Unit - III NEW KEYNESIAN MACROECONOMICS.pptx

NEW KEYNESIAN MACROECONOMICS: Core Proposition of New KEYNESIAN MACROECONOMICS

1. NEW KEYNESIAN MACROECONOMICS UNIT – III Dr. A. Royal Edward Williams

2. New Keynesian macroeconomics It was builds upon Keynesian ideas by incorporating rational expectations and market imperfections to explain short-run economic fluctuations.  Key propositions include: the existence of involuntary unemployment due to sticky prices and wages, the potential for aggregate demand to be insufficient to achieve full employment, and the role of monetary and fiscal policy in stabilizing the economy. 

3. New Keynesian Economics comes with two main assumptions. The Main Two Assumptions: First, that people and companies behave rationally and with rational expectations. Second, New Keynesian Economics assumes a variety of market inefficiencies – including sticky wages and imperfect competition.

4. The core assumptions of New Keynesian Economics (NKM) are the followings: Rational Expectations : Economic agents (households and firms) form their expectations about the future optimally, using all available information. This is a crucial departure from the adaptive expectations of Old Keynesian models. Imperfect Competition : The model assumes that firms are not price-takers in a perfectly competitive market. Instead, they have some degree of market power and face downward-sloping demand curves. This allows them to set prices rather than just accept them. Nominal Rigidities : The central pillar of NKM. Prices and wages are not fully flexible and adjust slowly in response to economic shocks. This is the key reason why markets don't clear instantly and why short-run output can deviate from its long-run potential. Market Failures : The presence of these rigidities means that the economy can have persistent unemployment and an output gap (where actual output is below potential output) even in a long-run equilibrium. Importance of Monetary Policy : Because of nominal rigidities, changes in the money supply are not neutral in the short run. This provides a theoretical justification for active stabilization policies.

5. Sticky wages refer to when employee wages don’t necessarily reflect their company’s or the economy’s performance; moreover, wages are said to be stickier downwards than upwards due to the unwillingness of employees to receive lower nominal pay. Also, the employees’ unwillingness to receive lower wages can result in involuntary unemployment. In addition to sticky wages, the New Keynesian Economics assumption of imperfect competition refers to market situations that can include monopolies, duopolies, cartels, and collusion. It can help explain the varying effects of fiscal policy on different companies in the same industry.

6. The Five Core Propositions of NKM 1. Price Stickiness (Nominal Rigidity) 2. Wage Stickiness 3. Imperfect Competition in Goods and Labour Markets 4. Non-neutrality of Money 5. Importance of Microeconomic Foundations

7. 1. Price Stickiness (Nominal Rigidity) Menu Costs : Named after the cost a restaurant incurs to print a new menu, this refers to any small, real cost associated with changing prices. Examples include the cost of printing new catalogues, updating price tags, or even the time and effort of management to decide on new prices. Coordination Failure : Firms may be reluctant to change their prices for fear of losing market share. For example, if a firm raises its prices and its competitors don't, it will lose customers. Staggered Price Setting : Not all firms adjust their prices at the same time. Some firms may set prices for a year, while others adjust them quarterly. This staggered process means that the aggregate price level changes slowly, even if individual firms' prices are adjusted periodically.

8. 2. Wage Stickiness Long-Term Labour Contracts : Many workers and firms enter into contracts that fix wages for a specific period (e.g., one to three years). This prevents wages from adjusting freely to short-term shocks. Efficiency Wage Theory : This theory, associated with economists like George Akerl of and Janet Yellen, suggests that firms may find it profitable to pay wages above the market-clearing level. The reasons include: Boosting productivity : Higher wages can motivate workers to work harder. Reducing turnover : Paying higher wages reduces the incentive for workers to quit, saving the firm the costs of hiring and training new employees.

9. Attracting better talent : Higher wages attract a larger and more qualified pool of job applicants. Preventing averting : In a high-unemployment environment, a worker who is caught shirking is easily replaceable, so the fear of being fired is a powerful motivator. Insider–Outsider Models : This framework highlights the bargaining power of current employees ("insiders") over potential new hires ("outsiders"). Unions and other institutional factors can give insiders the power to negotiate for higher wages, making it difficult for firms to lower wages to a market-clearing level.

10. 3. Imperfect Competition in Goods and Labour Markets Unlike New Classical models which assume perfect competition, NKM posits that firms operate in an environment of monopolistic competition or oligopoly . This means firms are not "price takers." Instead, they face a downward-sloping demand curve and have some control over the price of their product.

11. This is crucial for NKM because if firms had no control over their prices, the concept of menu costs or staggered price setting would be irrelevant. This market power allows firms to set prices with a mark-up over their marginal costs, which is a key feature in NKM models. Similarly, in labour markets, unions or other forms of worker bargaining power can create imperfect competition, preventing wages from adjusting freely.

12. 4. Non-neutrality of Money This is a direct and powerful consequence of the first three propositions. In a world with price and wage rigidities, a change in the aggregate money supply is not immediately and proportionally offset by a change in the price level. If the central bank increases the money supply, firms cannot instantly raise their prices due to menu costs and staggered pricing. As a result, the increase in money supply leads to an increase in real purchasing power and aggregate demand. Firms, seeing the increase in demand, will respond by increasing output and hiring more workers, at least in the short run. This means that monetary policy has real effects on output and employment , a direct rejection of the New Classical "Policy Ineffectiveness Proposition." This is one of the most important policy implications of NKM: active demand management can be a powerful tool for stabilizing the economy and reducing the size of business cycles.

13. 5. Importance of Microeconomic Foundations This proposition is what distinguishes NKM from Old Keynesianism. NKM does not simply assume that wages and prices are sticky. It builds these assumptions from the optimizing behaviour of individual firms and households. This allows NKM models to be internally consistent with the rational expectations assumption. A prime example is the use of dynamic stochastic general equilibrium (DSGE) models , which are complex computer simulations that model the entire economy as a system of interacting, optimizing agents. NKM adapted these models by introducing imperfections, such as Calvo pricing, to generate realistic business cycle dynamics.

14. Policy Implications Active Stabilization Policy Monetary and fiscal policies can and should be used to counteract demand shocks. Monetary Policy Rules Taylor Rule Links nominal interest rate to inflation gap and output gap. Inflation Targeting Low, stable inflation anchors expectations, making wage and price setting more predictable. Role of Fiscal Policy Especially important in liquidity traps (when interest rates are near zero).

15. WAGE AND PRICE RIGIDITIES Introduction to Wage and Price Rigidities In economics, wage and price rigidities refer to the phenomenon where wages and the prices of goods and services do not adjust immediately or completely to changes in supply and demand. These rigidities, also known as stickiness , are a cornerstone of Keynesian economics and a central feature of New Keynesian macroeconomics . They are the primary reason why economies can experience periods of high unemployment and output gaps, even when economic agents are rational and forward-looking.

16. In a hypothetical world of perfectly flexible wages and prices, any change in aggregate demand or supply would be met with an instantaneous adjustment in prices and wages. For example, a decrease in demand would lead to a rapid fall in prices, which would stimulate new demand and prevent a recession. Similarly, a surplus of labour would cause wages to fall until everyone willing to work at the new, lower wage was employed. Rigidities, however, prevent this seamless adjustment. They create market disequilibrium, leading to persistent unemployment, inflation, or output gaps.

17. Meaning and Definitions Wage Rigidity : Also known as sticky wages , this is the resistance of wages to move downward, or even upward, in response to changes in the labour market. While wages can be sticky in both directions, downward wage rigidity is a particularly important concept. It explains why, during a recession with high unemployment, wages don't fall to a level that would clear the labour market. Price Rigidity (Sticky Prices) : This is the tendency for the prices of goods and services to remain fixed for a period of time, despite changes in the costs of production or demand. For example, a grocery store might not change the price of milk every day, even if the cost of milk fluctuates.

18. Causes of Wage Rigidity The reasons for sticky wages are a mix of institutional, behavioural, and market-related factors. Institutional Factors Minimum Wage Laws Trade Unions and Collective Bargaining Long-Term Contracts

19. Behavioural and Psychological Factors Money Illusion Fair Wage Hypothesis Efficiency Wage Theory Increased Productivity Reduced Turnover Improved Morale Market Structure Factors Monopsony Power Sector-Specific Skills

20. Causes of Price Rigidity Menu Costs : This is the most famous explanation for price stickiness. Named after the physical cost of printing new restaurant menus, it refers to all the administrative and logistical costs associated with changing prices. These can include: Printing new catalogues, brochures, or price lists. Updating pricing information on websites or in computer systems. The time and effort managers spend deciding on new prices. The cost of relabelling products. Even if these costs are small, they can prevent firms from adjusting prices in response to minor economic fluctuations. Coordination Problems : Firms may be reluctant to change their prices because they are unsure what their competitors will do. If a firm raises its price and its competitors don't, it will lose customers. If it lowers its price and its competitors follow, it may start a price war and lower its profits. This uncertainty can lead to a state where all firms are hesitant to change prices, leading to price stickiness. Long-Term Relationships : Firms may maintain stable prices to build customer loyalty and avoid the uncertainty and hassle that frequent price changes can cause. Customers may appreciate the stability and predictability of prices. Price Regulation : In some industries, like utilities or transportation, prices may be set or regulated by the government, which makes them inherently sticky.

21. Theoretical and Policy Implications Classical View : Classical economists argued that wages and prices were perfectly flexible. They believed that markets would always self-correct to a state of full employment, and involuntary unemployment was a temporary phenomenon. Keynesian View : John Maynard Keynes, in his landmark work, argued that wages and prices were "sticky," particularly downward. He saw these rigidities as the primary cause of involuntary unemployment and recessions. As a result, he argued for active government intervention (fiscal and monetary policy) to stimulate demand and restore full employment. New Keynesian Economics : This modern school of thought provided the micro-foundations for Keynesian ideas, explaining why rational agents and firms would still behave in a way that leads to wage and price rigidities.

22. Policy Implications The existence of wage and price rigidities is critical for the effectiveness of monetary and fiscal policy : If wages and prices are rigid : Monetary and fiscal policies can influence real output and employment . A central bank's decision to increase the money supply, for instance, won't be immediately offset by an increase in prices. The increase in demand will instead lead to higher production and more jobs in the short run. If wages and prices are flexible : The economy would self-correct, and government intervention would be less necessary. A fiscal stimulus would simply lead to an immediate and full increase in prices without any change in real output.

23. Policy Implications of New Keynesian Macroeconomics

24. Introduction The New Keynesian Economics (NKE) emerged in the 1980s as a response to the challenges posed by Classical/Neoclassical Economics and New Classical Economics , particularly rational expectations and real business cycle (RBC) theories. It attempted to reconcile Keynesian macroeconomics with microeconomic foundations , incorporating concepts like price stickiness, wage rigidity, imperfect competition, menu costs, and information asymmetry . Unlike the New Classical School , which emphasized market-clearing and policy ineffectiveness, the New Keynesians argue that market imperfections cause nominal rigidities , making monetary and fiscal policy effective in the short run .

25. Key Features of New Keynesian Economics Micro foundations of Macroeconomics Price and Wage Rigidities Imperfect Competition Role of Expectations Market Failures

26. Policy Implications New Keynesian Economics supports active stabilization policies . Its major policy implications are: A. Monetary Policy B. Fiscal Policy C. Employment and Labour Market Policies D. Regulatory and Structural Policies

27. A. Monetary Policy Effectiveness of Monetary Policy Due to sticky prices and wages, monetary policy affects real variables (output, employment) in the short run. Contradicts New Classical “policy ineffectiveness proposition.” Interest Rate Rules (Taylor Rule) New Keynesians advocate rule-based monetary policy. Example: Taylor Rule links nominal interest rate to inflation and output gap, ensuring credibility. Inflation Targeting Central Banks should aim for low and stable inflation to anchor expectations. Nominal rigidities mean inflation volatility harms output and employment stability. Importance of Credibility and Transparency Time inconsistency problem ( Kydland & Prescott, 1977) → Governments may inflate to boost output, but rational agents anticipate this. Solution: Independent Central Bank + credible policy commitment.  

28. B. Fiscal Policy Role of Fiscal Stimulus In presence of rigidities, fiscal expansion (government spending, tax cuts) raises aggregate demand. Particularly effective in liquidity trap situations where monetary policy is less effective. Multiplier Effect Due to wage/price stickiness, the Keynesian multiplier works—government spending increases output and employment. Counter-Cyclical Fiscal Policy New Keynesians advocate active use of fiscal policy to smoothen business cycles. Example: During recession, deficit spending is justified.

29. C. Employment and Labour Market Policies Wage Rigidities Contracts, efficiency wages, and bargaining lead to persistent unemployment. Implication: Active labor market policies, wage subsidies, training programs are needed. Unemployment Persistence “Hysteresis” effect → unemployment remains high even after recovery. Justifies long-term government intervention.

30. D. Regulatory and Structural Policies Financial Market Imperfections Credit rationing, asymmetric information, and liquidity constraints limit investment. Policy implication: Strengthening financial regulation, ensuring access to credit. Industrial and Competition Policies Since markets are imperfect, state intervention can correct distortions and promote efficiency.

31. Criticisms of New Keynesian Economics Short-Run Focus Explains fluctuations but not long-run growth. Over-Reliance on Rigidities Assumes sticky wages/prices; critics argue markets may be more flexible in reality. Limited Role of Fiscal Policy in Some Models While acknowledging its effectiveness, many NK models emphasize monetary policy over fiscal policy. Post-Keynesian Critique Accused of being too close to neoclassical ideas and ignoring fundamental Keynesian uncertainty.