New Keynesian Economics: Sticky Pricesfaculty.missouri.edu/~hedlunda/teaching/2013b/13 -...

New Keynesian Economics: Sticky Prices

Economics 3307 - Intermediate Macroeconomics

Aaron Hedlund

Baylor University

Fall 2013

Econ 3307 (Baylor University) Business Cycles Fall 2013 1 / 23

Introduction

Outline:I Background and Construction of the New Keynesian Model

I New Keynesian Business Cycle Theories

I Monetary Non-Neutrality and Fiscal and Monetary Policy

I Assessing the New Keynesian Model


Introduction

Until the late 1970s, “Old Keynesian” models were predominant.

Some lessons of “Old Keynesian” models:I The economy’s response to shocks is inefficient.

I Money is non-neutral in the short-run.

I Stabilization policy is desirable and effective.

Events of the late 1970s revealed flaws in the consensus view:I The Lucas critique: historical relationships between aggregate

variables are insufficient to predict the effects of policy changes.

I The key insight: economic agents are forward-looking and adjust theirexpectations to changes in the economic environment.


The New Keynesian Model

The RBC model avoids the Lucas critique by incorporatingmicrofoundations and rational, forward-looking agents.

The New Keynesian model takes the methodology behind the RBCmodel and adds some Keynesian elements.

The key ingredient is short-run price stickiness.

Possible reasons for price stickiness:I Menu costs (costs associated with changing prices).

I Information frictions.

I Long-term contracts that specify prices in advance.


The New Keynesian Model

The goods and money markets clear but the labor market may not.

Assume the Federal Reserve follows an interest rate targeting rule.I The Fed adjusts the money supply Ms

1 to target a real interest rate of r .

Steps to find a short-run equilibrium:1 Given r , goods market clearing determines output: Y1 = Y d

1 (r).

2 Firms produce Y1 by hiring labor N1 such that Y1 = z1F (K1,N1).

3 The real wage w1 adjusts in the labor market until workers are willingto supply N1, i.e. Ns

1(w1; r) = N1.

4 Given P1, the Fed must choose Ms1 = P1L(Y1, r) ≡ Md

1 to clear themoney market at its target of r .

F Any other Ms1 causes the money market to clear at a different r .


New Keynesian Equilibrium

w1 =

Pe

rio

d 1

Re

al W

age

N1 = Period 1 Employment

N1(w1 ;r) s

N1

w1

N1(w1) d

rm

r =

Re

al In

tere

st R

ate

Y1 = Period 1 Output

Y1 (r) d

Ym

Y1(r) s

P1

P1 =

Pri

ce L

eve

l

M1 = Period 1 Money

M1 s

M1 = P1L(Y1 ,r) d

N1

Y1

N1

Y1 = z1F(K1 ,N1)

Y1

r

Y1


Short-Run and Long-Run Equilibrium

The short-run equilibrium interest rate and output are r and Y1.I In the long run, P1 is flexible and the economy moves to rm and Ym.

I Denote rm as the natural rate of interest, Ym as potential output, andY1 − Ym as the output gap.

F The output gap can be recessionary (< 0) or inflationary (> 0).

How does the economy move from the short run to the long run?I In a recession, P1 gradually falls, causing Ms

1 6= Md1 at r and Y1.

I To clear the money market, r decreases, causing output Y d1 (r) and

demand for real money balances L(Y1, r) to increase.

I This process stops when the real interest rate is rm, output isYm = Y d

1 (rm), and Ms1 = Md

1 ≡ PmL(Ym, rm).

I Labor Nm satisfies Ym = z1F (K1,Nm), wm satisfies Ns1(wm; rm) = Nm,

and the labor market clears because Ns1(wm; rm) = Nd

1 (wm) = Nm.


Long-Run Transition from a Recessionary Gap

rm

r =

Re

al In

tere

st R

ate


Y1 (r) d

Ym

Y1(r) s

N1

Y1

N1

Y1 = z1F(K1 ,N1)

Y1

r

Y1

P1

P1 =

Pri

ce L

eve

l

M1 = Period 1 Money

M1 s

P1L(Y1 ,r)

Pm

P1L(Ym ,rm)

Nm

Ym

w1 =

Pe

rio

d 1

Re

al W

age


N1(w1 ;r) s

N1

w1

N1(w1) d

Nm

wm

N1(w1 ;rm) s


Long-Run Transition from an Inflationary Gap

rm

r =

Re

al In

tere

st R

ate


Y1 (r) d

Ym

Y1(r) s

N1

Y1

Nm

Y1 = z1F(K1 ,N1)

Ym

r

Y1

Pm

P1 =

Pri

ce L

eve

l

M1 = Period 1 Money

M1 s

P1L(Ym ,rm)

P1

P1L(Y1 ,r)

N1

Y1

w1 =

Pe

rio

d 1

Re

al W

age


N1(w1 ;rm) s

N1

w1

N1(w1) d

Nm

wm

N1(w1 ;r) s


Is Money Neutral?

Suppose the Fed increases the money supply from Ms1 to Ms

1 , causingthe money market to no longer clear at r and Y1.

Because P1 is fixed in the short run, r declines to r , increasing output

Y1 = Y d1 (r) and money demand until Ms

1 = Md1 ≡ P1L(Y1, r).

Labor N1 and the real wage w1 increase to N1 and w1, respectively,where Y1 = z1F (K1, N1) and Ns

1(w1; r) = N1.

Summary: ↓ r , ↑ Y1, ↑ C1, ↑ I1, ↑ N1, ↑ w1, ↑ Ms1 .

This policy is expansionary. In the long run, money is neutral becauseP1 adjusts until the economy returns to its flexible-price equilibrium.


Monetary Non-Neutrality

r =

Re

al In

tere

st R

ate


Y1 (r) d

Y1(r) s

N1

Y1

N1

Y1 = z1F(K1 ,N1)

Y1

r

Y1

P1

P1 =

Pri

ce L

eve

l

M1 = Period 1 Money

M1 s

M1 = P1L(Y1 ,r ) ~ ~ ~ d

M1 = P1L(Y1 ,r)

r ~

Y1 ~

Y1 ~

N1 ~ M1

s ~

w1 =

Pe

rio

d 1

Re

al W

age


N1(w1 ;r) s

N1

w1

N1(w1) d

N1 ~

w1 ~

N1(w1 ;r ) s ~


New Keynesian Business Cycles

Monetary policy shocks (fluctuations in targeted r) as a possiblesource of business cycles:

I Lower r increases Y1 = Y d1 (r) because of higher C1(Y1; r) and I1(r).

I Labor and wages increase until Y1 = z1F (K1,N1) and N1(w1; r) = N1

but labor productivity Y1/N1 decreases because of diminishing MPN .

I Money demand Md1 = P1L(Y1, r) increases, requiring the Fed to

increase Ms1 to clear the money market at its lower target.

I Summary: ↓ r ⇒↑ Ms1 , ↑ Y1, ↑ C1, ↑ I1, ↑ N1, ↑ w1, and ↓ Y1/N1.

Data vs. Predictions of NK Monetary Policy Shocks

Data Model

Consumption Procyclical Procyclical

Investment Procyclical Procyclical

Price Level Countercyclical Acyclical

Money Supply Procyclical Procyclical

Employment Procyclical Procyclical

Real Wage Procyclical Procyclical

Average Labor Productivity Procyclical Countercyclical



“Demand shocks” (fluctuations in future TFP, z2) as a possiblesource of business cycles, assuming monetary policy holds r constant:

I Higher z2 increases MPN and MPK next period, resulting in higherI1(r) and C1(Y1; r) and thus a shift to the right of Y d

1 (r).

I Output Y1 = Y d1 (r) increases, labor and wages increase until

Y1 = z1F (K1,N1) and Ns1(w1; r) = N1, and the Fed must increase Ms

1

to ensure that the money market clears at the target of r .

I Summary: ↑ z2 ⇒↑ Y1, ↑ C1, ↑ I1, ↑ N1, ↑ w1, ↑ Ms1 , and ↓ Y1/N1.

Data vs. Predictions of NK “Demand Shocks”

Data Model

Consumption Procyclical Procyclical

Investment Procyclical Procyclical

Price Level Countercyclical Acyclical

Money Supply Procyclical Procyclical

Employment Procyclical Procyclical

Real Wage Procyclical Procyclical

Average Labor Productivity Procyclical Countercyclical



Productivity shocks (fluctuations in z1) as a possible source ofbusiness cycles, assuming monetary policy holds r constant:

I Higher z1 causes no change in output Y1 = Y d1 (r) because the output

demand curve does not shift.

I Employment decreases because fewer workers are needed to producethe same output. Therefore, wages also decrease.

I Money demand does not shift, and therefore the Fed need not changeMs

1 to hit its target of r .

This theory is strongly at odds with the data, given our monetarypolicy assumption.

Because Y s1 (r) increases but Y1 = Y d

1 (r) is unchanged, an outputgap appears. The Fed may actually want to lower r in booms andraise r in busts. It matters how monetary policy is specified!


Efficiency and Policy in the New Keynesian Model

Recall from the First Welfare Theorem that, under certain conditions,a competitive equilibrium is Pareto optimal (efficient).

In the New Keynesian model, the economy is inefficient because thelabor market may not clear in the short run.

During a recession, the government has three options:I Do nothing: the economy gradually moves to its flexible price

equilibrium as P1 falls, r falls, and Y1 increases.

I Monetary policy: the Fed lowers r to rm by expanding Ms1 , causing Y1

to increase without requiring a gradual decline in P1.

I Fiscal policy: an increase in G1. What are the effects of this policy?


Fiscal Policy in the New Keynesian Model

Assume the Fed maintains its target r and adjusts Ms1 as needed.

As in the real intertemporal model, an increase in G1 by ∆G shiftsY d1 (r) to the right by ∆G and thus Y1 = Y1 + ∆G .

Higher G1 requires higher taxes (now or later), increasing labor supplyto N1(w1; r) and increasing output supply to Y s

1 (r).

Labor and wages satisfy Y1 = z1F (K1, N1) and Ns1(w1; r) = N1.

Higher Y1 increases Md1 = P1L(Y1, r), requiring the Fed to increase

Ms1 to ensure money market clearing at the targeted level of r .

Summary: ↑ Y1, ↑ N1, ↑ Ms1 , no change in C1 or I1, and an

ambiguous change in w1.


Expansionary Fiscal Policy

r =

Re

al In

tere

st R

ate


Y1 (r) d

Y1(r) s

N1

Y1

N1

Y1 = z1F(K1 ,N1)

Y1

Y1

P1

P1 =

Pri

ce L

eve

l

M1 = Period 1 Money

M1 s

M1 = P1L(Y1 ,r) ~ ~ d

M1 = P1L(Y1 ,r)

r

Y1 = Y1 + ΔG ~

Y1 ~

N1 ~ M1

s ~

w1 =

Pe

rio

d 1

Re

al W

age


N1

w1

N1(w1) d

N1 ~

w1 ~

N1(w1 ;r ) s

N1(w1 ;r) s ~

Y1(r) s Y1 (r)

d ~ ~


Fiscal Policy vs. Monetary Policy

Fiscal policy and monetary policy are both able to bring the economyto its flexible-price equilibrium where Y d

1 = Y s1 .

However, the composition of the increase in output differs.I With monetary policy, the entire increase in Y1 comes from higher C1

and I1 because of lower r .

I With fiscal policy, the entire increase in Y1 comes from higher G1.

Because of implementation lags, fiscal policy is usually less effective.

However, when r ≈ 0, the economy may be in a liquidity trap,making monetary policy ineffective.


Liquidity Traps

When r = 0, money and savings are perfect substitutes because theyhave the same rate of return.

Money demand is therefore perfectly elastic at r = 0.

Increasing Ms1 no longer lowers r or stimulates higher Y1.

P1

P1 =

Pri

ce L

eve

l

M1 = Period 1 Money

M1 s

M1 = P1L(Y1 ,0)

r =

Re

al In

tere

st R

ate


Y1 (r) d

Y1(r) s

Y1

r = 0


Policy Options During Liquidity Traps

Other monetary policy options during liquidity crises:I Quantitative easing: the Fed purchases mortgages and other assets

to lower long-term interest rates.F Thus far, we have modeled economies with only one real interest rate,

but in reality, there are many different assets and interest rates.

F Quantitative easing might also alleviate credit frictions.

I Commitment to future low rates to alter inflation expectations.F The zero lower bound on interest rates actually applies to R, not r .

Therefore, increasing i allows R = r + i = 0 and r < 0.

Possible issues:I The policies may have only a limited effect on long-term rates or

troubled credit markets.

I Higher inflation expectations are usually bad, putting the Fed in atricky place if and when inflation increases in the future.


Policy Options During Liquidity Traps

Fiscal policy can also be used during a liquidity trap to increaseoutput without requiring a decrease in r .

The U.S. tried this in the 2008 – 2009 recession and Japan tried thisin the 1990s.

Possible issues:I Policy lags may mean higher G1 (or lower taxes in a non-Ricardian

world) are too little, too late.

I To be effective, the size of the fiscal expansion may need to be verylarge, resulting in much higher government debt.

I If government debt becomes so high as to cause investors to fear asovereign default, borrowing interest rates will increase.


Quantitative Easing During the 2008 – 2009 Recession


Assessing the New Keynesian Model

Empirical evidence confirms short-run price stickiness at the individualfirm level.

There is a positive correlation between money supply and output,which may indicate short-run monetary non-neutrality.

I Correlation is not causation. Plus, there may be reverse causality withthe Fed responding to changes in output by changing the money supply.

Evaluating the performance of the NK vs. RBC models is difficultbecause monetary policy affects the dynamics of the NK model.

I Because monetary policy is endogenous, i.e. ‘chosen’ by the Fed inresponse to economic events, it is difficult to deal with double causality.

Business cycle research is a very active subfield of macroeconomicswith several competing theories and an ongoing race for better theory,data, and empirical methods...


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