Intermediate Macroeconomics: New Keynesian Model

Among mainstream academic economists and policymakers, the leading alternative to the real business cycle theory is the New Keynesian model. Whereas the real business cycle model features monetary neutrality and emphasizes that there should be no active stabilization policy by governments, the New Keynesian model builds in a friction that generates monetary non-neutrality and gives rise to a welfare justification for activist economic policies. New Keynesian economics is sometimes caricatured as being radically different than real business cycle theory. This caricature is unfair. The New Keynesian model is built from exactly the same core that our benchmark model is – there are optimizing households and firms, who interact in markets and whose interactions give rise to equilibrium prices and allocations. There is really only one fundamental difference in the New Keynesian model relative to the real business cycle model – nominal prices are assumed to be “sticky.” By “sticky” I simply mean that there exists some friction that prevents Pt, the money price of goods, from adjusting quickly to changing conditions. This friction gives rise to monetary non-neutrality and means that the competitive equilibrium outcome of the economy will, in general, be inefficient. By “inefficient” we mean that the equilibrium allocations in the sticky price economy are different than the fictitious social planner would choose. New Keynesian economics is to be differentiated from “old” Keynesian economics. Old Keynesian economics arose out of the Great Depression, adopting its name from John Maynard Keynes. Old Keynesian models were typically much more ad hoc than the optimizing models with which we work and did not feature very serious dynamics. They also tended to emphasize nominal wage as opposed to price stickiness. Wage and price stickiness both accomplish some of the same things in the model – they mean that the equilibrium is inefficient and that money is non-neutral. But nominal wage stickiness implies that real wages may be countercyclical, which is inconsistent with the data. For this and other reasons, New Keynesian models tend to emphasize price stickiness (though many of these models also feature wage stickiness, too). The New Keyensian framework is the dominant paradigm for thinking about fluctuations and policy. A nice aspect of the model is that, at its core, it is the same as the real business cycle