Question

How to use the new Keynesian model framework to explain the great recession, (It also incorporated the effects of monetary and fiscal policies pursued by the federal reserve and the federal government, respectively.)

and how does the interpretation change when using real business cycle models?

Answer 1

New keynesian used micro economic foundations to explain the macro economic problems. They used micro economics tools comprehensively to explain economic recession. Price and wage stickiness deviate economy from automatic mechanism to correct disequilibrium in economy.

They posits that market is imperfect and monopoly firms do not change their prices frequently. Even when recession hits, prices do not change for many goods and services. Further, there is cost of changing prices frequently.

Further, wage is sticky due to labor union and efficiency wage. So rigid wage does not cause equilibrium in economy.

unlike old keynesians, New keynesian contend that monetary policy is effective to produce right effects on output and employments. Monetary policy acts through the interest rate. Interest rate is prime factor in influencing economy. They have agreed with effectiveness of fiscal policy.

Real Business cycle models do not agree with Keynesian explanations for recession, they play down the importance of aggregate demand. They believe that real factor such as productivity, change in technology and supply shocks are accountable for recession and boom in economy, Government must pay heed towards the supply.