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:

In keynesian and new keynesian views, business cycles are mainly driven by changes in aggre-
gate demand or "demand shocks". The intuition is well understood. Prices and wages are sticky
and firm output is demand determined. A rise in aggregate demand will lead to an increase
in aggregate supply instead of increasing prices. This idea has been backed by a variety of
empirical evidences. Blanchard and Quah (1989) show in a VAR model with long run restric-
tions that demand shocks accounts for two third of output variance at three years horizon and
more than 85% of the employment variance. The recent wave of Bayesian DSGE models also
support a prominent role for demand, especially investment. Smets and Wouters (2007) model
suggest that markup wage shock drives output variation, but historical decomposition shows
the result is mainly due to the 70-80 period of inflation and disinflation. True recessions are
mostly generated by demand shocks. In following models like Justiniano-Primiceri-Tambalotti (2011) or Christiano Motto Rostagno (2014), demand shocks play even a larger role. Business cycles is mostly driven by investment fluctuation explained either by a generic investment specific technologic shock or by fluctuations in financial conditions. Beside these macroeconomic evidences, the new keynesian mechanism have also received some empirical support. Prices and wage stickiness have been supported by Bils and Klenow (2014), Kehoe and Midrigan (2010), and Barattieri, Basu and Gottschalk (2014). Bils and Klenow (2013) also found evidences for a keynesian labor demand. The value of these very stylized evidences should not be overestimated but they make the case for studying demand driven business cycles.
An increase in aggregate demand have several effects in the new keynesian model. First,
there is the direct effect on output. Firms increase their production when their demand in-
creases. Beside this direct effect, there is an indirect channel through monetary policy. This
channel can be decomposed in two effects, one demand side effect and one less known supply
side effect.

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.