Macroeconomics MAFE502

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MacroeconomicsMAFE502

• Lecture 2 New Keynesian Macroeconomics

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New Classical Economics the salient features

• Classical Dichotomy revisited
• Expectations augmented Phillips curve NRU or
  NAIRU
• Expectations augmented AS curve
• Barro-Ricardo Equivalence proposition
• Lucas critique
• Representative agent models
• Time inconsistency proposition

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Lucas Critique (1976)

• Argues that econometric models cannot be used to
  predict the effects of proposed policy.
• Because of expectations, relationships between
  economic variables (equations) change with policy
  changes.
• Can we predict the economy at all?
• If we cannot predict, how can we employ activist
  counter cyclical policies?

1995 Nobel prize
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Representative agent

• Introduced by Lucas (1976)
• Usefulness
• Avoids the Lucas critique The impact on the
  macro model can be ascertained by recalculating
  optimization problem of the agent (in view of new
  policy)
• Provides rigorous micro foundations to
  macroeconomics
• Help build Walrasian general equilibrium models
  With heterogeneous agent this would be impossible
• James E. Hartley (1996) Retrospectives The
  origins of the representative agent, Journal of
  Economic Perspectives, 10 169-177.

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Representative agent a critique

• The absence of trade and exchange, which is
  contradicted by empirical data.
• simply ignore valid aggregation concerns, they
  usually commit the so-called fallacy of
  composition.
• The reduction of a group of heterogeneous agents
  to a representative agent is not just an
  analytical convenience, but it is "both
  unjustified and leads to conclusions which are
  usually misleading and often wrong.
• A possible alternative to the representative
  agent approach to economics could be agent-based
  simulation models which are capable of dealing
  with many heterogeneous agents.

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Time Inconsistency

• Kydland and Prescott (1977) got 2004 Nobel Prize
  for the work on the time inconsistency problem.
  
• Game theoretic contribution to the rules vs.
  discretion debate.
• The policymaker analyzes the economy and
  implements an optimal policy.
• But once the policy is implemented, if the
  policymaker re-analyzes the economy, it appears
  that the policy is no longer optimal.
• In fact, what appears to be optimal policy never
  becomes optimal policy once it is implemented.

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Time Inconsistency

• The time inconsistency problem is that the
  government will tell people that they need to use
  their own savings for retirement, but then change
  its mind when it sees that people are destitute.
  Mandatory savings accounts are the solution.

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Time inconsistency

• Kydland and Prescott (1977) show that if given an
  opportunity to re-optimize and change its plan at
  a later date, the government will generally do
  so.
• This is not rooted in conflicting objectives
  between the government and its citizens
• Nor is it due to the ability of unrestricted
  policymakers to react to unforeseen shocks.
• Instead, it is to do with private-sector
  expectations placing restrictions on the policy
  decisions.

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Time inconsistency
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Policy implications

• Active policy will not work becuase
• Anticipated (policy ineffectiveness)
• Unanticipated (cannot control the impact)
• Shocks dont persist (arent guaranteed to
  persist).
• Time inconsistency problem
• Hence there is no role for stabilization policy
• Anticipated policy can be used to control
  inflation
• Systematic money supply policy would avoid
  expectational errors that would likely move the
  economy temporarily away from full employment.
• Constant money growth rule

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Policy Ineffectiveness Proposition

• Real output and employment are unaffected by
  systematic or predictable changes in aggregate
  demand policy.
• If policy changes are systematic, therefore
  predictable, then agents will not make systematic
  mistakes in their forecasts.
• Agents recognize that mistakes are costly, and
  will seek out all available information to avoid
  such mistakes.
• They will only make mistakes when they are
  surprised.
• Unanticipated policy changes will have a short
  run impact.

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Real Business Cycle (RBC)

• The most famous New Classical model
• Representative agents with rational expectations
• Rational expectations imply neutrality of money
• Productivity (Tec) shocks ? Business cycles
  (inter-temporal substitution of goods and
  leisure)
• No involuntary unemployment
• Fiscal or monetary intervention into the economy
  will always be futile
• Any action arising from a policy rule will be
  perfectly anticipated by agents
• The government cannot improve upon market
  outcomes (Thus unanticipated policy is dangerous)

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New Classical View of Keynesian Economics

• Failure on a grand scale.
• Made up of ad hoc assumptions, not built on a
  strong foundation of rational agents.
• Must assume rational, optimizing agents.
• Must assume that markets clear.
• Keynesians do not explicitly handle expectations,
  and expectations have been shown to be critically
  important.
• Have not given explicit structural explanations
  of wage stickiness.
• How can you explain persistence in business
  cycles?

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New Keynesian Response (1)

• Persistence
• There have been and are persistent and
  substantial deviations from full employment.
  There is nothing to the persistence question.
• Unemployment in Great Britain was greater than or
  equal to 10 from 1923-1939.
• U.S. Great Depression, unemployment was greater
  than or equal to 14 for 10 years.

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New Keynesian Response (2)

• Extreme Informational Assumptions
• NKs accept that adaptive expectations are ad hoc
  and unrealistic, but
• Unconstrained REH implies unrealistically
  sophisticated agents
• Bounded rationality
• Structural impediments

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New Keynesian Response (3)

• Justify wage stickiness by using a contractual
  view of the labor market
• Okun an invisible handshake rules the labor
  market, not an invisible hand
• Agents choose to contract because it minimizes
  costs and stabilizes nominal cash flows.
• Agents may contract in overlapping contracts, and
  firms may make offers while looking at wages set
  by other firms.

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New and Old Keynesians

• Difference is the use of micro foundations
• Keynes did use micro foundations as much as
  possible
• Keynesians could not because the micro models at
  their times (50s and 60s) were based on perfect
  competition etc. Bruce and Stiglitz (1993)

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New Keynesian Economists

• Markets do not clear continuously (demand is not
  always equal to supply either in product or input
  market)
• Price do not adjust quickly enough
• Voluntary unemployment is not realistic
• Quantity adjustment is more than price adjustment

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New Keynesian Economists

• Wage and prices are sticky even with RE
• Prices are sticky because of imperfect markets
  (price searchers as opposed to price takers) and
  menu costs.
• Wages are sticky because explicit long-term labor
  contracts and implicit contracts (more senior
  workers are laid off last). The latter implies
  that workers shun risk more than employers.

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Nominal Price Rigidity
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Two approaches in New Keynesian economics

• Nominal price and wage rigidities
• The classical dichotomy breaks down
• Therefore monetary policy could have real effects

• Incomplete contracts and imperfect indexing
  (Market failures)
• These amplifies the shocks even if wages and
  prices are flexible
• Thailand is a small Economy. 30 percent real
  devaluation should ? D
• Thai exports fell after the crisis.
• Monetary policy could have real effects even with
  price flexibility

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The effect on sticky prices
AS2
ASa
AS1
Pa
P1
AD2
AD1
Yn Ya
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NCM and NKM A comparison

• Short-run output and price movements
• Stabilization policy
• The effect on Labor markets in the short-run
• Anti inflation policy

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Short-run output and price movements

• These movements are the same for unanticipated
  policy shocks for all three models. (For
  expansionary policy Y? and P?)
• For anticipated policy shocks there may be
  different short-run Y and P movements depending
  on the model being used.

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Stabilization policy NCM view

• Policy activism (the use of discretionary policy)
  will not work because
• Time inconsistency
• Anticipation of policy by the people
• The credibility problem (use rigid policy rules)
• All of the above three reasons are inter related
  and also feed on NCM idea that economy is
  inherently stable.
• When policy maker and the public are trying to
  outsmart each other the result is less stability
  rather than more.

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Stabilization policy NKM view

• Economy in inherently unstable.
• Changes in public expectation causes substantial
  economic instability
• These can be offset by stabilization policy
• The use of rigid policy is not desirable.
• Price wage stickiness means
• No credibility problem
• Y can be affected by unanticipated as well as
  actual changes in policy variables
• Policy activism can be prescribed even with RE

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Labor Markets NCM view

• Unexpected increase in AD will increase
  production Increase prices more than wages
• Increased demand will not push up wages (Elastic
  supply because competitiveness in mkt)

Labor market
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Labor Markets NKM view

• Same as NCM conclusions regarding unexpected
  policy but the high elasticity of the labor
  supply curve come from sources other than
  competition
• Involuntary unemployment because wages are higher
  then in competitive model
• Efficiency wages theory
• Insider/outsider theory

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Anti inflation policy NCM

• Government stops the growth in money
• AD will remain at AD1 and not shift to AD2
• Anti-inflation policy need not incur an output
  cost provided that
• the policy is credible
• it is anticipated.

AS1(PeP1)
P2 P2 P1
AD2
AD1
Y2 Yn
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Anti inflation policy NKM

• Government stops the growth in money
• AD will remain at AD1 and not shift to AD2
• Anti-inflation policy need not incur an output
  cost provided that
• the policy is credible
• it is anticipated.

AS2 (PeP2)
AS1(PeP1)
AS1(PeP1)
P2 P2 P1
AD2
AD1
Y2 Yn
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Conclusion

• The shift from Keynesian economics to New
  Classical Economics
• Historical factors (Stagflation)
• Theoretical factors (REH)
• Importance of Expectation, specially Rational
  expectations