Intermediate Macroeconomics: Keynesian Models

At the risk of some oversimplification, the leading alternatives to the neoclassical / real business cycle model for understanding short run fluctuations are Keynesian models. I phrase this in the plural because there are multiple different versions of the Keynesian model, which differ in terms of how the aggregate supply block of the economy is formulated. Whereas neoclassical models emphasize changes in supply as drivers of the business cycle, feature monetary neutrality, and have no role for activist economic policies, Keynesian models are the opposite – they emphasize demand changes as the source of business cycles (though changes in supply can also have effects on output), money is non-neutral, and there is a role for activist stabilization policies. Though often caricatured as being fundamentally different from the neoclassical model, modern Keynsian models (which are often called “New Keynesian” models) actually have exactly the same backbone and structure as the neoclassical model. Agents are optimizing and forward-looking. There is a well-defined equilibrium concept. The fundamental difference between Keynsian and neoclassical theories concerns the flexibility of prices and wages. Keynesian theories typically emphasize nominal rigidities, in the since that the aggregate price level and/or nominal wages may be imperfectly flexible. This imperfect flexibility of prices and wages (sometimes called price and wage “stickiness”) can be motivated via the common experience that the prices of the goods we buy, and the wages we are paid for work, don’t instantaneously change period-to-period in response to changing conditions. This could be because of things like “menu costs” (it is costly to change posted prices for some reason), institutional constraints (wage contracts are set in advance and are difficult to change on the fly), or simply because firms find it costly to pay attention to aggregate conditions and constantly re-evaluate their prices and wages. Whatever the reason why prices and/or wages are sticky, this stickiness will do a couple of important things in the model: (i) it will allow changes in the money supply to have real effects, so that money is non-neutral and (ii) it will mean that the equilibrium response to other shocks will generally be inefficient, in the sense of differing from what a fictitious social planner would choose. The fact that the equilibrium will generally be inefficient gives some justification for activist economic policies designed to stabilize