New Keynesian School

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New Keynesian School

• Nominal Rigidities

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Nominal Rigidities

• Some Keynesian models rely on the failure of
  nominal wages and prices to adjust to their new
  market clearing levels following an aggregate
  demand disturbance.
• These models typically concentrate on the labor
  market and nominal wage stickiness to explain the
  tendency of market economies to depart from full
  employment equilibrium.

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Saved by the Bell..

• Fischer (1977) and Phelps and Taylor (1977)
  showed that nominal disturbances were capable of
  producing real effects in models incorporating
  rational expectations, providing the assumption
  of continuously clearing markets was dropped.
• This means that the acceptance of rational
  expectations did not mean the end of Keynesian
  economics.

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Nominal Rigidities Long Term Wage Contracts

• In developed markets, wages are not determined in
  spot markets.
• Rather, wages tend to be set for an agreed period
  in the form of an explicit (or implicit)
  contract.
• The existence of these contracts can generate
  sufficient nominal wage rigidity for monetary
  policy to be effective.

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Long Term Contracts

• These models assume that economic agents
  negotiate contracts in nominal terms for periods
  longer than the time it takes the monetary
  authority to react to changing economic
  circumstances.
• Monetary policy, therefore, can have real effects
  in the short run, but will be neutral in the long
  run.

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Long Term Contracts
The initial equilibrium occurs at point A. An
unexpected nominal demand shock such as a drop in
velocity causes aggregate demand to shift from
AD0 to AD1. If prices are flexible but nominal
wages equal W0 and are set by contract in the
previous period, the economy moves to point
B. Output falls from YN to Y1. If nominal wages
were flexible, SAS(W0) would shift to SAS(W1) to
re-establish the natural rate of output at point
C.
LAS
P
SAS(W0)
SAS(W1)
A
P0
B
P1
C
AD0
AD1
0
Y1 YN Y
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Long Term Contracts

• Summary
• The existence of long term contracts prevents the
  rapid establishment of equilibrium at point C and
  provides the monetary authority with an
  opportunity to expand the money supply, which,
  even if anticipated, shifts the AD curve to the
  right and re-establishes equilibrium at point A.
• If the central bank is free to act while workers
  are not, there is room for demand management,
  because the fixed nominal wage gives the central
  bank influence over the real wage and hence
  employment and output.

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Long Term Contracts

• Why are long term contracts formed if they
  increase macroeconomic instability?
• There are private advantages to both firms and
  workers
• Wage negotiations are costly in time for both
  workers and firms.
• The potential for wage negotiations to break down
  always exists, increasing the risk of a strike.
• Decreasing wages following a negative shock may
  reduce the firms wage relative to other firms
  and increase labor turnover.

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Long Term Contracts Criticisms

• The existence of such contracts is not explained
  from solid microeconomic principles.
• The models predict that monetary expansion
  increases employment by lowering the real wage,
  but real wages do not appear to be
  counter-cyclical in the real world.
• Research switched to explaining business cycles
  by rigidities in the goods market.

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Nominal Rigidities Real Goods Market

• When firms face a downward sloping demand curve,
  price reductions increase sales but also result
  in less revenue per unit sold.
• However, if the drop in profits is not
  substantive compared to the cost of changing
  prices, the presence of even small costs to price
  adjustment can generate considerable aggregate
  nominal price rigidity.
• The presence of frictions or barriers to price
  adjustment are known as menu costs.
• Examples of menu costs include the physical costs
  of resetting prices and expensive management time
  used in the supervision and renegotiation of
  purchase and sales contracts with suppliers and
  customers.

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Menu Costs

• The key insight of this model is that the private
  cost of nominal rigidities to the individual firm
  is much smaller than the macroeconomic
  consequences of such rigidities.

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Background Definitions

• Profit maximization rule
• Produce where marginal cost equals marginal
  revenue.
• Marginal revenue is the revenue received from
  producing the next unit of output.
• Marginal cost is the cost associated with
  producing the next unit of output.

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Background MR MC

• When a firm produces at the point where marginal
  revenue equals marginal cost, every unit of
  output that contributes to profit has been
  produced.
• When a firm produces at a point where marginal
  revenue exceeds marginal cost, units of output
  that contribute to profit are not produced.
• When a firm produces at a point where marginal
  revenue is less that marginal cost, units of
  output that decrease profit are produced.

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Background Profit Maximization
P
At Q1, MR gt MC, the firm should produce
more. At Q3, MRlt MC, the firm should produce
less. At Q2, MR MC, profits are
maximized. .
MC
D
MR
0
Q
Q1 Q2 Q3
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Background TR, TC, Profits
P
TR ? TC ? Profits ?
V
T
W
S
MC
D
MR
Q
Q
0
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Menu Costs

• In imperfectly competitive markets, a firms
  demand curve depends on
• The relative price of its good
• Aggregate demand
• The firm decides how much to produce by setting
  marginal cost equal to marginal revenue unless
  menu costs are significant.

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Menu Costs
Given the demand curve D0, the firm maximizes
profits by setting price equal to P0 and selling
Q0. A drop in aggregate demand causes the demand
curve facing the firm to shift to the left to
D1. Given the demand curve D1, the firm
maximizes profits by setting price equal to P1
and selling Q1. If the firm chooses to continue
to charge P1 when its demand curve is D1, it
sells the amount Q and no longer maximizes
profits.
P
J
Y
P0
W
P1
S
MC
T
V
X
D0
D1
MR1
MR0
0
Q
Q Q1 Q0
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Menu Costs
Profits equal total revenues minus total
costs. On demand curve D0, before the decline in
aggregate demand, the firms total revenue equals
the area 0P0YQ0 and the firms total costs equal
0SXQ0. Its profits equal the area SP0YX.
P
J
Y
P0
W
P1
S
MC
T
V
X
D0
D1
MR1
MR0
0
Q
Q Q1 Q0
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Menu Costs
Profits equal total revenues minus total
costs. After the decline in aggregate demand, on
demand curve D1, the firms total revenue equals
the area 0P1WQ1 and the firms total costs equal
0SVQ1. Its profits equal the area SP1WV.
P
J
Y
P0
W
P1
S
MC
T
V
X
D0
D1
MR1
MR0
0
Q
Q Q1 Q0
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Menu Costs
Profits equal total revenues minus total
costs. After the decline in aggregate demand, if
the firm does not decrease price from P0, the
firms total revenue equals the area 0P0JQ and
the firms total costs equal 0STQ. Its profits
equal the area SP0JT.
P
J
Y
P0
W
P1
S
MC
T
V
X
D0
D1
MR1
MR0
0
Q
Q Q1 Q0
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Menu Costs

• The firm must decide whether or not to reduce
  price to the new profit maximizing point, W on
  the new demand curve, D1.
• With no adjustment costs, the firm makes a profit
  equal to SP1WV and would reduce output to Q1.
• But, if the firm faces non-trivial menu costs of
  z, the firm may decide to leave the price at P0,
  thereby moving from point Y to point J.

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Menu Costs
By reducing price from P0 to P1, the firm
would increase its profits by B A, but there is
no incentive for the firm to reduce price if z gt
B A. If z gt B A, the firm would to charge P0
and sell Q. The loss to society of producing Q
rather than Q1 is the amount B C, which equals
the loss of total surplus.
P
J
P0
A
C
W
P1
B
If B C gt z gtB A, then the firm will not cut
its price even though doing so would be
socially optimal
S
MC
T
V
D1
Q Q1 Q0 Q
0
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Summary Menu Costs

• If the presence of menu costs causes nominal
  price rigidity, shocks to nominal aggregate
  demand will cause fluctuations in output and
  welfare.
• Such fluctuations are inefficient, indicating the
  need for stabilization policy.
• In addition if nominal wages are rigid because of
  contracts, the marginal cost curve will be
  sticky, thus reinforcing the impact of menu costs
  in producing price rigidities.