the integration of Keynesian economics with neoclassical economics. World War II, or the Second World War, (often abbreviated WWII) was a global military conflict which involved a majority of the world's nations, including Paul Anthony Samuelson (born May 15, 1915) is an American neoclassical Economist known for his contributions to many fields of Neoclassical synthesis refers to a postwar academic movement in Economics which attempted to absorb the Macroeconomic thought of John Maynard Keynes into Neoclassical economics is a term variously used for approaches to Economics focusing on the determination of prices outputs and income distributions in markets The idea was that the government and the central bank would maintain rough full employment, so that neoclassical notions—centered on the axiom of the universality of scarcity—would apply. Neoclassical economics is a term variously used for approaches to Economics focusing on the determination of prices outputs and income distributions in markets Scarcity (also called paucity) is the problem of Infinite human needs and Wants, in a world of Finite Resources In other John Hicks' IS/LM model was central to the neoclassical synthesis. Sir John Richard Hicks ( April 8, 1904 May 20, 1989) was one of the most important and influential Economists and Religious Inclusivists The IS/LM model, first developed by Sir John Hicks and Alvin Hansen, has been used from 1937 onwards to summarize a major part of Keynesian

Later work by economists such as James Tobin and Franco Modigliani involving more emphasis on the microfoundations of consumption and investment was sometimes called neo-Keynesianism . James Tobin ( March 5, 1918 March 11, 2002) was an American Economist. Franco Modigliani ( Rome, June 18, 1918 – September 25, 2003) was an Italian-American Economist at the In economics the term microfoundations refers to the microeconomic analysis of the behavior of individual agents such as households or firms that underpins a John Maynard Keynes provided the framework for synthesizing a host of economic ideas present between 1900 and 1940 and that synthesis bears his name It is often contrasted with the post-Keynesianism of Paul Davidson, which emphasizes the role of fundamental uncertainty in economic life, especially concerning issues of private fixed investment. Post Keynesian economics is a school of thought with its origins in The General Theory of John Maynard Keynes, although its subsequent development was influenced Paul Davidson (b 1930 New York is an American Macroeconomist who has been one of the leading spokesmen of the American branch of the Post Keynesian Uncertainty is a term used in subtly different ways in a number of fields including Philosophy, Statistics, Economics, Finance, Insurance Fixed investment in Economics refers to investment in Fixed capital, i

New Keynesianism, associated with Gregory Mankiw, David Romer, Olivier Blanchard, Jordi Galí, and Michael Woodford, is a response to Robert Lucas and the new classical school. Nicholas Gregory "Greg" Mankiw (mæŋˈkjuː (born February 3, 1958) is an American macroeconomist. Olivier Jean Blanchard (born December 27, 1948, Amiens, France) is currently the Class of 1941 Professor of Economics at MIT Jordi Galí (born January 4, 1961, Barcelona, Spain) is a Catalan macroeconomist who is regarded as one of the main figures Michael Dean Woodford is an American macroeconomist who currently teaches at Columbia University Robert Emerson Lucas Jr (born September 15, 1937, Yakima Washington) is an American Economist at the University of Chicago New classical macroeconomics emerged as a school in Macroeconomics during the 1970s That school criticized the inconsistencies of Keynesianism in light of the concept of "rational expectations. Rational expectations is an assumption used in many contemporary macroeconomic models, and also in other areas of contemporary Economics and Game theory " The new classicals combined a unique market-clearing equilibrium (at full employment) with rational expectations. In Economics, market clearing refers to either a simplifying assumption made by the new classical school that Markets always In Macroeconomics, full employment is when all people looking for employment can find a job The New Keynesians use "microfoundations" to demonstrate that price stickiness hinders markets from clearing. Thus, the rational expectations-based critique does not apply.

Whereas the neoclassical synthesis hoped that fiscal and monetary policy would maintain full employment, the new classicals assumed that price and wage adjustment would automatically attain this situation in the short run. Fiscal policy, taking the scope of Budgetary policy, refers to government policy that attempts to influence the direction of the economy through changes in government taxes Monetary policy is the process by which the Government, Central bank, or monetary authority of a country controls (i the Supply of Money, In Macroeconomics, full employment is when all people looking for employment can find a job New classical macroeconomics emerged as a school in Macroeconomics during the 1970s The new Keynesians, on the other hand, see full employment as being automatically achieved only in the long run, since prices are "sticky" in the short run. Government and central-bank policies are needed because the "long run" may be very long.

References

  1. ^ N. Gregory Mankiw and David Romer, eds. , (1991), New Keynesian Economics. Vol. 1: Imperfect competition and sticky prices, MIT Press, ISBN 0-262-63133-4. Vol. 2: Coordination Failures and Real Rigidities. MIT Press, ISBN 0-262-63133-2.
  2. ^ Michael Woodford (2003), Interest and Prices: Foundations of a Theory of Monetary Policy. Princeton University Press, ISBN 0691010498.
  3. ^ N. Gregory Mankiw (1985), 'Small menu costs and large business cycles: a macroeconomic model of monopoly'. Quarterly Journal of Economics 100, pp. 529-39. Reprinted as Ch. 1 of Mankiw and Romer, op. cit.
  4. ^ Mikhail Golosov and Robert E. Lucas, Jr. (2003), 'Menu costs and Phillips curves'. National Bureau of Economic Research Working Paper #10187, Cambridge, Mass.
  5. ^ Olivier Blanchard and Nobuhiro Kiyotaki (1987), 'Monopolistic competition and the effects of aggregate demand'. American Economic Review 77, pp. 647-66. Reprinted as Ch. 13 of Mankiw and Romer, op. cit.
  6. ^ Ben Bernanke and Mark Gertler (1989), 'Agency costs, net worth, and business fluctuations'. American Economic Review 79, pp. 14-31.
  7. ^ Nobuhiro Kiyotaki and John H. Moore (1997), 'Credit cycles'. Journal of Political Economy' 105 (2), pp. 211-48.
  8. ^ Russell Cooper and Andrew John (1988), 'Coordinating coordination failures in Keynesian models'. Quarterly Journal of Economics 103, pp. 441-63. Reprinted as Ch. 16 of Mankiw and Romer, op. cit.
  9. ^ Carl Shapiro and Joseph Stiglitz (1984), 'Equilibrium unemployment as a worker discipline device'. Quarterly Journal of Economics 74, pp. 433-44.
  10. ^ a b Olivier Blanchard and Jordi Galí (2007), 'A New Keynesian model with unemployment'. CFS working paper 2007/08, Center for Financial Studies, Goethe University, Frankfurt.
  11. ^ Olivier Blanchard and Jordi Galí (2007), 'Real wage rigidities and the New Keynesian model'. Journal of Money, Credit, and Banking supplement to vol. 39 (1), pp. 35-65.

See also

External links

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