Monetary Business Cycles. Introduction: The New Keynesian Model in the context of Macro Theory

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1 Monetary Business Cycles Introduction: The New Keynesian Model in the context of Macro Theory

2 Monetary business cycles Continuation of Real Business cycles (A. Pommeret) 2 problem sets Common exam Martina.Insam@unil.ch, Extranef 123 Kenza.Benhima@unil.ch, Extranef 250

3 Broader context What are the sources of macroeconomic fluctuations? Should we and how do we use policy?

4 Main subject: the short-run relationship between nominal and real variables Theory: Question of the neutrality of money Lucas (Nobel Lecture): «This tensions between two incompatible ideas that changes in money are neutral unit changes and that they induce movements in employment and production in the same direction has been at the center of monetary theory at least since Hume wrote» Corner stone of macro theory

5 Main subject: the short-run relationship between nominal and real variables Empirical studies tend to confirm this positive link between money and income Important to understand how monetary policy works and how to use it

6 Reminder of the context Consensus: IS/LM with fixed prices + Phillips curve Limits Empirical: stagflation in the 70 s Theoretical: lack of microeconomic foundations Expectations Origin of nominal rigidities

7 RBC Rational expectations Optimizing representative agent Flexible prices Perfect competition

8 Implications of RBC (1) Output is driven by supply shocks (productivity shock) (2) No effect of money in the economy (3) Cycles at equilibrium

9 Implications of RBC (1) Output is driven by supply shocks (productivity shock) Why? Central role of intertemporal substitution of labor. Why?

10 Implications of RBC (2) Effect of money in the economy Money in standard RBC: No effect or very small and negative (this course) + Imperfect information (see Advanced Macro course): effects are positive but short-lived Example: Lucas Island model

11 Implications of RBC (3) Cycles at equilibrium no cost of fluctuations no room for policy

12 Very successful models Highly parcimonious and rigorously microeconomically founded Natural extension of the standard intertemporal general equilibrium model Mimic most macroeconomic variables quite well Prescott: «The business cycle is not a puzzle; rather, it would be a puzzle if we did not observe business cycles»

13 Criticism of RBC (1) Empirical limits (2) Policy irrelevance

14 Criticism of RBC (1) Empirical limits Criticism of productivity shocks as the main sources of fluctuations Intertemporal substitution of labor is low Effect of money on the economy is positive and longlived (ex. Volcker disinflation) Existence of nominal rigidities

15 Criticism of RBC Mankiw (1989)

16 Criticism of RBC (2) «No room for policy»: dangerous statement! Natural outcome of a model with optimizing agents and no frictions (Pareto-efficiency) New Keynesians keep optimizing agents, but introduce frictions

17 Fixed price models Disequilibrium analysis (Clower, Patinkin, Bénassy) General approach: what happens when actual prices differ from the walrasian prices? Parallel to the development of RBC

18 Fixed price models Three possible regimes (see PS1): Excess supply in both the labor and good market: Keynesian unemployment Excess supply in the labor market and excess demand in the good market: Classical unemployment Excess demand in both the labor and good market: Suppressed inflation

19 Fixed price models Keynesian unemployment is of particular interest: Output is demand-driven, Monetary and fiscal policy are effective Room for policy Troubling resemblance with a Keynesian economy (IS/LM) But lack of microfoundations : why would the economy be in that regime in particular?

20 New Keynesian model(s) Microfoundations: Similar to RBC (rational expectations and optimizing agents) But adds frictions, notably imperfect competition Nominal rigidities (staggered price-setting) Demand-driven supply

21 Lucas critique IS/LM RBC Imperfect information Rational expectations Fixed Price models Nominal rigidities Demand-driven supply New Keynesian model Imperfect competition

22 New Keynesian model(s) «New IS/LM» with «New Phillips curve» Empirical implications: Monetary shocks add to the stochastic dimension ( demand shocks) Effect of money in the economy Room for policy (why?)

23 New IS/LM Similar to «old» IS/LM What s the point?

24 Success story Concepts that infused into policy practice (ex. «capacity output») Shapes monetary doctrines (ex. inflation targeting) Considerable debate around different specifications, variants of the NK Models Many criticisms, notably because it is not fit to analyse crisis times However, still a benchmark model for policy analysis

25 Useful surveys: Mankiw, «A Quick Refresher Course in Macroeconomics» JEL (1990) Mankiw, «Real Business Cycles, a New Keynesian Perspective» JEP (1989) Blanchard, «What Do We Know About Macroeconomics That Fisher and Wicksell Did Not?», QJE (2000) Blanchard, «The State of Macro» (2008)

26 Course The literature has been pursuing two goals: 1) Find an empirically relevant model 2) Draw recommendations for monetary policy 2) intimately linked to 1) We will follow the same logic

27 Outline Introduction The neoclassical model with money (flexible prices) Empirical evidence on the effect of money The neo-keynesian model (nominal rigidities) Monetary policy: principles and practice Limits