The New Keynesian Synthesis

By David Romer

Presented by: Matt Sheahan, Matt Rudquist,

Dan Becker

Background

• Departure from Keynesian macroeconomics– Widespread involuntary unemployment– Aggregate demand was a central source of short-

run aggregate economic activity• Neoclassical Synthesis– Blamed sluggish nominal wage– Classical dichotomy failed– Remainder was Walrasian

Background

• Split into two schools of thought• Real Business Cycle Theory– Deny involuntary unemployment and failure of classical

dichotomy• New Keynesian Macroeconomics– Aimed to correctly define the microeconomy to better

understand the macroeconomy– Looked for small departures from prevailing beliefs that had

large effects

Nominal Frictions

• Barriers to full price flexibility• It is costly to inform customers about nominal

price changes because they are usually left unchanged

• Firms choose to leave prices unchanged

What are the Frictions?

• Expressing price nominally• Firms choose nominally ridged pricing policies• Menu Costs• Price-setters deciding to change price

Frictions / Inflation

• High Inflation– Prices adjusted often– Optimal price-setters– Consumers put less importance on nominal prices

• Low Inflation– Adjust Slower

• Nominal Shocks are smaller with high inflation

Real Rigidities

• Issue: can small frictions cause nominal disturbances to have large effects on the aggregate economy?

• If incentive is small, firms may not adjust prices to reduction in output

• If incentive is high, all firms will adjust prices due to reduction in output

Real Rigidities

• Function of 2 factors: impact of profit maximizing real price and cost to firm of departure from it real maximizing price

• Real rigidity is low when incentive to change price is high, and high when incentive to change price is high

Sources of Real Rigidity

1. Thick Market Externalities2. Capital Market Imperfections form Imperfect

Information3. Cyclical Behavior of Demand Elasticity in

Goods Market4. No Evidence of Real Wages being Procyclical

Welfare (New Keynesian Model)

• There is asymmetry between demand driven booms and recessions.

• Economy is operating below social optimum as MC is below price.

• Therefore, an increase in output increases welfare and a decrease in output decreases welfare.

Welfare (New Keynesian Model)

• A firms decision to raise price above the normal price level impacts aggregate price and aggregate demand.

• If all firms cut Prices to respond to the decreased aggregate demand output does not fall.

• However firms incentive to reduce price is often low.

• A fall in aggregate demand could lead to a recession if prices remain unchanged.

Welfare (New Keynesian Model)

• Other similar inefficiencies can also to a recession. Example- efficiency wages

• Firms can also create externalities that impact the volatility of output. Example- holding prices stable during demand shifts.

Coordination Failure

• Coordination Failure occurs when firms fail to coordinate decision making and must, therefore, settle for a less efficient equilibrium

• Example- Real rigidity might be so strong that a negative demand shock could cause a firm to raise its price and cut output even more.

Coordination Failure

If government wishes to intervene to prevent coordination failure they must aim to push output to a point above A.

Directions of Research

• Frictions themselves– Pricing policies of firms– Timing of change in prices (fixed time rather than change in

aggregate demand)– Barriers to price adjustment

• Real Rigidities– existence of factors that affect employment hours and

changes in real wages, not only prices• Examine the macroeconomic evidence concerning the

effects of monetary and other aggregate demand disturbances.

Questions?