Question

In the New Keynesian Macroeconomics business cycles are driven by demand shocks, while in the New Classical Macroeconomics they are driven by supply shocks. Explain this statement using your knowledge of the AD-AS model.

Answer 1

Answer:

New keynesian model by demand shocks:

Demand shocks likely play a key role in driving business cycles. However, in the standard new
keynesian model, the monetary policy reaction to these shocks have a supply side effect. The
change in real rate affects the marginal utility of consumption generating an income effect on
labor supply. Wages, inflation and through monetary policy, aggregate demand will increase.This supply side effect have a surprising importance for the model, especially when the sensi-tivity of aggregate demand to interest rate is low. A demand shock will have a large impact
(close to one) on output, but a very small one on the output gap. The limited monetary policy
movement induced by the taylor rule remains very close to the natural rate of interest. There
are nearly no differences between the sticky price and the flexible price model. It represents
a very disappointing result, the entire purpose of sticky prices being to generate inefficiencies
when the aggregate demand is hit. Coupled with very tiny empirical support for this supply
side effect of monetary policy, it suggests to explore the theoretical possibilities to kill this ef-
fect. First, we review the two ways the literature have proposed, nonseparable preferences and
sticky wages. The main drawback is a strong reliance on very specific assumption for the labor
market. We explore an alternative approach. We attempt a radical departure from traditionnal
assumption about the optimizing behavior of the representative agent. Instead of optimizing
simulatneously with respect to hours, consumption and saving, the household decomposes the problem in two steps. First, the agent chooses between labor income and hours. Second, heoptimizes between consumption and saving. The interest is to disentangle the income effect which affects the labor equation and those affecting the intertemporal choice. Thus it is possibleto reduce the wealth effect on labor supply whereas keeping a low sensitivity of consumptionto interest rate. This flexible approach also allows to challenge the effect of interest rate on wealth offering a potential explanation for small effects of interest rate on both labor supply and consumption whereas keeping large income effects.

New classical model by supply shocks:

Like classical economic thought, new classical economics focuses on the determination of long-run aggregate supply and the economy’s ability to reach this level of output quickly. But the similarity ends there. Classical economics emerged in large part before economists had developed sophisticated mathematical models of maximizing behavior. The new classical economics puts mathematics to work in an extremely complex way to generalize from individual behavior to aggregate results.

Because the new classical approach suggests that the economy will remain at or near its potential output, it follows that the changes we observe in economic activity result not from changes in aggregate demand but from changes in long-run aggregate supply. New classical economics suggests that economic changes don’t necessarily imply economic problems.

New classical economists pointed to the supply-side shocks of the 1970s, both from changes in oil prices and changes in expectations, as evidence that their emphasis on aggregate supply was on the mark. They argued that the large observed swings in real GDP reflected underlying changes in the economy’s potential output. The recessionary and inflationary gaps that so perplexed policy makers during the 1970s were not gaps at all, the new classical economists insisted. Instead, they reflected changes in the economy’s own potential output.