Transcript M17_Gordon8014701_12_Macro_C17

Chapter 17
New Classical
Macro and
New Keynesian
Macro
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The Development of Macroeconomics
• The development of new theories and the
abandonment of old theories often occur in
response to major macroeconomic development
– In the 1930s, the Great Depression spurred the Keynesian
revolution
– Keynesian thought dominated macroeconomics until
significant inflation emerged in the late 1960s and brought
about the monetarist “counterrevolution”
• Since the early 1970s, macroeconomics has been
split between two basic explanations of business
cycles
– New Classical Macroeconomics
– New Keynesian Economics
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The “Fooling Model”
• In 1967, Milton Friedman developed a model of
the economy where all markets clear continuously, but there is imperfect information
– Firms always know the current value of P, but workers
only learn the actual price level with a time lag
• Suppose there is an increase in AD
– Higher AD boosts prices encouraging firms to increase output.
– Nominal wages also rise, but not as quickly as the price level
– Because workers do not realized that their real wage has fallen, they are
willing to work more in response to AD
– When workers realize that their nominal wages did not keep up with the
price level (i.e. that they were “fooled”), they demand higher wages
shifting back AS
• Implication: Business cycles happen only because workers are fooled
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Other Versions of the Fooling Model
• The Fooling Model obeys the Natural Rate
Hypothesis, which states that shifts in AD
have no long-run effect on real GDP
• Edmund Phelps developed a similar model
to Friedman’s where both firms and workers
were fooled by a general rise in P
• In another model, turnover unemployment
is reduced (thus boosting output) when
workers stay with their own firms when receiving wage
increases not realizing that all wages have risen
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The Lucas Model
• The Lucas Model (named after Robert Lucas)
has three basic assumptions:
– Markets clear
– There is imperfect information
– There are Rational Expectations, which are expectations that
need not be correct, but must make the best use of available
information, avoiding errors that could have been foreseen by
knowledge of history
• Suppose there is a “price surprise”
– Firms cannot distinguish between an increase in their own price vs. an increase in
the general price level
– Firms respond to a higher price by increasing output and employment (and thus
wages)
– If firms discover that the “price surprise” was a general increase in the price level,
they reduce their output and wages back to their original levels
• Implication: Anticipated monetary policy cannot change real GDP in
a regular and predictable way. This is the Policy Ineffectiveness
Proposition
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The Real Business Cycle Model
• The problem with the Fooling Model and the Lucas
model is the easily available aggregate price
information that makes it unlikely that imperfect
information is the only source of business cycles
• The Real Business Cycle (RBC) model explains
business cycles in output and employment as being
caused by technology or supply shocks
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Figure 17-1 Effect of an Adverse Supply Shock
on Output and Employment in the Real Business
Cycle Model
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Criticisms of RBC models
• Although technology may advance at an irregular
pace, there is no retreat in technological progress
to explain recessions
– Big recessions require big supply shocks
• RBC models imply that prices should fluctuate
positively with output, but sometimes prices rise
during recessions
• RBC models imply that real wages are procyclical,
however the statistical evidence suggests there is
no systematic movement of real wages
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International Perspective Productivity
Fluctuations in the United States and Japan
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The 2007-09 Crisis and the RBC
model
• The Great Depression has always been an
embarrassment for RBC model advocates
– Massive U in 1930’s implied to be voluntary
– 1929-33 decline in Y implied to be due to massive adverse
supply shock
• 2007-09 Crisis poses similar problem
– No massive adverse supply shock
– Productivity actually improved 2009-10
• Instead, both crises caused by massive demand
shocks!
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Contributions of New Classical Macro
• What are the attractions of new classical theory to
economists?
– The assumption of rational expectations requires that
people do not repeat mistakes
• It also provides microeconomic foundations to macroeconomic
theory
– Many of the ideas developed by new classical economists
have been applied successfully to financial markets where
continuous market clearing is a reasonable assumption
– Greater understanding of economic policy
– New techniques of analysis developed have had a pervasive
effect on economic research
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The New Keynesian Economics
• New and old Keynesian models are Non-Market Clearing
models
– Wage-setting occurs in labor markets
– Price-setting occurs in product markets
• The New Keynesian Economics explains both nominal rigidity
in prices and wages as well as real rigidities in real wages
and relative prices
– Nominal rigidities can arise from menu costs or staggered
contracts
– Real rigidities are explained by the efficiency wage model
• The difference between new and old Keynesian models is that
the new approach attempts to explain the microeconomic
foundations of slow adjustment of both wages and prices and
assumes rational expectations
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Figure 17-2 The Price-Setting Decision
of a Monopolist
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Figure 17-3 The Price-Setting Choice of
a Monopolist Facing a Decline in Demand
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The Effect of Small Rigidities
• A Menu Cost is any expense associated with
changing prices, including the cost of printing new
menus or distributing new catalogs
• A Macroeconomic Externality is a cost incurred by
society as a result of a decision by an individual
worker or firm
• A Coordination Failure occurs when there is no
private incentive for firms to act together to avoid
actions that impose social costs on society
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Long Term Labor Contracts as a
Source of the Business Cycle
• Long term labor contracts are agreements
between firms and workers that set the level of
nominal wage rates for a year or more
– Unions represent about 10% of the U.S. labor force
– Union set wages patterns for non-union workers too
– Cost-of-Living Agreements (COLAs) provide for
automatic increase in the wage rate in response to an
increase in the price level
• Result: Long term contracts are an important source
of wage stickiness
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Assessment of the New Keynesian
Approach
• The new Keynesian approach solves the main
dilemma of earlier business cycle models studied.
That is, it explains observed business cycles
without:
–
–
–
–
Assuming away output fluctuations
Assuming complete wage rigidity
Requiring imperfect information
Assuming procyclical wages.
• Criticisms of the new Keynesian approach:
– It provide too many reasons why wages and prices are
sticky.
– Empirical testing of this approach is still in its infancy.
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Dynamic Stochastic General EQM
(DSGE) Models
• DSGE models combine aspects of both New Classical
and New Keynesian macroeconomics
– “Dynamic” refers to explicit modeling of time
– “Stochastic” refers to any model with random variables
– “General Equilibrium” refers to any model that explains the
whole economy (instead of only part of it)
• DSGE models are generally first taught in graduate
school because of their mathematical complexity
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