The New Keynesian Synthesis

1. The New Keynesian Synthesis By David Romer Presented by: Matt Sheahan, Matt Rudquist, Dan Becker

2. Background • Departure from Keynesian macroeconomics • Widespread involuntary unemployment • Aggregate demand was a central source of short-run aggregate economic activity • Neoclassical Synthesis • Blamed sluggish nominal wage • Classical dichotomy failed • Remainder was Walrasian

3. Background • Split into two schools of thought • Real Business Cycle Theory • Deny involuntary unemployment and failure of classical dichotomy • New Keynesian Macroeconomics • Aimed to correctly define the microeconomy to better understand the macroeconomy • Looked for small departures from prevailing beliefs that had large effects

4. Nominal Frictions • Barriers to full price flexibility • It is costly to inform customers about nominal price changes because they are usually left unchanged • Firms choose to leave prices unchanged

5. What are the Frictions? • Expressing price nominally • Firms choose nominally ridged pricing policies • Menu Costs • Price-setters deciding to change price

6. Frictions / Inflation • High Inflation • Prices adjusted often • Optimal price-setters • Consumers put less importance on nominal prices • Low Inflation • Adjust Slower • Nominal Shocks are smaller with high inflation

7. Real Rigidities • Issue: can small frictions cause nominal disturbances to have large effects on the aggregate economy? • If incentive is small, firms may not adjust prices to reduction in output • If incentive is high, all firms will adjust prices due to reduction in output

8. Real Rigidities • Function of 2 factors: impact of profit maximizing real price and cost to firm of departure from it real maximizing price • Real rigidity is low when incentive to change price is high, and high when incentive to change price is high

9. Sources of Real Rigidity • Thick Market Externalities • Capital Market Imperfections form Imperfect Information • Cyclical Behavior of Demand Elasticity in Goods Market • No Evidence of Real Wages being Procyclical

10. Welfare (New Keynesian Model) • There is asymmetry between demand driven booms and recessions. • Economy is operating below social optimum as MC is below price. • Therefore, an increase in output increases welfare and a decrease in output decreases welfare.

11. Welfare (New Keynesian Model) • A firms decision to raise price above the normal price level impacts aggregate price and aggregate demand. • If all firms cut Prices to respond to the decreased aggregate demand output does not fall. • However firms incentive to reduce price is often low. • A fall in aggregate demand could lead to a recession if prices remain unchanged.

12. Welfare (New Keynesian Model) • Other similar inefficiencies can also to a recession. Example- efficiency wages • Firms can also create externalities that impact the volatility of output. Example- holding prices stable during demand shifts.

13. Coordination Failure • Coordination Failure occurs when firms fail to coordinate decision making and must, therefore, settle for a less efficient equilibrium • Example- Real rigidity might be so strong that a negative demand shock could cause a firm to raise its price and cut output even more.

14. Coordination Failure If government wishes to intervene to prevent coordination failure they must aim to push output to a point above A.

15. Directions of Research • Frictions themselves • Pricing policies of firms • Timing of change in prices (fixed time rather than change in aggregate demand) • Barriers to price adjustment • Real Rigidities • existence of factors that affect employment hours and changes in real wages, not only prices • Examine the macroeconomic evidence concerning the effects of monetary and other aggregate demand disturbances.

17. Questions?