New Keynesian Economics

New Keynesian Economics

  • Founded with an attempt to build microeconomic foundations for Keynesian economics
    • Particularly sticky wages and prices
    • Why are changes in aggregate price level sticky?
    • Why don’t price changes mimic changes in nominal GNP?
    • Regards the choices of monopolistically competitive firms that set their individual prices to accept the level of real sales as a constraint.
      • Firms do not assume that marginal costs will move in parallel with aggregate demand
    • What are sticky wages and prices, exactly?
      • Sticky wages are when worker’s earnings don’t adjust quickly to changes in labor market conditions. (ex. Wages won’t go down in a recession and rise in an expansion. Instead we experience unemployment in recessions)
      • Sticky prices are when prices do not respond immediately to changing economic conditions. Haircuts have a sticky price, while gas prices do not.
    • Believe that many markets are imperfectly competitive and have a degree of monopoly power
      • Businesses have the opportunity to be more flexible with pricing
    • Believe RIR differ from nominal IR (like the monetarists?)
    • Recognize necessity for monetary and fiscal policy
    • Heavy reliance on DSGE models
      • Taylor rule: optimal interest rates given the given rate of inflation and the output gap
      • Hit target inflation and you will have optimum growth and employment (hello Janet Yellen)
    • Reasons for sticky prices:
    • Staggering of prices. Firms may respond to changing prices slowly. If one firm cuts price of raw materials, it may take a few months for retailers to pass this cost saving onto consumers.
    • Demand is inelastic in imperfect competition, there is no incentive to cut prices as revenue falls.
    • Reducing prices can increase real incomes for consumers, which might be spent on other goods (firm doesn’t benefit)
  • Reasons for sticky wages:
    • Trade unions resist wage cuts for their workers.
  • Workers are mainly concerned about their wage, and not the overall level of employment
  • Cutting wages may reduce worker morale and reduce productivity.