Question

Keynes (1936) argued that, from a policy perspective, everything that can be achieved by a nominal wage cut can be more effectively achieved through an appropriate monetary policy.

(a) Does this statement hold in the deficient-demand Keynesian model for a negative shock to (i) aggregate demand and (ii) aggregate labor productivity?

(b) Does this statement hold in the new Keynesian model for a negative shock to (i) aggregate demand and (ii) aggregate labor productivity?

Answer 1

(a)

What Is Keynesian Economics?
Keynesian economics is a macroeconomic economic theory of total spending in the economy and its effects on output, employment, and inflation. Keynesian economics was developed by the British economist John Maynard Keynes during the 1930s in an attempt to understand the Great Depression. Keynesian economics is considered a "demand-side" theory that focuses on changes in the economy over the short run. Keynes’s theory was the first to sharply separate the study of economic behaviour and markets based on individual incentives from the study of broad national economic aggregate variables and constructs.

Based on his theory, Keynes advocated for increased government expenditures and lower taxes to stimulate demand and pull the global economy out of the depression. Subsequently, Keynesian economics was used to refer to the concept that optimal economic performance could be achieved—and economic slumps prevented—by influencing aggregate demand through activist stabilization and economic intervention policies by the government.

Keynesian economics focuses on using active government policy to manage aggregate demand in order to address or prevent economic recessions.

Keynes developed his theories in response to the Great Depression, and was highly critical of previous economic theories, which he referred to as “classical economics”.

Activist fiscal and monetary policy are the primary tools recommended by Keynesian economists to manage the economy and fight unemployment.

Aggregate demand in Keynesian Modal
Key points
Aggregate demand is the sum of four components: consumption, investment, government spending, and net exports.
Consumption can change for a number of reasons, including movements in income, taxes, expectations about future income, and changes in wealth levels.
Investment can change in response to its expected profitability, which in turn is shaped by expectations about future economic growth, the creation of new technologies, the price of key inputs, and tax incentives for investment. Investment can also change when interest rates rise or fall.
Government spending and taxes are determined by political considerations.
Exports and imports change according to relative growth rates and prices between two economies.
Disposable income is income after taxes.
An inflationary gap exists when equilibrium is at a level of output above potential GDP.
A recessionary gap exists when equilibrium is at a level of output below potential GDP.
Aggregate demand in Keynesian analysis
The Keynesian perspective focuses on aggregate demand. The general idea being that firms produce output only if they expect it to sell.
Thus, while the availability of the factors of production determines a nation’s potential gross domestic product, or GDP, the amount of goods and services actually being sold—known as real GDP—depends on how much demand exists across the economy. You can see this concept represented graphically in the diagram below.

Key points

• Aggregate demand is the sum of four components: consumption, investment, government spending, and net exports.

• Consumption can change for a number of reasons, including movements in income, taxes, expectations about future income, and changes in wealth levels.

• Investment can change in response to its expected profitability, which in turn is shaped by expectations about future economic growth, the creation of new technologies, the price of key inputs, and tax incentives for investment. Investment can also change when interest rates rise or fall.

• Government spending and taxes are determined by political considerations.

• Exports and imports change according to relative growth rates and prices between two economies.

• Disposable income is income after taxes.

• An inflationary gap exists when equilibrium is at a level of output above potential GDP.

• A recessionary gap exists when equilibrium is at a level of output below potential GDP.

Aggregate demand in Keynesian analysis

The Keynesian perspective focuses on aggregate demand. The general idea being that firms produce output only if they expect it to sell.

Thus, while the availability of the factors of production determines a nation’s potential gross domestic product, or GDP, the amount of goods and services actually being sold—known as real GDP—depends on how much demand exists across the economy. You can see this concept represented graphically in the diagram below.

The Keynesian AD/AS model

This Keynesian view of the AD/AS model shows that with a horizontal aggregate supply, a decrease in demand leads to a decrease in output but no decrease in prices.

Image credit: Figure 1 in "Aggregate Demand in Keynesian Analysis" by OpenStaxCollege, CC BY 4.0

Keynes argued that, for reasons we'll explain shortly, aggregate demand is not stable—it can change unexpectedly.

Suppose the economy starts where \text{AD0}AD0start text, A, D, 0, end text intersects \text{SRAS}SRASstart text, S, R, A, S, end text at \text{P0}P0start text, P, 0, end text and \text{Yp}Ypstart text, Y, p, end text in the diagram above. Because \text{Yp}Ypstart text, Y, p, end text is potential output, the economy is at full employment. But because aggregate demand is volatile, it can easily fall. Thus, even if we start at \text{Yp}Ypstart text, Y, p, end text, if aggregate demand falls, we find ourselves in what Keynes termed a recessionary gap. The economy is in equilibrium but with less than full employment, as shown at \text{Y1}Y1start text, Y, 1, end text. Keynes believed that the economy would tend to stay in a recessionary gap, with its attendant unemployment, for a significant period of time.

Similarly—though not shown in the figure—if aggregate demand increases, the economy could experience an inflationary gap, where demand is attempting to push the economy past potential output. As a consequence, the economy would experience inflation.

The key policy implication for either situation is that government needs to step in and close the gap, increasing spending during recessions and decreasing spending during booms, to return aggregate demand to match potential output.

Since aggregate demand is total spending, economy-wide, on domestic goods and services, economists also refer to it as total planned expenditure. We can calculate aggregate demand by adding up its four components: consumption expenditure, investment expenditure, government spending, and spending on net exports—exports minus imports.

In this article, we'll examine each component from the Keynesian perspective.

What determines consumption expenditure?

Consumption expenditure is spending by households and individuals on durable goods, nondurable goods, and services. Durable goods are things that last and provide value over time, such as automobiles. Nondurable goods are things like groceries—once you consume them, they are gone. Services are intangible things consumers buy, like healthcare or entertainment.

Keynes identified three factors that affect consumption:

• Disposable income: For most people, the single most powerful determinant of how much they consume is how much income they have in their take-home pay. This left-over income is also also known as disposable income, which is income after taxes.

• Expected future income: Consumer expectations about future income also are important in determining consumption. If consumers feel optimistic about the future, they are more likely to spend and increase overall aggregate demand. News of recession and troubles in the economy will make them pull back on consumption.

• Wealth or credit: When households experience a rise in wealth, they may be willing to consume a higher share of their income and to save less. When the US stock market rose dramatically in the late 1990s, for example, US rates of saving declined, probably in part because people felt that their wealth had increased and there was less need to save. How do people spend beyond their income when they perceive their wealth increasing? The answer is borrowing. On the other side, when the US stock market declined about 40% from March 2008 to March 2009, people felt far greater uncertainty about their economic future, so rates of saving increased while consumption declined.

Finally, Keynes noted that a variety of other factors combine to determine how much people save and spend. If household preferences about saving shift in a way that encourages consumption rather than saving, then aggregate demand will shift out to the right.

What determines investment expenditure?

Spending on new capital goods is called investment expenditure. Investment falls into four categories: producer’s durable equipment and software, new nonresidential structures, changes in inventories, and residential structures. The first three types of investment are conducted by businesses, while the last is conducted by households.

Keynes’s treatment of investment focuses on the key role of expectations about the future in influencing business decisions.

When a business decides to make an investment in physical assets—like plants or equipment—or in intangible assets—like skills or a research and development project—that firm considers both the expected benefits of the investment, like future profits, and the costs of the investment, such as interest rates.

The clearest driver of the benefits of an investment is expectations for future profits. When an economy is expected to grow, businesses perceive a growing market for their products. Their higher degree of business confidence will encourage new investment. For example, in the second half of the 1990s, US investment levels surged from 18% of GDP in 1994 to 21% in 2000. However, when a recession started in 2001, US investment levels quickly sank back to 18% of GDP by 2002.

Interest rates also play a significant role in determining how much investment a firm will make. Just as individuals need to borrow money to purchase homes, businesses need financing when they purchase big ticket items. The cost of investment thus includes the interest rate. Even if the firm has the funds, the interest rate measures the opportunity cost of purchasing business capital. Lower interest rates stimulate investment spending and higher interest rates reduce it.

Many factors can affect the expected profitability on investment. For example, if the price of energy declines, then investments that use energy as an input will yield higher profits. If the government offers special incentives for investment—for example, through the tax code—then investment will look more attractive; conversely, if government removes special investment incentives from the tax code or increases other business taxes, then investment will look less attractive.

Keynes believed that business investment is the most variable of all the components of aggregate demand.

What determines government spending?

The third component of aggregate demand is spending by federal, state, and local governments. Although the United States is usually thought of as a market economy, government still plays a significant role in the economy. Government provides important public services such as national defense, transportation infrastructure, and education.

Keynes recognized that the government budget offered a powerful tool for influencing aggregate demand. Not only could aggregate demand be stimulated by more government spending—or reduced by less government spending—but consumption and investment spending could be influenced by lowering or raising tax rates.

Keynes concluded that during extreme times like deep recessions, only the government had the power and resources to move aggregate demand.

What determines net exports?

Exports are products produced domestically and sold abroad, and imports are products produced abroad but purchased domestically. Since aggregate demand is defined as spending on domestic goods and services, export expenditures add to aggregate demand, while import expenditures subtract from aggregate demand.

Two sets of factors can cause shifts in export and import demand: changes in relative growth rates between countries and changes in relative prices between countries.

The level of demand for a nation’s exports tends to be most heavily affected by what is happening in the economies of the countries that would be purchasing those exports. For example, if major importers of US-made products like Canada, Japan, and Germany have recessions, exports of US products to those countries are likely to decline since quantity of a nation’s imports is directly affected by the amount of income in the domestic economy. More income will bring a higher level of imports.

Exports and imports can also be affected by relative prices of goods in domestic and international markets. If US goods are relatively cheaper compared with goods made in other places—perhaps because a group of US producers has mastered certain productivity breakthroughs—then US exports are likely to rise. If US goods become relatively more expensive—perhaps because a change in the exchange rate between the US dollar and other currencies has pushed up the price of inputs to production in the United States—then exports from US producers are likely to decline.

A quick overview of what drives aggregate demand

We've gone over all the components of aggregate demand and what drives them to change above, but you may find it useful to refer to the table below that summarizes this information.

Determinants of aggregate demand

Reasons for a decrease in aggregate demand		Reasons for an increase in aggregate demand
Consumption	Rise in taxes, fall in income, rise in interest, desire to save more, decrease in wealth, fall in future expected income	Consumption	Decrease in taxes, increase in income, fall in interest rates, desire to save less, rise in wealth, rise in future expected income
Investment	Fall in expected rate of return, rise in interest rates, drop in business confidence	Investment	Rise in expected rate of return, drop in interest rates, rise in business confidence
Government	Reduction in government spending, increase in taxes	Government	Increase in government spending, decrease in taxes
Net exports	Decrease in foreign demand, relative price increase of US goods	Net exports	Increase in foreign demand, relative price drop of S. goods

Summary

• Aggregate demand is the sum of four components: consumption, investment, government spending, and net exports.

• Consumption can change for a number of reasons, including movements in income, taxes, expectations about future income, and changes in wealth levels.

• Investment can change in response to its expected profitability, which in turn is shaped by expectations about future economic growth, the creation of new technologies, the price of key inputs, and tax incentives for investment. Investment can also change when interest rates rise or fall.

• Government spending and taxes are determined by political considerations.

• Exports and imports change according to relative growth rates and prices between two economies.

• Disposable income is income after taxes.

• An inflationary gap exists when equilibrium is at a level of output above potential GDP.

• A recessionary gap exists when equilibrium is at a level of output below potential GDP.

• Key points

• Keynesian economics is based on two main ideas. First, aggregate demand is more likely than aggregate supply to be the primary cause of a short-run economic event like a recession. Second, wages and prices can be sticky, and so, in an economic downturn, unemployment can result.

• The coordination argument states that downward wage and price flexibility requires perfect information about the level of lower compensation acceptable to other laborers and market participants.

• The expenditure multiplier is a Keynesian concept that asserts that a change in autonomous spending causes a more than proportionate change in real GDP.

• A macroeconomic externality occurs when what happens at the macro level is different from and inferior to what happens at the micro level.

• Menu costs are costs firms face when changing prices.

• Sticky wages and prices are wages and prices that do not fall in response to a decrease in demand or do not rise in response to an increase in demand.

• The building blocks of Keynesian analysis

  Keynesian economics focuses on explaining why recessions and depressions occur and offering a policy prescription for minimizing their effects. The Keynesian view of recession is based on two key building blocks:

• Aggregate demand, AD, is not always automatically high enough to provide firms with an incentive to hire enough workers to reach full employment.

• The macroeconomy may adjust only slowly to shifts in aggregate demand because of sticky wages and prices—wages and prices that do not respond to decreases or increases in demand.

• The expenditure multiplier

  Another key concept in Keynesian economics is the expenditure multiplier. The expenditure multiplier is the idea that not only does spending affect the equilibrium level of GDP but that spending is powerful. More precisely, it means that a change in spending causes a more than proportionate change in GDP.

  \frac{\mathrm{\Delta Y}}{\mathrm{\Delta Spending}}>1ΔSpendingΔY​>1start fraction, delta, Y, divided by, delta, S, p, e, n, d, i, n, g, end fraction, is greater than, 1

  The reason for the expenditure multiplier is that one person’s spending becomes another person’s income, which leads to additional spending and additional income, and so forth, so the cumulative impact on GDP is larger than the initial increase in spending. The multiplier is important for understanding the effectiveness of fiscal policy, but it occurs whenever any autonomous increase in spending occurs. Additionally, the multiplier operates in a negative as well as a positive direction.

  Thus, when investment spending collapsed during the Great Depression, it caused a much larger decrease in real GDP. The size of the multiplier is critical and was a key element in recent discussions of the effectiveness of the Obama administration’s fiscal stimulus package, officially titled the American Recovery and Reinvestment Act of 2009.

  Summary

• Keynesian economics is based on two main ideas. First, aggregate demand is more likely than aggregate supply to be the primary cause of a short-run economic event like a recession. Second, wages and prices can be sticky, and so, in an economic downturn, unemployment can result.

• The coordination argument states that downward wage and price flexibility requires perfect information about the level of lower compensation acceptable to other laborers and market participants.

• The expenditure multiplier is a Keynesian concept that asserts that a change in autonomous spending causes a more than proportionate change in real GDP.

• A macroeconomic externality occurs when what happens at the macro level is different from and inferior to what happens at the micro level.

• Menu costs are costs firms face when changing prices.

• Sticky wages and prices are wages and prices that do not fall in response to a decrease in demand or do not rise in response to an increase in demand.

• Let's look at each of these two claims more closely. The first building block of the Keynesian diagnosis is that recessions occur when the level of household and business sector demand for goods and services is less than what is produced when labor is fully employed. In other words, the intersection of aggregate supply and aggregate demand occurs at a level of output less than the level of GDP consistent with full employment.

  Suppose the stock market crashes, as occurred in 1929. Household wealth declines, and consumption expenditure follows. Businesses see that consumer spending is falling, which reduces expectations of the profitability of investment, so they decrease investment expenditure.

  This seems to be what happened during the Great Depression since the physical capacity of the economy to supply goods did not alter much. No flood or earthquake or other natural disaster ruined factories in 1929 or 1930. No outbreak of disease decimated the ranks of workers. No key input price, like the price of oil, soared on world markets. The US economy in 1933 had just about the same factories, workers, and state of technology as it had had four years earlier in 1929—and yet the economy shrank dramatically.

  Keynes recognized that the events of the Great Depression contradicted Say’s law, which states that supply creates its own demand. Although production capacity existed, the markets were not able to sell their products. As a result, real GDP was less than potential GDP.

  Wage and price stickiness

  Keynes also noticed that when AD fluctuated, prices and wages did not immediately respond as economists expected. Instead, prices and wages were “sticky,” making it difficult to restore the economy to full employment and potential GDP.

  Keynes emphasized one particular reason why wages are sticky: the coordination argument. This argument points out that, even if most people would be willing—at least hypothetically—to see a decline in their own wages in bad economic times as long as everyone else also experienced such a decline, a market-oriented economy has no obvious way to implement a plan of coordinated wage reductions. There are a number of reasons why wages might be sticky downward, most of which center on the argument that businesses avoid wage cuts because they may in one way or another depress morale and hurt the productivity of the existing workers.

  Some modern economists have argued in a Keynesian spirit that, along with wages, other prices may be sticky, too. Many firms do not change their prices every day or even every month. When a firm considers changing prices, it must consider two sets of costs. First, changing prices uses company resources—managers must analyze the competition and market demand and decide what the new prices will be, sales materials must be updated, billing records will change, and product labels and price labels must be redone. Second, frequent price changes may leave customers confused or angry—especially if they find out that a product now costs more than expected.

  These costs of changing prices are called menu costs—because they are similar to the costs of printing up a new set of menus with different prices in a restaurant. Prices do respond to forces of supply and demand, but from a macroeconomic perspective, the process of changing all prices throughout the economy takes time.

  To understand the effect of sticky wages and prices in the economy, consider Diagram A below, illustrating the overall labor market, and Diagram B, illustrating a market for a specific good or service.

  The original equilibrium \text{E0}E0start text, E, 0, end text in each market occurs at the intersection of the demand curve \text{D0}D0start text, D, 0, end text and supply curve \text{S0}S0start text, S, 0, end text. When aggregate demand declines, the demand for labor shifts to the left—to \text{D1}D1start text, D, 1, end text in diagram A—and the demand for goods shifts to the left—to \text{D1}D1start text, D, 1, end text in diagram B. Because of sticky wages and prices, however, the wage remains at its original level, \text{W0}W0start text, W, 0, end text, for a period of time and the price remains at its original level, \text{P0}P0start text, P, 0, end text.

  As a result, a situation of excess supply—where the quantity supplied exceeds the quantity demanded at the existing wage or price—exists in markets for both labor and goods, and \text{Q1}Q1start text, Q, 1, end text is less than \text{Q0}Q0start text, Q, 0, end text in both diagram A and diagram B. When many labor markets and many goods markets all across the economy find themselves in this position, the economy is in a recession; that is, firms cannot sell what they wish to produce at the existing market price and do not wish to hire all who are willing to work at the existing market wage.

  

  Two graphs show how sticky wages have varying effects based on whether the market is a labor market or a goods market.

  Image credit: Figure 1 in "The Building Blocks of Keynesian Analysis" by OpenStaxCollege, CC BY 4.0

  [Why is the pace of wage adjustments slow?]

  The two Keynesian assumptions in the AD/AS Model

  The two Keynesian assumptions—the importance of aggregate demand in causing recession and the stickiness of wages and prices—can be illustrated using an aggregate demand/aggregate supply, or AD/AS, diagram like the one below. Note that because of the stickiness of wages and prices, the aggregate supply curve is flatter than the supply curves in diagrams A and B above. In fact, if wages and prices were so sticky that they did not fall at all, the aggregate supply curve would be completely flat below potential GDP.

  This outcome is an important example of a macroeconomic externality, meaning that what happens at the macro level is different from and inferior to what happens at the micro level. For example, a firm should respond to a decrease in demand for its product by cutting its price to increase sales. But if all firms experience a decrease in demand for their products, sticky prices in the aggregate prevent aggregate demand from rebounding—which would be shown as a movement along the AD curve in response to a lower price level.

  The original equilibrium of this economy occurs where the aggregate demand \text{AD0}AD0start text, A, D, 0, end text intersects with aggregate supply. Since this intersection occurs at potential GDP, \text{Yp}Ypstart text, Y, p, end text, the economy is operating at full employment. When aggregate demand shifts to the left, all the adjustment occurs through decreased real GDP. There is no decrease in the price level. Since the equilibrium occurs at \text{Y1}Y1start text, Y, 1, end text, the economy experiences substantial unemployment.

  A Keynesian perspective of recession

  

  The graph shows three aggregate demand curves and one aggregate supply curve. The aggregate curve farthest to the left represents an economy in a recession.

  Image credit: Figure 3 in "The Building Blocks of Keynesian Analysis" by OpenStaxCollege, CC BY 4.0

(b)

What Is New Keynesian Economics?

New Keynesian Economics is a modern macroeconomic school of thought that evolved from classical Keynesian economics. This revised theory differs from classical Keynesian thinking in terms of how quickly prices and wages adjust.

New Keynesian advocates maintain that prices and wages are "sticky," meaning they adjust more slowly to short-term economic fluctuations. This, in turn, explains such economic factors as involuntary unemployment and the impact of federal monetary policies.

KEY TAKEAWAYS

• New Keynesian Economics is a modern twist on the macroeconomic doctrine that evolved from classical Keynesian economics principles.
• Economists argued that prices and wages are “sticky," causing involuntary unemployment and monetary policy to have a big impact on the economy.
• This way of thinking became the dominant force in academic macroeconomics from the 1990s through to the financial crisis of 2008.

Understanding New Keynesian Economics

British economist John Maynard Keynes' idea in the aftermath of the Great Depression that increased government expenditures and lower taxes can stimulate demand and pull the global economy out of a downturn became the dominant way of thinking for much of the 20^th century. That slowly began to change in 1978 when "After Keynesian Economics" was published.

In the paper, new classical economists Robert Lucas and Thomas Sargent pointed out that the stagflation experienced during the 1970s was incompatible with traditional Keynesian models.

Lucas, Sargent, and others sought to build on Keynes’ original theory by adding microeconomic foundations to it. The two major areas of microeconomics which may significantly impact the macroeconomy, they said, are price and wage rigidity. These concepts intertwine with social theory, negating the pure theoretical models of classical Keynesianism.

The new Keynesian theory attempts to address, among other things, the sluggish behavior of prices and its cause, and how market failures could be caused by inefficiencies and might justify government intervention. The benefits of government intervention remains a flashpoint for debate. New Keynesian economists made a case for expansionary monetary policy, arguing that deficit spending encourages saving, rather than increasing demand or economic growth.

Criticism of New Keynesian Economics

New Keynesian Economics was criticized in some quarters for failing to see the Great Recession coming and for not accurately accounting for the period of secular stagnation that followed it.

The main issue of this economic doctrine is explaining why changes in aggregate price levels are “sticky.” Under new classical macroeconomics, competitive price-taking firms make choices on how much output to produce, and not at what price, while in New Keynesian Economics monopolistically competitive firms set their prices and accept the level of sales as a constraint.

From a New Keynesian Economics point of view, two main arguments try to answer why aggregate prices fail to imitate the nominal Gross National Product (GNP) evolution. Principally, under both approaches to macroeconomics, it is assumed economic agents, households, and firms have rational expectations.

However, New Keynesian Economics maintains that rational expectations become distorted as market failure arises from asymmetric information and imperfect competition. As economic agents can’t have a full scope of the economic reality, their information will be limited, and there will be little reason to believe that other agents will change their prices, and therefore keep their expectations unchanged. As such, expectations are a crucial element of price determination; as they remain unaltered, so will price, which leads to price rigidity.\

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, he optimizes 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 possible to reduce the wealth effect on labor supply whereas keeping a low sensitivity of consumption to 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.

The primary disagreement between new classical and new Keynesian economists is over how quickly wages and prices adjust. New classical economists build their macroeconomic theories on the assumption that wages and prices are flexible. They believe that prices “clear” markets—balance supply and demand—by adjusting quickly. New Keynesian economists, however, believe that market-clearing models cannot explain short-run economic fluctuations, and so they advocate models with “sticky” wages and prices. New Keynesian theories rely on this stickiness of wages and prices to explain why involuntary unemployment exists and why monetary policy has such a strong influence on economic activity.

A long tradition in macroeconomics (including both Keynesian and monetarist perspectives) emphasizes that monetary policy affects employment and production in the short run because prices respond sluggishly to changes in the money supply. According to this view, if the money supply falls, people spend less money and the demand for goods falls. Because prices and wages are inflexible and do not fall immediately, the decreased spending causes a drop in production and layoffs of workers. New classical economists criticized this tradition because it lacks a coherent theoretical explanation for the sluggish behavior of prices. Much new Keynesian research attempts to remedy this omission.

Menu Costs and Aggregate-Demand Externalities

One reason prices do not adjust immediately to clear markets is that adjusting prices is costly. To change its prices, a firm may need to send out a new catalog to customers, distribute new price lists to its sales staff, or, in the case of a restaurant, print new menus. These costs of price adjustment, called “menu costs,” cause firms to adjust prices intermittently rather than continuously.

Economists disagree about whether menu costs can help explain short-run economic fluctuations. Skeptics point out that menu costs usually are very small. They argue that these small costs are unlikely to help explain recessions, which are very costly for society. Proponents reply that “small” does not mean “inconsequential.” Even though menu costs are small for the individual firm, they could have large effects on the economy as a whole.

Proponents of the menu-cost hypothesis describe the situation as follows. To understand why prices adjust slowly, one must acknowledge that changes in prices have externalities—that is, effects that go beyond the firm and its customers. For instance, a price reduction by one firm benefits other firms in the economy. When a firm lowers the price it charges, it lowers the average price level slightly and thereby raises real income. (Nominal income is determined by the money supply.) The stimulus from higher income, in turn, raises the demand for the products of all firms. This macroeconomic impact of one firm’s price adjustment on the demand for all other firms’ products is called an “aggregate-demand externality.”

In the presence of this aggregate-demand externality, small menu costs can make prices sticky, and this stickiness can have a large cost to society. Suppose General Motors announces its prices and then, after a fall in the money supply, must decide whether to cut prices. If it did so, car buyers would have a higher real income and would therefore buy more products from other companies as well. But the benefits to other companies are not what General Motors cares about. Therefore, General Motors would sometimes fail to pay the menu cost and cut its price, even though the price cut is socially desirable. This is an example in which sticky prices are undesirable for the economy as a whole, even though they may be optimal for those setting prices.

The Staggering of Prices

New Keynesian explanations of sticky prices often emphasize that not everyone in the economy sets prices at the same time. Instead, the adjustment of prices throughout the economy is staggered. Staggering complicates the setting of prices because firms care about their prices relative to those charged by other firms. Staggering can make the overall level of prices adjust slowly, even when individual prices change frequently.

Consider the following example. Suppose, first, that price setting is synchronized: every firm adjusts its price on the first of every month. If the money supply and aggregate demand rise on May 10, output will be higher from May 10 to June 1 because prices are fixed during this interval. But on June 1 all firms will raise their prices in response to the higher demand, ending the three-week boom.

Now suppose that price setting is staggered: half the firms set prices on the first of each month and half on the fifteenth. If the money supply rises on May 10, then half of the firms can raise their prices on May 15. Yet because half of the firms will not be changing their prices on the fifteenth, a price increase by any firm will raise that firm’s relative price, which will cause it to lose customers. Therefore, these firms will probably not raise their prices very much. (In contrast, if all firms are synchronized, all firms can raise prices together, leaving relative prices unaffected.) If the May 15 price setters make little adjustment in their prices, then the other firms will make little adjustment when their turn comes on June 1, because they also want to avoid relative price changes. And so on. The price level rises slowly as the result of small price increases on the first and the fifteenth of each month. Hence, staggering makes the price level sluggish, because no firm wishes to be the first to post a substantial price increase.

Coordination Failure

Some new Keynesian economists suggest that recessions result from a failure of coordination. Coordination problems can arise in the setting of wages and prices because those who set them must anticipate the actions of other wage and price setters. Union leaders negotiating wages are concerned about the concessions other unions will win. Firms setting prices are mindful of the prices other firms will charge.

To see how a recession could arise as a failure of coordination, consider the following parable. The economy is made up of two firms. After a fall in the money supply, each firm must decide whether to cut its price. Each firm wants to maximize its profit, but its profit depends not only on its pricing decision but also on the decision made by the other firm.

If neither firm cuts its price, the amount of real money (the amount of money divided by the price level) is low, a recession ensues, and each firm makes a profit of only fifteen dollars.

If both firms cut their price, real money balances are high, a recession is avoided, and each firm makes a profit of thirty dollars. Although both firms prefer to avoid a recession, neither can do so by its own actions. If one firm cuts its price while the other does not, a recession follows. The firm making the price cut makes only five dollars, while the other firm makes fifteen dollars.

The essence of this parable is that each firm’s decision influences the set of outcomes available to the other firm. When one firm cuts its price, it improves the opportunities available to the other firm, because the other firm can then avoid the recession by cutting its price. This positive impact of one firm’s price cut on the other firm’s profit opportunities might arise because of an aggregate-demand externality.

What outcome should one expect in this economy? On the one hand, if each firm expects the other to cut its price, both will cut prices, resulting in the preferred outcome in which each makes thirty dollars. On the other hand, if each firm expects the other to maintain its price, both will maintain their prices, resulting in the inferior solution, in which each makes fifteen dollars. Hence, either of these outcomes is possible: there are multiple equilibria.

The inferior outcome, in which each firm makes fifteen dollars, is an example of a coordination failure. If the two firms could coordinate, they would both cut their price and reach the preferred outcome. In the real world, unlike in this parable, coordination is often difficult because the number of firms setting prices is large. The moral of the story is that even though sticky prices are in no one’s interest, prices can be sticky simply because price setters expect them to be.

Efficiency Wages

Another important part of new Keynesian economics has been the development of new theories of unemployment. Persistent unemployment is a puzzle for economic theory. Normally, economists presume that an excess supply of labor would exert a downward pressure on wages. A reduction in wages would in turn reduce unemployment by raising the quantity of labor demanded. Hence, according to standard economic theory, unemployment is a self-correcting problem.

New Keynesian economists often turn to theories of what they call efficiency wages to explain why this market-clearing mechanism may fail. These theories hold that high wages make workers more productive. The influence of wages on worker efficiency may explain the failure of firms to cut wages despite an excess supply of labor. Even though a wage reduction would lower a firm’s wage bill, it would also—if the theories are correct—cause worker productivity and the firm’s profits to decline.

There are various theories about how wages affect worker productivity. One efficiency-wage theory holds that high wages reduce labor turnover. Workers quit jobs for many reasons—to accept better positions at other firms, to change careers, or to move to other parts of the country. The more a firm pays its workers, the greater their incentive to stay with the firm. By paying a high wage, a firm reduces the frequency of quits, thereby decreasing the time spent hiring and training new workers.

A second efficiency-wage theory holds that the average quality of a firm’s workforce depends on the wage it pays its employees. If a firm reduces wages, the best employees may take jobs elsewhere, leaving the firm with less-productive employees who have fewer alternative opportunities. By paying a wage above the equilibrium level, the firm may avoid this adverse selection, improve the average quality of its workforce, and thereby increase productivity.

A third efficiency-wage theory holds that a high wage improves worker effort. This theory posits that firms cannot perfectly monitor the work effort of their employees and that employees must themselves decide how hard to work. Workers can choose to work hard, or they can choose to shirk and risk getting caught and fired. The firm can raise worker effort by paying a high wage. The higher the wage, the greater is the cost to the worker of getting fired. By paying a higher wage, a firm induces more of its employees not to shirk, and thus increases their productivity.

A New Synthesis

During the 1990s, the debate between new classical and new Keynesian economists led to the emergence of a new synthesis among macroeconomists about the best way to explain short-run economic fluctuations and the role of monetary and fiscal policies. The new synthesis attempts to merge the strengths of the competing approaches that preceded it. From the new classical models it takes a variety of modeling tools that shed light on how households and firms make decisions over time. From the new Keynesian models it takes price rigidities and uses them to explain why monetary policy affects employment and production in the short run. The most common approach is to assume monopolistically competitive firms (firms that have market power but compete with other firms) that change prices only intermittently.

The heart of the new synthesis is the view that the economy is a dynamic general equilibrium system that deviates from an efficient allocation of resources in the short run because of sticky prices and perhaps a variety of other market imperfections. In many ways, this new synthesis forms the intellectual foundation for the analysis of monetary policy at the Federal Reserve and other central banks around the world.

Policy Implications

Because new Keynesian economics is a school of thought regarding macroeconomic theory, its adherents do not necessarily share a single view about economic policy. At the broadest level, new Keynesian economics suggests—in contrast to some new classical theories—that recessions are departures from the normal efficient functioning of markets. The elements of new Keynesian economics—such as menu costs, staggered prices, coordination failures, and efficiency wages—represent substantial deviations from the assumptions of classical economics, which provides the intellectual basis for economists’ usual justification of laissez-faire. In new Keynesian theories recessions are caused by some economy-wide market failure. Thus, new Keynesian economics provides a rationale for government intervention in the economy, such as countercyclical monetary or fiscal policy. This part of new Keynesian economics has been incorporated into the new synthesis that has emerged among macroeconomists. Whether policymakers should intervene in practice, however, is a more difficult question that entails various political as well as economic judgments.