Snowdon & Vane Modern Macroeconomics

The reader should be aware that new Keynesian economists are an extremely heterogeneous group, so much so that the use of the term ‘school’ is more convenient than appropriate. Nevertheless, economists who have made significant contributions to the new Keynesian literature, even if some of them may object to the label ‘new Keynesian’, include Gregory Mankiw and Lawrence Summers (Harvard); Olivier Blanchard (MIT), Stanley Fischer (Citigroup, and formerly at MIT); Bruce Greenwald, Edmund Phelps and Joseph Stiglitz (Columbia); Ben Bernanke (Princeton); Laurence Ball (Johns Hopkins); George Akerlof, Janet Yellen and David Romer (Berkeley); Robert Hall and John Taylor (Stanford); Dennis Snower (Birkbeck, London) and Assar Lindbeck (Stockholm). The proximity of US new Keynesians to the east and west coasts inspired Robert Hall to classify these economists under the general heading of ‘Saltwater’ economists. By a strange coincidence new classical economists tend to be associated with ‘Freshwater’ academic institutions: Chicago, Rochester, Minnesota and Carnegie-Mellon (see Blanchard, 1990b; Snowdon and Vane, 1999b; Snowdon, 2002a).

At this point it should be noted that some writers have also identified a ‘European’ brand of macroeconomic analysis which has also been called ‘new Keynesian’. The European variant emphasizes imperfect competition in the labour market as well as the product market, reflecting the higher unionization rates which characterize European economies (Hargreaves-Heap, 1992). The appropriateness of a bargaining approach to wage determination, as a microfoundation to Keynesian macroeconomics, is much more contentious in the USA, where a minority of workers belong to a union. The use of the imperfect competition macro model to examine the problem of unemployment is best represented in the work of Richard Layard, Stephen Nickell and Richard Jackman (LSE), Wendy Carlin (University College, London) and David Soskice (Duke). These economists provide the most comprehensive introduction to the European brand of new Keynesianism (see Layard et al., 1991, 1994; Carlin and Soskice, 1990). There is of course considerable overlap between the two brands of new Keynesianism, especially when it comes to the issue of real wage rigidity (see section 7.7.3). Economists such as Bénassy, Drèze, Grandmont and Malinvaud have also developed general equilibrium models where non-market-clearing and price-making agents give such models Keynesian features. In a survey of this literature Bénassy (1993) suggests that ‘it would certainly be worthwhile to integrate the most relevant new Keynesian insights’ into this general equilibrium approach.

At the beginning of the 1980s, three alternative explanations of the business cycle were on offer within mainstream economics (there were others outside the mainstream such as Austrian, Post Keynesian and Marxian; see Chapters 8 and 9, and Snowdon and Vane, 2002b). The mainstream alternatives were (i) flexible price, monetary misperception equilibrium business

cycle theories developed and advocated by Lucas (see Chapter 5); (ii) sticky price expectational models emphasizing some element of wage and price rigidity (for example, Fischer, 1977; Phelps and Taylor, 1977; Taylor, 1980); and (iii) real business cycle models which increasingly became the main flagship of the new classical equilibrium theorists during the 1980s (see Chapter 6). By the mid-1980s the ‘Saltwater–Freshwater’ debate was essentially between the sticky price and real business cycle varieties, given the demise of the new classical monetary models. However, a major concern of new Keynesian theorists has been to explain how nominal rigidities arise from optimizing behaviour. Ball et al. (1988) consider the decline of Keynesian economics during the 1970s to have been mainly due to the failure to solve this theoretical problem.

In the remainder of this chapter we will examine the main elements of the very diverse new Keynesian literature. First we identify the essential characteristics of what is commonly understood to be the new Keynesian approach.

7.4Core Propositions and Features of New Keynesian Economics

New Keynesian economics emerged mainly as a response to the theoretical crisis facing Keynesian economics that emerged during the 1970s. In their brief survey of new Keynesian economics Mankiw and Romer (1991) define new Keynesian economics with reference to the answer a particular theory gives to the following pair of questions:

Question 1 Does the theory violate the classical dichotomy? That is, is money non-neutral?

Question 2 Does the theory assume that real market imperfections in the economy are crucial for understanding economic fluctuations?

Of the mainstream schools only new Keynesians answer both questions in the affirmative. Non-neutralities arise from sticky prices, and market imperfections explain this behaviour of prices. Thus, according to Mankiw and Romer, it is the ‘interaction of nominal and real imperfections’ that distinguishes new Keynesian economics from the other research programmes in macroeconomics. In contrast, the early real business cycle models gave a negative response to both questions.

The disequilibrium Keynesian models of the 1970s (for example, Barro and Grossman, 1976) imposed wage and price rigidities on a Walrasian system, whereas more traditional Keynesian and monetarist models did not regard the explanation of nominal rigidities as a priority. The latter two groups tend to regard empirical evidence as being far more important than theoretical purity; for example, speaking from a monetarist perspective, Laidler

(1992b) has argued emphatically that ‘better and more explicit microfoundations do not guarantee more accurate empirical predictions about the outcome of any macropolicy experiment’. However, as Mankiw and Romer (1991) highlight, new Keynesians are not protagonists in the old 1960s-style monetarist–Keynesian debate. This is for two reasons. First, there is no unified new Keynesian view of the role of fiscal policy although new Keynesians do give much greater weight to the stabilizing role of monetary policy compared to the old Keynesian view (see Mankiw, 2002, and Chapters 3 and 4). For this reason Mankiw and Romer argue that much of new Keynesian economics could just as easily be renamed ‘new monetarist economics’ (see also DeLong, 2000). Second, new Keynesians do not hold a unified view on the desirability and feasibility of activist (discretionary) stabilization policy. While most new Keynesians accept the thrust of Friedman’s critique relating to the problems that arise from uncertainty, time lags and the potential for political distortions of policy, they also reject the ‘hard core’ monetarist argument relating to the need for a strict monetary growth rate rule. Their views relating to Friedman’s natural rate hypothesis also vary from extreme scepticism to modified acceptance in terms of a ‘time-varying NAIRU’ (see Gordon, 1997, 1998; Galbraith, 1997; Stiglitz, 1997; Phelps and Zoega, 1998; Mankiw, 2001; Akerlof, 2002; Ball and Mankiw, 2002; Mankiw and Reis, 2002).

During the 1980s new Keynesian developments had a distinctly non-em- pirical flavour. Those younger-generation economists seeking to strengthen the Keynesian model did so primarily by developing and improving the microfoundations of ‘Fort Keynes’ which had come under theoretical attack (see Blinder, 1992a). This is recognized by Mankiw and Romer (1991), who note that the reconstruction of Keynesian economics has ‘been part of a revolution in microeconomics’. Those Keynesian commanders who allocated scarce research resources to the theoretical, rather than empirical, front in defence of ‘Fort Keynes’ did so because they felt that the modified Keynesian model incorporating both the Phelps–Friedman expectations-augmented Phillips curve and the impact of supply shocks was sufficiently resilient to hold its own on the empirical front. Once the theoretical defences had been reinforced, resources could gradually be reallocated to the empirical front in order to test the new Keynesian models.

A crucial difference between new classical and new Keynesian models arises with regard to price-setting behaviour. In contrast to the price takers who inhabit new classical models, new Keynesian models assume pricemaking monopolistic, rather than perfectly competitive, firms (Dixon, 1997). Although the theory of monopolistic competition had been developed independently by Robinson (1933) and Chamberlin (1933) before the publication of Keynes’s General Theory, it is only recently that mainstream Keynesian theorists have begun seriously to incorporate imperfect competition into non-

market-clearing models. In this matter Post Keynesians were first off the mark (see Chapter 8, and Dixon and Rankin, 1994).

Most new Keynesian models assume that expectations are formed rationally. This is clearly one area where the new classical revolution of the 1970s has had a profound effect on macroeconomists in general. However, some prominent Keynesians (Blinder, 1987b; Phelps, 1992), as well as some economists within the orthodox monetarist school (Laidler, 1992b) remain critical of the theoretical foundations and question the empirical support for the rational expectations hypothesis. Hence, although the incorporation of rational expectations in new Keynesian models is the norm, this need not always be the case.

Although new Keynesian economists share an interest in improving the supply side of Keynesian models, they hold a wide diversity of views relating to policy issues such as the debate over the importance of discretion, rather than rules, in the conduct of fiscal and monetary policy. New Keynesians regard both supply and demand shocks as potential sources of instability (see Blanchard and Quah, 1989) but part company with real business cycle theorists particularly when it comes to an assessment of a market economy’s capacity to absorb such shocks so that equilibrium (full employment) is maintained. Many new Keynesians (but not all) also share Keynes’s view that involuntary unemployment is both possible and likely.

New Keynesian economists inhabit a brave new theoretical world characterized by imperfect competition, incomplete markets, heterogeneous labour and asymmetric information, and where agents are frequently concerned with fairness. As a result the ‘real’ macro world, as seen through new Keynesian eyes, is characterized by the possibility of coordination failures and macroeconomic externalities. One problem with new Keynesian developments is that the research programme has proved to be so ‘article-laden’ (Colander, 1988) that there is no single unified new Keynesian model; rather there is a multiplicity of explanations of wage and price rigidities and their macroeconomic consequences. Different elements within the new Keynesian school emphasize various aspects and causes of market imperfections and their macroeconomic effects. However, the numerous explanations are not mutually exclusive and often complement each other. In short, as Leslie’s (1993) comment captures so well, ‘New Keynesianism throws bucketfuls of grit into the smooth-running neoclassical paradigms.’

Because the literature reviewed here is so wide-ranging, it is convenient to divide the explanations of rigidities between those that focus on nominal rigidities and those that focus on real rigidities. A nominal rigidity occurs if something prevents the nominal price level from adjusting so as exactly to mimic nominal demand disturbances. A real rigidity occurs if some factor prevents real wages from adjusting or there is stickiness of one wage relative

to another, or of one price relative to another (see Gordon, 1990). First we shall examine the impact of nominal rigidities.

7.5Nominal Rigidities

Both orthodox and new Keynesian approaches assume that prices adjust slowly following a disturbance. But, unlike the Keynesian cross or IS–LM approaches, which arbitrarily assume fixed nominal wages and prices, the new Keynesian approach seeks to provide a microeconomic underpinning for the slow adjustment of both wages and prices. In line with the choice-theoretical framework of new classical analysis, the new Keynesian approach assumes that workers and firms are rational utility and profit maximizers, respectively.

As we have seen, new classicists adopt the flexible price auction model and apply this to the analysis of transactions conducted in all markets, including the labour market. In contrast, new Keynesians argue that it is important to utilize the Hicksian (1974) distinction between markets which are essentially fix-price, predominantly the labour market and a large section of the goods market, and markets which are flex-price, predominantly financial and commodity markets. In fix-price markets price setting is the norm, with price and wage inertia a reality. In order to generate monetary non-neutrality (real effects) Keynesian models rely on the failure of nominal wages and prices to adjust promptly to their new market-clearing levels following an aggregate demand disturbance. Keynesians have traditionally concentrated their attention on the labour market and nominal wage stickiness in order to explain the tendency of market economies to depart from full employment equilibrium. However, it is important to note that for any given path of nominal aggregate demand it is price, not wage, stickiness which is necessary to generate fluctuations in real output. Providing profits are sufficiently flexible, nominal prices could adjust to exactly mimic changes in nominal aggregate demand, leaving real output unaffected (see Gordon, 1990).

Nevertheless the first wave of new Keynesian reaction to the new classical critique concentrated on nominal wage rigidity.

7.5.1 Nominal wage rigidity

In traditional Keynesian models the price level is prevented from falling to restore equilibrium by the failure of money wages (costs) to adjust (see Figure 2.6). In the new classical models developed by Lucas, Sargent, Wallace and Barro during the 1970s, any anticipated monetary disturbance will cause an immediate jump of nominal wages and prices to their new equilibrium values, so preserving output and employment. In such a world, systematic monetary policy is ineffective. Initially it was widely believed that this new classical policy ineffective proposition was a direct implication of incorpo-

are flexible but nominal wages are temporarily rigid (and set = W0) as the result of contracts negotiated in the previous period and which extend beyond the current period, the economy will move to point B, with real output falling from YN to Y1. With flexible wages and prices the short-run aggregate supply curve would shift down to the right from SRAS (W0) to SRAS (W1), to reestablish the natural rate level of output at point C. However, the existence of long-term nominal wage contracts prevents this and provides the monetary authorities with an opportunity to expand the money supply which, even if anticipated, shifts the AD curve to the right and re-establishes equilibrium at point A. Providing the authorities are free to react to exogenous shocks at every time period, while workers are not, there is scope for demand management to stabilize the economy even if agents have rational expectations. In effect, if the monetary authorities can react to nominal demand shocks more quickly than the private sector can renegotiate nominal wages, there is scope for discretionary intervention. The fixed nominal wage gives the monetary authorities a handle on the real wage rate and hence employment and output. The non-neutrality of money in the Fischer model is not due to an unanticipated monetary surprise. Anticipated monetary policy has real effects because it is based on information that only becomes available after the contract has been made.

Wage contracts are an important feature in all major industrial market economies. However, there are significant differences between countries with respect to both contract duration and the timing of contract renegotiations. For example, in Japan nominal wage contracts typically last for one year and expire simultaneously. The synchronized renegotiation of contracts (the shunto system) in Japan is consistent with greater macroeconomic stability than is the case in the US economy, which has a system of non-synchronized overlapping (staggered) contracts, many of which last for three years (see Gordon, 1982b; Hall and Taylor, 1997). In the UK contracts are overlapping but are typically shorter than in the USA, usually lasting for one year. When contracts are staggered, nominal wages will exhibit more inertia in the face of shocks than would be the case if existing contracts were renegotiated in a synchronized way so as to accommodate new information. Taylor (1980) demonstrated that if workers are concerned with their nominal wage relative to others, then staggered contracting will allow the impact of monetary policy on real variables to persist well beyond the length of the contracting period. Taylor (1992b) has shown that the responsiveness of wages to supply and demand conditions is much greater in Japan than in the USA, Canada and other major European countries, and this accounts for the more stable macroeconomic performance in Japan during the 1970s and early 1980s.

An immediate question arises from the above discussion. Why are longterm wage agreements formed if they increase macroeconomic instability?

According to Phelps (1985, 1990) there are private advantages to both firms and workers from entering into long-term wage contracts:

1.Wage negotiations are costly in time for both workers and firms. Research must be carried out with respect to the structure of wage relativities both within and outside the negotiating organization. In addition, forecasts are required with respect to the likely future paths of key variables such as productivity, inflation, demand, profits and prices. The longer the period of the contract, the less frequently are such transaction costs incurred and in any case management will always tend to prefer a pre-set schedule for dealing with the complex issues associated with pay negotiations.

2.There always exists the potential for such negotiations to break down, with workers feeling that they may need to resort to strike action in order to strengthen their bargaining position. Such disruption is costly to both firms and workers.

3.It will not be an optimal strategy for a firm to ‘jump’ its wage rates to the new ‘ultimate’ equilibrium following a negative demand stock because if other firms do not do likewise the firm will have reduced its relative wage, which would be likely to increase labour turnover, which is costly to the firm.

Thus the responsiveness of wage rates during a recession does not follow the new classical ‘precision drill process’; rather we observe a ‘ragged, disorderly retreat’ as new information becomes available (Phelps, 1985, p. 564).

Another important question raised by this discussion relates to the absence of indexing. Why are labour contracts not indexed to the rate of inflation? Full cost of living agreements (COLAs) are simply too risky for firms (see Gordon, 2003). The danger for firms is that not all shocks are nominal demand shocks. If a firm agreed to index its wage rates to the rate of inflation, then supply shocks, such as occurred in the 1970s, would drive up the price level and with it a firm’s wage costs, so preventing the necessary fall in real wages implied by the energy shock.

Finally, we should also note that the staggering of wage contracts does have some microeconomic purpose even if it causes macroeconomic problems. In a world where firms have imperfect knowledge of the current economic situation, they can gain vital information by observing the prices and wages set by other firms. According to Hall and Taylor (1997), staggered wage setting provides useful information to both firms and workers about the changing structure of wages and prices. In a decentralized system without staggering, ‘tremendous variability’ would be introduced into the system. Ball and Cecchetti (1988) show how imperfect information can make stag-

gered price and wage setting socially optimal by helping firms set prices closer to full information levels, leading to efficiency gains which outweigh the costs of price level inertia. Thus staggered price adjustment can arise from rational economic behaviour. In contrast, the case of wage setting in a synchronized system would seem to require some degree of active participation from the government.

7.5.2 Nominal price rigidity

Keynesian models based on nominal wage contracting soon came in for considerable criticism (see Barro, 1977b). Critics pointed out that the existence of such contracts is not explained from solid microeconomic principles. A further problem relates to the countercyclical path of the real wage in models with nominal wage contracts. In Fischer’s model, a monetary expansion increases employment by lowering the real wage. Yet, as we have seen, the stylized facts of the business cycle do not provide strong support for this implication since real wages appear to be mildly procyclical (see Mankiw, 1990). Indeed, it was this issue that persuaded Mankiw (1991) that sticky nominal wage models made little sense. A combination of price-taking firms, neoclassical production technology and sticky nominal wages implies that aggregate demand contractions will be associated with a rise in the real wage, that is, real wages move countercyclically. As Mankiw notes, if this were the case then recessions would be ‘quite popular’. While many people will be laid off, most people who remain employed will enjoy a higher real wage! ‘If high real wages accompanied low employment as the General Theory and my Professors has taught me, then most households would welcome economic downturns’. So ‘it was thinking about the real wage puzzle that originally got me interested in thinking about imperfections in goods markets, and eventually, about monopolistically competitive firms facing menu costs’ (Mankiw, 1991, pp. 129–30).

As a result of these and other criticisms, some economists sympathetic to the Keynesian view that business cycles can be caused by fluctuations of aggregate demand switched their attention to nominal rigidities in the goods market, rather than continue with research into nominal wage inertia (Andersen, 1994). Indeed, the term ‘new Keynesian’ emerged in the mid-1980s as a description of those new theories that attempted to provide more solid microfoundations for the phenomenon of nominal price rigidity (see Rotemberg, 1987). From this standpoint, the ‘fundamental new idea behind new Keynesian models is that of imperfect competition’ (Ibid.). This is the crucial innovation which differentiates new Keynesians from Keynes, orthodox Keynesians, monetarists and new classicals.

If the process of changing prices were a costless exercise and if the failure to adjust prices involved substantial changes in a firm’s profitability we would