New Keynesian economics
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New Keynesian economics is a school of macroeconomics that strives to provide microeconomic foundations for Keynesian economics. It developed partly as a response to criticisms of Keynesian macroeconomics by adherents of new classical macroeconomics.
Two main assumptions define the New Keynesian approach to macroeconomics. Like the New Classical approach, New Keynesian macroeconomic analysis usually assumes that households and firms have
Wage and price stickiness, and the other present descriptions of market failures in New Keynesian
New Keynesianism became part of the new neoclassical synthesis that incorporated parts of both it and new classical macroeconomics, and forms the theoretical basis of mainstream macroeconomics today.[2][3][4][5]
Development of New Keynesian economics
1970s
The first wave of New Keynesian economics developed in the late 1970s. The first model of Sticky information was developed by
1980s
Menu costs and imperfect competition
In the 1980s the key concept of using menu costs in a framework of
While some studies suggested that menu costs are too small to have much of an aggregate impact,
Even if prices are perfectly flexible, imperfect competition can affect the influence of fiscal policy in terms of the multiplier. Huw Dixon and Gregory Mankiw developed independently simple general equilibrium models showing that the fiscal multiplier could be increasing with the degree of imperfect competition in the output market.
The Calvo staggered contracts model
In 1983
Coordination failure
Labor market failures: Efficiency wages
New Keynesians offered explanations for the failure of the labor market to clear. In a Walrasian market, unemployed workers bid down wages until the demand for workers meets the supply.
In efficiency wage models, workers are paid at levels that maximize productivity instead of clearing the market.[36] For example, in developing countries, firms might pay more than a market rate to ensure their workers can afford enough nutrition to be productive.[37] Firms might also pay higher wages to increase loyalty and morale, possibly leading to better productivity.[38] Firms can also pay higher than market wages to forestall shirking. Shirking models were particularly influential.[39]Carl Shapiro and Joseph Stiglitz's 1984 paper "Equilibrium Unemployment as a Worker Discipline Device" created a model where employees tend to avoid work unless firms can monitor worker effort and threaten slacking employees with unemployment.[40][41] If the economy is at full employment, a fired shirker simply moves to a new job.[42] Individual firms pay their workers a premium over the market rate to ensure their workers would rather work and keep their current job instead of shirking and risk having to move to a new job. Since each firm pays more than market clearing wages, the aggregated labor market fails to clear. This creates a pool of unemployed laborers and adds to the expense of getting fired. Workers not only risk a lower wage, they risk being stuck in the pool of unemployed. Keeping wages above market clearing levels creates a serious disincentive to shirk that makes workers more efficient even though it leaves some willing workers unemployed.[43]
1990s
The new neoclassical synthesis
In the early 1990s, economists began to combine the elements of new Keynesian economics developed in the 1980s and earlier with
Taylor Rule
In 1993,[47] John B Taylor formulated the idea of a Taylor rule, which is a reduced form approximation of the responsiveness of the nominal interest rate, as set by the central bank, to changes in inflation, output, or other economic conditions. In particular, the rule describes how, for each one-percent increase in inflation, the central bank tends to raise the nominal interest rate by more than one percentage point. This aspect of the rule is often called the Taylor principle. Although such rules provide concise, descriptive proxies for central bank policy, they are not, in practice, explicitly proscriptively considered by central banks when setting nominal rates.
Taylor's original version of the rule describes how the nominal interest rate responds to divergences of actual inflation rates from target inflation rates and of actual gross domestic product (GDP) from potential GDP:
In this equation, is the target short-term nominal interest rate (e.g. the federal funds rate in the US, the Bank of England base rate in the UK), is the rate of inflation as measured by the GDP deflator, is the desired rate of inflation, is the assumed equilibrium real interest rate, is the logarithm of real GDP, and is the logarithm of potential output, as determined by a linear trend.
The New Keynesian Phillips curve
The New Keynesian Phillips curve was originally derived by Roberts in 1995,[48] and has since been used in most state-of-the-art New Keynesian DSGE models.[49] The new Keynesian Phillips curve says that this period's inflation depends on current output and the expectations of next period's inflation. The curve is derived from the dynamic Calvo model of pricing and in mathematical terms is:
The current period t expectations of next period's inflation are incorporated as , where is the discount factor. The constant captures the response of inflation to output, and is largely determined by the probability of changing price in any period, which is :
The less rigid nominal prices are (the higher is ), the greater the effect of output on current inflation.
The science of monetary policy
The ideas developed in the 1990s were put together to develop the new Keynesian
These three equations formed a relatively simple model which could be used for the theoretical analysis of policy issues. However, the model was oversimplified in some respects (for example, there is no capital or investment). Also, it does not perform well empirically.
2000s
In the new millennium there have been several advances in new Keynesian economics.
The introduction of imperfectly competitive labor markets
Whilst the models of the 1990s focused on sticky prices in the output market, in 2000 Christopher Erceg, Dale Henderson and Andrew Levin adopted the Blanchard and Kiyotaki model of unionized labor markets by combining it with the Calvo pricing approach and introduced it into a new Keynesian DSGE model.[52]
The development of complex DSGE models
To have models that worked well with the data and could be used for policy simulations, quite complicated new Keynesian models were developed with several features. Seminal papers were published by Frank Smets and Rafael Wouters[53][54] and also Lawrence J. Christiano, Martin Eichenbaum and Charles Evans[55] The common features of these models included:
- Habit persistence. The marginal utility of consumption depends on past consumption.
- Calvo pricing in both output and product markets, with indexation so that when wages and prices are not explicitly reset, they are updated for inflation.
- Capital adjustment costs and variable capital use.
- New shocks
- Demand shocks, which affect the marginal utility of consumption
- Markup shocks that influence the desired markup of price over marginal cost.
- Monetary policy is represented by a Taylor rule.
- Bayesian estimation methods.
Sticky information
The idea of sticky information found in Fischer's model was later developed by Gregory Mankiw and Ricardo Reis.[56] This added a new feature to Fischer's model: there is a fixed probability that a worker can replan their wages or prices each period. Using quarterly data, they assumed a value of 25%: that is, each quarter 25% of randomly chosen firms/unions can plan a trajectory of current and future prices based on current information. Thus if we consider the current period: 25% of prices will be based on the latest information available; the rest on information that was available when they last were able to replan their price trajectory. Mankiw and Reis found that the model of sticky information provided a good way of explaining inflation persistence.
Sticky information models do not have nominal rigidity: firms or unions are free to choose different prices or wages for each period. It is the information that is sticky, not the prices. Thus when a firm gets lucky and can re-plan its current and future prices, it will choose a trajectory of what it believes will be the optimal prices now and in the future. In general, this will involve setting a different price every period covered by the plan. This is at odds with the empirical evidence on prices.[57][58] There are now many studies of price rigidity in different countries: the United States,[59] the Eurozone,[60] the United Kingdom[61] and others. These studies all show that whilst there are some sectors where prices change frequently, there are also other sectors where prices remain fixed over time. The lack of sticky prices in the sticky information model is inconsistent with the behavior of prices in most of the economy. This has led to attempts to formulate a "dual stickiness" model that combines sticky information with sticky prices.[58][62]
2010s
The 2010s saw the development of models incorporating household heterogeneity into the standard New Keynesian framework, commonly referred as 'HANK' models (Heterogeneous Agent New Keynesian). In addition to sticky prices, a typical HANK model features uninsurable idiosyncratic labor income risk which gives rise to a non-degenerate wealth distribution. The earliest models with these two features include Oh and Reis (2012),[63] McKay and Reis (2016)[64] and Guerrieri and Lorenzoni (2017).[65]
The name "HANK model" was coined by Greg Kaplan, Benjamin Moll and Gianluca Violante in a 2018 paper[66] that additionally models households as accumulating two types of assets, one liquid and the other illiquid. This translates into rich heterogeneity in portfolio composition across households. In particular, the model fits empirical evidence by featuring a large share of households holding little liquid wealth: the 'hand-to-mouth' households. Consistent with empirical evidence,[67] about two-thirds of these households hold non-trivial amounts of illiquid wealth, despite holding little liquid wealth. These households are known as wealthy hand-to-mouth households, a term introduced in a 2014 study of fiscal stimulus policies by Kaplan and Violante.[68]
The existence of wealthy hand-to-mouth households in New Keynesian models matters for the effects of monetary policy, because the consumption behavior of those households is strongly sensitive to changes in disposable income, rather than variations in the interest rate (i.e. the price of future consumption relative to current consumption). The direct corollary is that monetary policy is mostly transmitted via general equilibrium effects that work through the household labor income, rather than through intertemporal substitution, which is the main transmission channel in Representative Agent New Keynesian (RANK) models.
There are two main implications for monetary policy. First, monetary policy interacts strongly with fiscal policy, because of the failure of
Policy implications
New Keynesian economists agree with
Nonetheless, New Keynesian economists do not advocate using expansive monetary policy for short run gains in output and employment, as it would raise inflationary expectations and thus store up problems for the future. Instead, they advocate using monetary policy for stabilization. That is, suddenly increasing the money supply just to produce a temporary economic boom is not recommended as eliminating the increased inflationary expectations will be impossible without producing a recession.
However, when the economy is hit by some unexpected external shock, it may be a good idea to offset the macroeconomic effects of the shock with monetary policy. This is especially true if the unexpected shock is one (like a fall in consumer confidence) which tends to lower both output and inflation; in that case, expanding the money supply (lowering interest rates) helps by increasing output while stabilizing inflation and inflationary expectations.
Studies of optimal monetary policy in New Keynesian DSGE models have focused on interest rate rules (especially 'Taylor rules'), specifying how the central bank should adjust the nominal interest rate in response to changes in inflation and output. (More precisely, optimal rules usually react to changes in the output gap, rather than changes in output per se.) In some simple New Keynesian DSGE models, it turns out that stabilizing inflation suffices, because maintaining perfectly stable inflation also stabilizes output and employment to the maximum degree desirable. Blanchard and Galí have called this property the 'divine coincidence'.[71]
However, they also show that in models with more than one market imperfection (for example, frictions in adjusting the employment level, as well as sticky prices), there is no longer a 'divine coincidence', and instead there is a tradeoff between stabilizing inflation and stabilizing employment.[72] Further, while some macroeconomists believe that New Keynesian models are on the verge of being useful for quarter-to-quarter quantitative policy advice, disagreement exists.[73]
Alves (2014)[74] showed that the divine coincidence does not necessarily hold in the non-linear form of the standard New-Keynesian model. This property would only hold if the monetary authority is set to keep the inflation rate at exactly 0%. At any other desired target for the inflation rate, there is an endogenous trade-off, even under the absence real imperfections such as sticky wages, and the divine coincidence no longer holds.
Relation to other macroeconomic schools
Over the years, a sequence of 'new' macroeconomic theories related to or opposed to
Later work by economists such as
New Keynesianism was a response to
Whereas the neoclassical synthesis hoped that
Ultimately, the differences between new classical macroeconomics and New Keynesian economics were resolved in the new neoclassical synthesis of the 1990s, which forms the basis of mainstream economics today,[2][3][4] and the Keynesian stress on the importance of centralized coordination of macroeconomic policies (e.g., monetary and fiscal stimulus), international economic institutions such as the World Bank and International Monetary Fund (IMF), and of the maintenance of a controlled trading system was highlighted during the 2008 global financial and economic crisis. This has been reflected in the work of IMF economists[77] and of Donald Markwell.[78]
Major New Keynesian economists
- Jordi Galí
- Mark Gertler
- Nobuhiro Kiyotaki
- Michael Woodford
- Gregory Mankiw
See also
- Calvo (staggered) contracts
- 2008–2009 Keynesian resurgence
- New neoclassical synthesis
- Sticky prices
- Welfare cost of business cycles
- Taylor Contracts (economics)
References
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Further reading
- Clarida, Richard; Galí, Jordi; Gertler, Mark (1999). "The Science of Monetary Policy: A New Keynesian Perspective". S2CID 55045787.
- Robert J. Gordon Gordon, Robert (1990), What is New-Keynesian Economics?, Journal of Economic Literature.
- .
- OCLC 237794267.
- Rowe, Nick. "The Growth Stages of the New Keynesian Model". Worthwhile Canadian Initiative. Retrieved 24 July 2014.