Chapter 17

1. Chapter 17 New Classical Macro andNew Keynesian Macro

2. The Development of Macroeconomics The development of new theories and the abandonment of old theories often occur in response to major macroeconomic development In the 1930s, the Great Depression spurred the Keynesian revolution Keynesian thought dominated macroeconomics until significant inflation emerged in the late 1960s and brought about the monetarist “counterrevolution” Since the early 1970s, macroeconomics has been split between two basic explanations of business cycles New Classical Macroeconomics New Keynesian Economics

3. The “Fooling Model” In 1967, Milton Friedman developed a model ofthe economy where all markets clear contin-uously, but there is imperfect information Firms always know the current value of P, but workersonly learn the actual price level with a time lag Suppose there is an increase in AD Higher AD boosts prices encouraging firms to increase output. Nominal wages also rise, but not as quickly as the price level Because workers do not realized that their real wage has fallen, they are willing to work more in response to AD When workers realize that their nominal wages did not keep up with the price level (i.e. that they were “fooled”), they demand higher wages shifting back AS Implication: Business cycles happen only because workers are fooled

4. Other Versions of the Fooling Model The Fooling Model obeys the Natural Rate Hypothesis, which states that shifts in AD have no long-run effect on real GDP Edmund Phelps developed a similar modelto Friedman’s where both firms and workerswere fooled by a general rise in P In another model, turnover unemploymentis reduced (thus boosting output) when workers stay with their own firms when receiving wage increases not realizing that all wages have risen

5. The Lucas Model The Lucas Model (named after Robert Lucas) has three basic assumptions: Markets clear There is imperfect information There are Rational Expectations, which are expectations that need not be correct, but must make the best use of available information, avoiding errors that could have been foreseen by knowledge of history Suppose there is a “price surprise” Firms cannot distinguish between an increase in their own price vs. an increase in the general price level Firms respond to a higher price by increasing output and employment (and thus wages) If firms discover that the “price surprise” was a general increase in the price level, they reduce their output and wages back to their original levels Implication: Anticipated monetary policy cannot change real GDP in a regular and predictable way. This is the Policy Ineffectiveness Proposition

6. The Real Business Cycle Model The problem with the Fooling Model and the Lucas model is the easily available aggregate price information that makes it unlikely that imperfect information is the only source of business cycles The Real Business Cycle (RBC) model explains business cycles in output and employment as being caused by technology or supply shocks

7. Figure 17-1 Effect of an Adverse Supply Shock on Output and Employment in the Real Business Cycle Model

8. Criticisms of RBC models Although technology may advance at an irregular pace, there is no retreat in technological progress to explain recessions Big recessions require big supply shocks RBC models imply that prices should fluctuate positively with output, but sometimes prices rise during recessions RBC models imply that real wages are procyclical, however the statistical evidence suggests there is no systematic movement of real wages

9. International Perspective Productivity Fluctuations in the United States and Japan

10. The 2007-09 Crisis and the RBC model The Great Depression has always been an embarrassment for RBC model advocates Massive U in 1930’s implied to be voluntary 1929-33 decline in Y implied to be due to massive adverse supply shock 2007-09 Crisis poses similar problem No massive adverse supply shock Productivity actually improved 2009-10 Instead, both crises caused by massive demand shocks!

11. Contributions of New Classical Macro What are the attractions of new classical theory to economists? The assumption of rational expectations requires that people do not repeat mistakes It also provides microeconomic foundations to macroeconomic theory Many of the ideas developed by new classical economists have been applied successfully to financial markets where continuous market clearing is a reasonable assumption Greater understanding of economic policy New techniques of analysis developed have had a pervasive effect on economic research

12. The New Keynesian Economics New and old Keynesian models are Non-Market Clearing models Wage-setting occurs in labor markets Price-setting occurs in product markets The New Keynesian Economics explains both nominal rigidity in prices and wages as well as real rigidities in real wages and relative prices Nominal rigidities can arise from menu costs or staggered contracts Real rigidities are explained by the efficiency wage model The difference between new and old Keynesian models is that the new approach attempts to explain the microeconomic foundations of slow adjustment of both wages and prices and assumes rational expectations

13. Figure 17-2 The Price-Setting Decision of a Monopolist

14. Figure 17-3 The Price-Setting Choice of a Monopolist Facing a Decline in Demand

15. The Effect of Small Rigidities A Menu Cost is any expense associated with changing prices, including the cost of printing new menus or distributing new catalogs A Macroeconomic Externality is a cost incurred by society as a result of a decision by an individual worker or firm A Coordination Failure occurs when there is no private incentive for firms to act together to avoid actions that impose social costs on society

16. Long Term Labor Contracts as a Source of the Business Cycle Long term labor contracts are agreements between firms and workers that set the level of nominal wage rates for a year or more Unions represent about 10% of the U.S. labor force Union set wages patterns for non-union workers too Cost-of-Living Agreements (COLAs) provide for automatic increase in the wage rate in response to an increase in the price level Result: Long term contracts are an important source of wage stickiness

17. Assessment of the New Keynesian Approach The new Keynesian approach solves the main dilemma of earlier business cycle models studied. That is, it explains observed business cycles without: Assuming away output fluctuations Assuming complete wage rigidity Requiring imperfect information Assuming procyclical wages. Criticisms of the new Keynesian approach: It provide too many reasons why wages and prices are sticky. Empirical testing of this approach is still in its infancy.

18. Dynamic Stochastic General EQM (DSGE) Models DSGE models combine aspects of both New Classical and New Keynesian macroeconomics “Dynamic” refers to explicit modeling of time “Stochastic” refers to any model with random variables “General Equilibrium” refers to any model that explains the whole economy (instead of only part of it) DSGE models are generally first taught in graduate school because of their mathematical complexity