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New Keynesian Revival
• They use the micro foundations approach as
used by the New Classical school.
• They argue that the Keynesian conclusions
about the effectiveness of fiscal and monetary
policy are still valid because goods and
labour market do not clear quickly because of
imperfections in these markets. Prices and
wages are sticky.
Macroeconomic Themes:5
1
Market fails and prices and wages are sticky
because of following reasons:
• menu cost
• long period sales and purchase agreements and
• imperfect competitions in goods markets and
• wage contracts between unions and employers,
• insider-outsider behaviour of unions,
• efficiency wage behaviour in the labour market.
Macroeconomic Themes:5
2
Impact on firms pricing and output decision of a reduction in aggregate demand
MC
p0
p1
B
A
C
E
a
d
d1
mr
mr1
0
y2 y1 y0
Originally firm sets price and quantity using marginal revenue = marginal cost
principle as p0 and y0. Now consider a reduction in aggregate demand, which
causes a decline firms demand from d to d1. Economically firm should change
its price to p1 but because of contracts or menu costs firm may continue
charging p0 with reducing output to y2 rather than y1. If may firms do like this
there will be a significant macroeconomic impact of reduction in AD.
Macroeconomic Themes:5
3
Role of Price and Wage Mark Ups for the Upward
Sloping Aggregate Supply Line?
Pt  1 Wt
Wt  1   Pte

The product of small number
(1)
are   ,  
, 
negligible numbers.
(2)
Pt  1 1   Pte (3)
    a y  y   b u  u 
Pte
Pt
 1 1  
P
P
t 1
t 1
(4)
(7)
 t     
(5)
 t  1                    1
Aggregate supply
 t                 
(6)
 t  
Macroeconomic Themes:5










,
,
are small and
 t    
 t    a y  y 
 t    b u  u 
1 t  1     1 

,

a y  y 
or
 b u  u
(8)
(9)









s
(10)
4
Old Question:Why is the AS Curve Upward Sloping?
New answer: Mark Ups in Wage Rate and Prices
Why is the aggregate demand upward sloping? Why increasing demand can increase
output in the short run?
Price
Classical Supply
New Classical Supply
p1
Keynesian supply
p0
AD1
AD
O
yn
Output
Write equations for each of these supply lines
Macroeconomic Themes:5
5
Menu Cost and Impact of an Increase in Aggregate
Demand
Profit maximising price and output of a monopolist
Impact of an increase in aggregate demand (Ne >N)
Price
And cost
P0
?
?
A
pm
C
pm
?
?
k
B
k
q
q1
Macroeconomic Themes:5
q
6
Menu Cost and Impact of an Increase in Aggregate
Demand
If the expected aggregate demand in
greater than the actual N e  N then p0  pm
and if
Ne N
then
p  pm .
0
Firms should change their price whenever
demand changes.
But there is a menu cost z of changing the
prices because menus have to be printed
again and sent to the customers.
Macroeconomic Themes:5
7
Output Impact of Menu Costs
Firms are reluctant to change such menus if
the extra profits from changing the prices
are less than the menu costs, B-A < z.
The loss of the social welfare is given by the
area, B+C .
If B-A < z then firms do not change price.
They would be producing q instead of q1.
If all firms act like this even a small menu
cost has large aggregate impacts. Thus the
nominal rigidity in prices causes extra
Macroeconomic Themes:5
output.
8
Mankiw’s Menu Cost Model
Cost
C  kqN
(1)
where C= cost, k is a constant, q = output of a firm,
N = aggregate demand
Demand: P  f qN (2)
here the price charged by the firm is a function of
the output supplied.
Divide both sides of (1) and (2) by N.
c  C  kq
N
P
(1’) p  N  f q
Macroeconomic Themes:5
9
Profit, Menu Cost and Output
Profit
q q1
Macroeconomic Themes:5
10
Efficiency wage and
unemployment
Involuntary unemployment exists because firms pay efficiency wage, rate that is above
the market clearing level, in order to (1) reduce turnover costs (2) reduce shirking by
workers (3) reduce the moral hazard and adverse selection and (4) to improve morale by
showing appropriate behaviour.
Wage rate
E1
E
E2
Macroeconomic Themes:5
11
Insider-outsider theories of wage bargaining and
determination of unemployment
Union preference function
Labour demand and union preference
W
W
U(w,e)
LD
U(w,E)
E
Wage negotiation and contract
E
Two sector model of unemployment
LD
LDN
Wu
U(e,w)
W
Wn’
U(w,e)
I
E
Wn
U
Macroeconomic Themes:5
12
References
1.
Akelof G A and Yellen J. L. (1985) A Near Rational Model of the Business Cycle with Wage and Price Inertia,
The Quarterly Journal of Economics, v. 100, supplement, 823-838.
2.
Blanchard O.J.and Kiyotaki (1987) Monopolistic competition and the effects of aggregate demand,
American Economic Review, 77: September,pp 647-66.
3.
Dixon H (1987) A Simple Model of Imperfect Competition with Walrasian Features, Oxford Economic Papers,
39, 134-160.
Mankiw N.G. (1989) Real Business cycle: A New Keynesian Perspective, Journal of Economic Perspectives, vol.
3, no. 3 pp. 79-90.
Mankiw N.G.(1985) Small Menu Costs and Large Business Cycles: A Macroeconomic Model of Monopoly, The
Quarterly Journal of Economics, May, 529-537.
4.
5.
6.
Rankin Neil (1992) Imperfect competition, expectations and the multiple effects of monetary growth,
the Economic Journal 102: 743-753.
7.
8.
Romer D. (1993) The New Keynesian Synthesis, Journal of Economic Perspectives, 7:1: 5-22, Winter.
Yellen J.L. (1984) Efficiency wage models of unemployment, AEA papers and proceedings vol.74
No.2, May pp. 199-205.
Macroeconomic Themes:5
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