PROBLEM SET 6 New Keynesian Economics Francesco Pappadà EPP Business Cycles February 16, 2011 1 / 13
Text Read N. Gregory Mankiw, A Quick Refresher Course in Macroeconomics, Journal of Economic Literature, 28, pp. 1645 1660, Dec. 1990. and answer the following questions: 1. Try to summarize the main developments in Macroeconomic literature in 1970 s and 1980 s. What does the breakdown consensus refer to? 2. Which are the three big directions of research that departed from the consensus breakdown? To what extent the introduction of rational expectations has been a revolutionary approach in Macroeconomics? 3. Discuss the time inconsistency of monetary policy argument and the rules versus discretion dilemma. 2 / 13
1. Main developments in 70s-80s and breakdown consensus Premise: before 1970s, the consensus was made by the IS-LM framework in Macroeconomic theory. The breakdown consensus comes from main developments in: 1. theory: the need for microfoundations of Macroeconomic models 2. empirical standpoint: the rise in inflation and unemployment during 1970s (no Phillips curve) Friedman and Phelps (1968): the unraveling of Phillips curve, at equilibrium the individual decisions determine unemployment level Lucas (1976) critique: policy changes affect the way individuals form expectations about the future (macroeconometric models could not take into account this endogenous response by individuals) 3 / 13
2. Three big directions of research after the breakdown consensus model expectations (Sargent and Wallace 75, Fisher 77) new classical models (imperfect information, RBC) new keynesian macroeconomics (price adjustment, sticky wages, monopolistic competition) Rational expectations, an exemple of revolutionary approach Sargent and Wallace (1975) argument: if monetary policy is systematic and agents have rational expectations, inflation does not deviate from its expected level and is therefore irrelevant (does not lower unemployment)! 4 / 13
3. The time inconsistency of optimal (monetary) policy and rules-discretion dilemma when monetary authority announces a policy of low inflation, agents know that monetary authority will then have a huge incentive to change policy, do high inflation and reduce unemployment Solution: get rid of the monetary authority s discretionary power and set a fixed policy rule. Example: New Zealand in 1988 was the first country to do so. In NZ, the governor of Central Bank may be fired if the inflation target is not achieved! 5 / 13
Question 10 Show that the game between all intermediate firms reveals externalities and strategic complementarities. 6 / 13
The best response function of firm i for price level P is The game features ( ) P i P φ M = M spillovers: when other firms increase their prices, the profit of my firm increases strategic complementarities: when other firms increase their prices, the marginal profit of my firm increases 7 / 13
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Picture iso-profit curves Π i (P i /M, P/M) = const. profit is higher close to the origin from E, a collective decline in prices leads to E in E prices are lower, real money balances higher, aggregate demand higher. the increase in production fills the gap of inefficient underproduction that is typical of imperfect competitive markets. Hence, economic welfare increases. However, this is not a Nash equilibrium : each firm is incentivized to increase its price, moving the equilibrium from E to E (dashed path) 9 / 13
Question 11 Does this framework support a Keynesian view on unemployment? Discuss the classical feature of this model. 10 / 13
Is it a Keynesian model? Answer is ambiguous: unemployment is not the issue of the imbalance between labor supply and demand; labor market is in equilibrium however, workers would prefer a less non competitive market and work more. Employment at equilibrium is not sufficient. 11 / 13
Classical features General equilibrium in imperfect (monopolistic) competition allows to explain equilibrium inefficiency, but not the existence of Keynesian multipliers. this model is dichotomous: aggregate demand only determine the level of nominal prices and wages, without affecting employment and real production. When drawing aggregate demand and aggregate supply in the plane (Y, P), we observe the dichotomy property of classical models and the supply curve is vertical. 12 / 13
Classical features There is no multiplier, in monetary terms, and all variations in aggregate demand convert in changes in price. if prices were rigid, classical dichotomy would break. imperfect competition models feature inefficiency property of the macroeconomic equilibrium and employment, but this inefficiency is not based on limited demand, as in traditional Keynesian theory. prices levels differ from the Walrasian ones, and demand-oriented policies are inefficient. 13 / 13