New Keynesian Business Cycle Theory
New Keynesian economists accept that the source of shocks which generate
aggregate disturbances can arise from the supply side or the demand side.
However, new Keynesians argue that there are frictions and imperfections
within the economy which will amplify these shocks so that large fluctuations
in real output and employment result. The important issue for new
Keynesians is not so much the source of the shocks but how the economy
responds to them.
Within new Keynesian economics there have been two strands of research
relating to the issue of aggregate fluctuations. The predominant
approach has emphasized the importance of nominal rigidities. The second
approach follows Keynes (1936) and Tobin (1975), and explores the potentially
destabilizing impact of wage and price flexibility. We will examine
each in turn. Consider Figure 7.8. In panel (a) we illustrate the impact of a
decline in the money supply which shifts aggregate demand from AD0 to
AD1. If a combination of menu costs and real rigidities makes the price
level rigid at P0, the decline in aggregate demand will move the economy
from point E0 to point E1 in panel (a). The decline in output reduces the
effective demand for labour. In panel (c) the effective labour demand curve
(DLe) shows how much labour is necessary to produce different levels of
output. As the diagram shows, L1 amount of labour is required to produce Y1
amount of output. With prices and the real wage fixed at P0 and w0, respectively,
firms move off the notional demand curve for labour, DL, operating
instead along their effective labour demand curve indicated by NKL1 in
panel (d). At the rigid real wage of w0, firms would like to hire L0 workers,
but they have no market for the extra output which would be produced by
hiring the extra workers. The aggregate demand shock has produced an
increase in involuntary unemployment of L0 – L1. The new Keynesian shortrun
aggregate supply curve SRAS (P0) is perfectly elastic at the fixed price
level. Eventually downward pressure on prices and wages would move the
economy from point E1 to E2 in panel (a), but this process may take an
unacceptably long period of time. Therefore new Keynesian economists,
like Keynes, advocate measures which will push the aggregate demand
curve back towards E0. In the new Keynesian model, monetary shocks
clearly have non-neutral effects in the short run, although money remains
neutral in the long run, as indicated by the vertical long-run aggregate
supply curve (LRAS).
The failure of firms to cut prices even though this would in the end benefit
all firms is an example of a ‘coordination failure’. A coordination failure
occurs when economic agents reach an outcome that is inferior to all of them
because there are no private incentives for agents to jointly choose strategies
that would produce a much better (and preferred) result (see Mankiw, 2003).
The inability of agents to coordinate their activities successfully in a decentralized
system arises because there is no incentive for a single firm to cut
price and increase production, given the assumed inaction of other agents.
Because the optimal strategy of one firm depends on the strategies adopted by
other firms, a strategic complementary is present, since all firms would gain
if prices were reduced and output increased (Alvi, 1993). To many Keynesian
economists the fundamental causes of macroeconomic instability relate to
problems associated with coordination failure (see Ball and Romer, 1991;
Leijonhufvud, 1992).
The second brand of new Keynesian business cycle theorizing suggests
that wage and price rigidities are not the main problem. Even if wages and
prices were fully flexible, output and employment would still be very unstable.
Indeed, price rigidities may well reduce the magnitude of aggregate
fluctuations, a point made by Keynes in Chapter 19 of the General Theory,
but often neglected (see Chapter 2 above, and General Theory, p. 269). A
reconsideration of this issue followed Tobin’s (1975) paper (see Sheffrin,
1989, for a discussion of this debate). Tobin himself remains highly critical
of new Keynesian theorists who continue to stress the importance of nominal
rigidities (Tobin, 1993), and Greenwald and Stiglitz have been influential in
developing new Keynesian models of the business cycle which do not rely on
nominal price and wage inertia, although real rigidities play an important
role.
In the Greenwald and Stiglitz model (1993a, 1993b) firms are assumed to
be risk-averse. Financial market imperfections generated by asymmetric information
constrain many firms from access to equity finance. Equity-rationed
firms can only partially diversify out of the risks they face. Their resultant
dependence on debt rather than new equity issues makes firms more vulnerable
to bankruptcy, especially during a recession when the demand curve
facing most firms shifts to the left. Faced with such a situation, a risk-averse
equity-constrained firm prefers to reduce its output because the uncertainties
associated with price flexibility are much greater than those from quantity
adjustment. As Stiglitz (1999b) argues, ‘the problem of price-wage setting
should be approached within a standard dynamic portfolio model, one that
takes into account the risks associated with each decision, the nonreversibilities,
as well as the adjustment costs associated with both prices and
quantities’.
Greenwald and Stiglitz argue that, as a firm produces more, the probability
of bankruptcy increases, and since bankruptcy imposes costs these will be
taken into account in firms’ production decisions. The marginal bankruptcy
cost measures the expected extra costs which result from bankruptcy. During
a recession the marginal bankruptcy risk increases and risk-averse firms react
to this by reducing the amount of output they are prepared to produce at each
price (given wages). Any change in a firm’s net worth position or in their
perception of the risk they face will have a negative impact on their willingness
to produce and shifts the resultant risk-based aggregate supply curve to
the left. As a result, demand-induced recessions are likely to induce leftward
shifts of the aggregate supply curve. Such a combination of events could
leave the price level unchanged, even though in this model there are no
frictions preventing adjustment. Indeed, price flexibility, by creating more
uncertainty, would in all likelihood make the situation worse. In the
Greenwald–Stiglitz model aggregate supply and aggregate demand are interdependent
and ‘the dichotomy between “demand” and “supply” side shocks
may be, at best, misleading’ (Greenwald and Stiglitz, 1993b, p. 103; Stiglitz,
1999b).
In Figure 7.9 we illustrate the impact of an aggregate demand shock which
induces the aggregate supply curve to shift to the left. The price level remains
at P0, even though output falls from Y0 to Y1. A shift of the aggregate supply
curve to the left as the result of an increase in perceived risk will also shift the
demand curve of labour to the left. If real wages are influenced by efficiency
wage considerations, involuntary unemployment increases without any significant
change in the real wage.
In addition to the above influences, new Keynesians have also examined the
consequences of credit market imperfections which lead risk-averse lenders to
respond to recessions by shifting their portfolio towards safer activities. This
behaviour can magnify an economic shock by raising the real costs of intermediation.
The resulting credit squeeze can convert a recession into a depression
as many equity-constrained borrowers find credit expensive or difficult to
obtain, and bankruptcy results. Because high interest rates can increase the
probability of default, risk-averse financial institutions frequently resort to
credit rationing. Whereas the traditional approach to analysing the monetary
transmission mechanism focuses on the interest rate and exchange rate channels,
the new paradigm emphasizes the various factors that influence the ability
of financial institutions to evaluate the ‘creditworthiness’ of potential borrowers
in a world of imperfect information. Indeed, in the new paradigm, banks are
viewed as risk-averse firms that are constantly engaged in a process of screening
and monitoring customers. In a well-known paper, Bernanke (1983) argues
that the severity of the Great Depression was in large part due to the breakdown
of the economy’s credit facilities, rather than a decline in the money supply
(see Jaffe and Stiglitz, 1990, and Bernanke and Gertler, 1995, for surveys of the
literature on credit rationing; see also Stiglitz and Greenwald, 2003, who
champion what they call ‘the new paradigm’ in monetary economics).
Some new Keynesians have also incorporated the impact of technology
shocks into their models. For example, Ireland (2004) explores the link
between the ‘current generation of new Keynesian models and the previous
generation of real business cycle models’. To identify what is driving aggregate
instability, Ireland’s model combines technology shocks with shocks to
household preferences, firm’s desired mark-ups, and the central bank’s monetary
policy rule. Ireland finds that monetary shocks are a major source of
real GDP instability, particularly before 1980. Technology shocks play only a
‘modest role’, accounting for less than half of the observed instability of
output in the post-1980 period.
New Keynesian economists accept that the source of shocks which generate
aggregate disturbances can arise from the supply side or the demand side.
However, new Keynesians argue that there are frictions and imperfections
within the economy which will amplify these shocks so that large fluctuations
in real output and employment result. The important issue for new
Keynesians is not so much the source of the shocks but how the economy
responds to them.
Within new Keynesian economics there have been two strands of research
relating to the issue of aggregate fluctuations. The predominant
approach has emphasized the importance of nominal rigidities. The second
approach follows Keynes (1936) and Tobin (1975), and explores the potentially
destabilizing impact of wage and price flexibility. We will examine
each in turn. Consider Figure 7.8. In panel (a) we illustrate the impact of a
decline in the money supply which shifts aggregate demand from AD0 to
AD1. If a combination of menu costs and real rigidities makes the price
level rigid at P0, the decline in aggregate demand will move the economy
from point E0 to point E1 in panel (a). The decline in output reduces the
effective demand for labour. In panel (c) the effective labour demand curve
(DLe) shows how much labour is necessary to produce different levels of
output. As the diagram shows, L1 amount of labour is required to produce Y1
amount of output. With prices and the real wage fixed at P0 and w0, respectively,
firms move off the notional demand curve for labour, DL, operating
instead along their effective labour demand curve indicated by NKL1 in
panel (d). At the rigid real wage of w0, firms would like to hire L0 workers,
but they have no market for the extra output which would be produced by
hiring the extra workers. The aggregate demand shock has produced an
increase in involuntary unemployment of L0 – L1. The new Keynesian shortrun
aggregate supply curve SRAS (P0) is perfectly elastic at the fixed price
level. Eventually downward pressure on prices and wages would move the
economy from point E1 to E2 in panel (a), but this process may take an
unacceptably long period of time. Therefore new Keynesian economists,
like Keynes, advocate measures which will push the aggregate demand
curve back towards E0. In the new Keynesian model, monetary shocks
clearly have non-neutral effects in the short run, although money remains
neutral in the long run, as indicated by the vertical long-run aggregate
supply curve (LRAS).
The failure of firms to cut prices even though this would in the end benefit
all firms is an example of a ‘coordination failure’. A coordination failure
occurs when economic agents reach an outcome that is inferior to all of them
because there are no private incentives for agents to jointly choose strategies
that would produce a much better (and preferred) result (see Mankiw, 2003).
The inability of agents to coordinate their activities successfully in a decentralized
system arises because there is no incentive for a single firm to cut
price and increase production, given the assumed inaction of other agents.
Because the optimal strategy of one firm depends on the strategies adopted by
other firms, a strategic complementary is present, since all firms would gain
if prices were reduced and output increased (Alvi, 1993). To many Keynesian
economists the fundamental causes of macroeconomic instability relate to
problems associated with coordination failure (see Ball and Romer, 1991;
Leijonhufvud, 1992).
The second brand of new Keynesian business cycle theorizing suggests
that wage and price rigidities are not the main problem. Even if wages and
prices were fully flexible, output and employment would still be very unstable.
Indeed, price rigidities may well reduce the magnitude of aggregate
fluctuations, a point made by Keynes in Chapter 19 of the General Theory,
but often neglected (see Chapter 2 above, and General Theory, p. 269). A
reconsideration of this issue followed Tobin’s (1975) paper (see Sheffrin,
1989, for a discussion of this debate). Tobin himself remains highly critical
of new Keynesian theorists who continue to stress the importance of nominal
rigidities (Tobin, 1993), and Greenwald and Stiglitz have been influential in
developing new Keynesian models of the business cycle which do not rely on
nominal price and wage inertia, although real rigidities play an important
role.
In the Greenwald and Stiglitz model (1993a, 1993b) firms are assumed to
be risk-averse. Financial market imperfections generated by asymmetric information
constrain many firms from access to equity finance. Equity-rationed
firms can only partially diversify out of the risks they face. Their resultant
dependence on debt rather than new equity issues makes firms more vulnerable
to bankruptcy, especially during a recession when the demand curve
facing most firms shifts to the left. Faced with such a situation, a risk-averse
equity-constrained firm prefers to reduce its output because the uncertainties
associated with price flexibility are much greater than those from quantity
adjustment. As Stiglitz (1999b) argues, ‘the problem of price-wage setting
should be approached within a standard dynamic portfolio model, one that
takes into account the risks associated with each decision, the nonreversibilities,
as well as the adjustment costs associated with both prices and
quantities’.
Greenwald and Stiglitz argue that, as a firm produces more, the probability
of bankruptcy increases, and since bankruptcy imposes costs these will be
taken into account in firms’ production decisions. The marginal bankruptcy
cost measures the expected extra costs which result from bankruptcy. During
a recession the marginal bankruptcy risk increases and risk-averse firms react
to this by reducing the amount of output they are prepared to produce at each
price (given wages). Any change in a firm’s net worth position or in their
perception of the risk they face will have a negative impact on their willingness
to produce and shifts the resultant risk-based aggregate supply curve to
the left. As a result, demand-induced recessions are likely to induce leftward
shifts of the aggregate supply curve. Such a combination of events could
leave the price level unchanged, even though in this model there are no
frictions preventing adjustment. Indeed, price flexibility, by creating more
uncertainty, would in all likelihood make the situation worse. In the
Greenwald–Stiglitz model aggregate supply and aggregate demand are interdependent
and ‘the dichotomy between “demand” and “supply” side shocks
may be, at best, misleading’ (Greenwald and Stiglitz, 1993b, p. 103; Stiglitz,
1999b).
In Figure 7.9 we illustrate the impact of an aggregate demand shock which
induces the aggregate supply curve to shift to the left. The price level remains
at P0, even though output falls from Y0 to Y1. A shift of the aggregate supply
curve to the left as the result of an increase in perceived risk will also shift the
demand curve of labour to the left. If real wages are influenced by efficiency
wage considerations, involuntary unemployment increases without any significant
change in the real wage.
In addition to the above influences, new Keynesians have also examined the
consequences of credit market imperfections which lead risk-averse lenders to
respond to recessions by shifting their portfolio towards safer activities. This
behaviour can magnify an economic shock by raising the real costs of intermediation.
The resulting credit squeeze can convert a recession into a depression
as many equity-constrained borrowers find credit expensive or difficult to
obtain, and bankruptcy results. Because high interest rates can increase the
probability of default, risk-averse financial institutions frequently resort to
credit rationing. Whereas the traditional approach to analysing the monetary
transmission mechanism focuses on the interest rate and exchange rate channels,
the new paradigm emphasizes the various factors that influence the ability
of financial institutions to evaluate the ‘creditworthiness’ of potential borrowers
in a world of imperfect information. Indeed, in the new paradigm, banks are
viewed as risk-averse firms that are constantly engaged in a process of screening
and monitoring customers. In a well-known paper, Bernanke (1983) argues
that the severity of the Great Depression was in large part due to the breakdown
of the economy’s credit facilities, rather than a decline in the money supply
(see Jaffe and Stiglitz, 1990, and Bernanke and Gertler, 1995, for surveys of the
literature on credit rationing; see also Stiglitz and Greenwald, 2003, who
champion what they call ‘the new paradigm’ in monetary economics).
Some new Keynesians have also incorporated the impact of technology
shocks into their models. For example, Ireland (2004) explores the link
between the ‘current generation of new Keynesian models and the previous
generation of real business cycle models’. To identify what is driving aggregate
instability, Ireland’s model combines technology shocks with shocks to
household preferences, firm’s desired mark-ups, and the central bank’s monetary
policy rule. Ireland finds that monetary shocks are a major source of
real GDP instability, particularly before 1980. Technology shocks play only a
‘modest role’, accounting for less than half of the observed instability of
output in the post-1980 period.
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