XVII. New Keynesian Economics

XVII.1 AD – AS model once again• Agregate demand : both in long and short term

decreasing function of price• Agregate supply

– In the long run – vertical at potential product– In the short term – horizontal at the level of fixed

price

• Shifts of AD (because of monetary or fiscal policy)– In the long run does not change product, but a price

level– In the short run changes product (and employment),

but price remains constant

AD shifts – short run

P

Y

SRASP1

AD1

Y1

AD2

E1

Y2

E2

AD shifts - long run

P

Y

LRAS

AD1

E1

Yf

P1

AD2

E2P2

P

Y

LRAS

SRAS

AD

Long term equilibrium

fY

E

From short to long run (1)

• Short run equilibrium:– AD equals AS, quantity adjustment, AS adjusts to

AD

– Price fixed, equilibrium as state of rest, on the labor market an excess supply might exist (unemployment)

– Product might be lower than potential (natural)

• Long run equilibrium:– AD equals AS

– Prices adjusted, so that on all markets supply equals demand

– Product on potential (natural) level

From short to long run (2)

Intuitive interpretation:• Fixed price: either depression (Keynes) or a

very short run, when prices (wages) are sluggish in any economy and (almost) in any situation (except e.g. hyperinflation)

• Long term equilibrium – prices and wages had to react to changes in demand and supply on various markets (including labor market) and cleared the markets through its adjustment

Aggregate supply in short to medium run

• Adjustment process (from short to long run) takes some time question– How is the aggregate supply specified in this

transition period? increasing function of price

• No unified theory till today– Neoclassical synthesis: downward wage and price

rigidities (no market clearing)– Phillips curve: adaptive expectations hypothesis– New Classical Economics: market clearing, rational

expectations, Lucas’ AS– End of 1980s – revival of Keynes: “The New

Keynesian Economics” (NKE)

Another view on the same problem …

• In the very long run: economy always at natural levels, AS vertical

• If AS positively sloped → money is not neutral, i.e. increase of money supply increases output (and price) and vice-versa

• Beginning of 1990s: NKE, 2 questions:– Is money non-neutral? Do we build the theory that denies classical

dichotomy?– Do real market imperfections determine economic fluctuations

• The second question defines NKE: theoretical explanation of market imperfections and the link to deviations from natural values– Prices are not fixed (adjust slowly, etc.) because of short run, but

because of market imperfections– Not unified theory, rather many different models and in next parts,

Mankiw’s textbook is followed (see Literature)

XVII.2 Nominal wage rigidity

• Originally: F.Modigliani (1944) – downward wage rigidity

• In general: wages rigid in both directions, reasons:– Long term wage contracts, eventually

implicit contracts, power of the unions• Intuitively: if wages rigid, then price increase

lowers real wage firms increase employment product increases and supply increasing function of the price

Wage: targeted and actualWage negotiations:

• Always negotiated nominal wage at the expected price Pe , so both firms and workers have in mind targeted real wage, so wT a W = wT . Pe

• Employment given by demand firms then decide according price P

- (W/P) = wT . (Pe /P)

– if P = Pe , then (W/P) = wT

– if P > Pe , then (W/P) < wT

– if P < Pe , then (W/P) > wT

– Unexpected growth of price means fall of real wage higher employment higher product; conversely, fall of price lower product

Higher price higher AS (and vice versa)

N

W/P

NDA

N1

W1

P1

N

Y

Y=F K,N

N1

Y1

Y

P

Y1

P1

P2

W1

P2

N2

N2

Y2 Y2

AS

A

B

B

From wage to AS

• Difference between actual and expected price reflects price movements– One possible interpretation – if in moment t,

expectation equals price, than actual price, determining real wage, is price in moment t+1

• Generalization:

• Counter cyclical movement of real wage

Y=Yf + P-Pe , > 0

XVII.3 Wrong perception of price level by workers

Starting assumption – firms always know prices, workers only expect them and will know real price only with a time lag

• Demand for labor

• Supply of labor

• Always and ratio reflects a degree of wrong perception of price level by workers

ND =ND W P NS =NS W Pe

W

Pe=

W

P.

P

PeePP

Model (1)

• Demand for labor: decreasing function of real wage

• Supply of labor: increasing function of expected real wage, can be written as

– Labor supply curve shifts according the ratio

• Model assumes simultaneous clearing of all markets

NS =NS W Pe =NS W P . P Pe

P Pe

Wrong price perception: price increase

• Demand – decreasing function od real wage

• Supply – increasing function of

• initial supply

• Unexpected price increase labor supply shifts to the right real wage fall new equilibrium with higher employment

N

W/P

ND =ND W P

N1S

W P . P Pe N1

S

N2S

W P 1

N1 N2

W P 2

Model (2)

• Price increase employment increase

• AD – increasing function of price

• In general again Y=Yf + P-Pe , > 0

P

Y

AS

fY

XVII.4 Incomplete price information

Assumptions:

• No difference between firms and workers

• On the markets, agents know– Very well the price of goods they produce– Not so well the price of most other goods

• Agents produce one good and consume many goods

Basic idea• Unexpected increase of overall price level, then

each agent– As producer perceives the increase of the price of

“its” product and feel incentives to increase production

– As a consumer doesn’t perceive the price increase as an overall one, as he doesn’t know all other prices

• In general – at change of absolute price level agent wrongly assumes the change of only relative prices (of “his” product) increases supply because of increase of price

• Formally again

Y=Yf + P-Pe , > 0

XVII.5 Sticky-Price Model

• Starting point: no perfect competition, different reasons for prices being sticky → firms are able to set their prices (at least to some extent)– i.e., firms have some degree of monopoly

• Two prices: overall level P, individual price of the firm p

• p determined by P and by deviation of output form natural level– higher output → higher marginal costs → higher p

p = P + a(Y – Yf) , a>0

Sticky and flexible prices

• Firms are price setters and some of them face sticky prices, some of them face flexible prices, i.e. they must react to change in demand, but can set their price (do not take it from the market)

• Flexible prices: p = P + a(Y – Yf)

• Sticky prices: p = Pe , i.e. firms, when setting a price that will remain sticky, set the price to the expected overall level

Price level determination

• Suppose that s – fraction of firms with sticky prices (0<s<1)

• Overall price level – weighted average of prices, set by the different groups of firms:

P = sPe + (1-s)[P + s(Y-Yf)]

• Subtracting (1-s)P from both sides and dividing by s:

P = Pe + [(1-s)a/s](Y-Yf)

Interpretation

• Pe high → P high: when firms with sticky prices expect high prices, they set their price high and contribute to the high overall price level

• Output high → demand high → firms with flexible prices set them high, again high overall level P

• Pro-cyclical movements of real wage

Y Yf P Pe , s

1-s a

XVII.6 Summary

• Particular models of short term aggregate supply differ, but do not exclude each other exclusively

• All models generate AS that – in the short run – is increasing function of price

Y=Yf + P-Pe , >0

Interpretation

• Variations from potential (natural) product are proportional to variations of actual price from expected one

• Actual price higher than expected product higher than potential; and vice versa

• In graphical terms: short term AS is increasing, slope

• Expected price becomes a model parameter– When actual and expected price equal, product on

potential level– Change of expected price shifts AS curve

• Dynamics

Y=Yf + P-Pe , > 0

1

AS in long and short term

Y

P LRASAS

fY

eP

Literature to Ch. XVIII

• Mankiw, Macroeconomics, Ch.13• Snowdon, Vane, Modern Macroeconomics,

Ch.7 Read parts 7.1 – 7.4. In subsequent parts the NKE is discussed in much more detail and from a slightly different angle

• See references in Snowdon and Vane