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EC201 Intermediate Macroeconomics
EC201 Intermediate Macroeconomics

Lecture 21: New Keynesian Macroeconomics
Lecture Outline:
- Introduction to New Keynesian macroeconomics:
Essential reading:
This Lecture Note
Introduction:
In the early 1980s, the Keynesian view of business cycles was in trouble
...
According to the Keynesian view, fluctuations in
output arise largely from fluctuations in nominal aggregate demand
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But those
nominal rigidities were assumed rather than explained
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Thus the 1970s and early 1980s saw many economists turn away
from Keynesian theories and toward new classical models with flexible wages and
prices
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This result was also a result of RBC theory that
assumes rational expectations and price flexibility
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New
Keynesian macroeconomists try to use the same methodology of new classical
macroeconomists and RBC theorists, meaning using microfoundations and
incorporating the idea of Rational Expectations in models, but including some
nominal rigidities in order to show that policies can have real effects in the short-run
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For example firms in the economy are normally in monopolistic
competition (meaning they can set prices)
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Indeed in an economy not everyone sets new wages or new prices at the same time
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Suppose there are two main sectors in the
economy, A and B
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This means that once the wage is set it
remains fixed in period t and t+1
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This is a simple way to model the idea of non synchronisation in wage decisions in
different sectors of the economy
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Suppose that the monetary policy is known, meaning that it is announced to the public
and so the public expects higher prices after that policy
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Workers in sector B can change their wage at the beginning of period t+1
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In sector B workers can change their nominal wage in
order to keep the same real wage after the policy and not loosing purchasing power
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The policy will have the effect of increasing prices, if the
nominal wage is fixed, the real wage must decrease
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In the economy, the total
production (given by the sum of productions in the two sectors) will increase and so
the policy will have real effects even if there are rational expectations
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The idea is exactly
the same, the only difference is that now firms in different sectors set their prices at
different periods and their prices must be constant for some periods
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Suppose first that every firm adjusts its price on the first of each month and the new
price lasts one month, so that price setting is synchronized
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But on July 1 all prices adjust in proportion to the fall in money,
and the recession ends
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If the money supply falls on June 10, then on
June 15 half the firms have an opportunity to adjust their prices
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Because half of all nominal prices remain
fixed, adjustment of the other prices implies changes in relative prices, which firms
may not want
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If the June 15 price setters make little
adjustment, then the other firms make little adjustment when their turn comes on July
1, because they do not desire relative price changes either
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The price level
declines slowly as the result of small decreases every first and fifteenth, and the real
effects of the fall in money die out slowly
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This non-synchronisation can create more stickiness of the prices or wages and so it
can

break

the

policy

ineffectiveness

proposition

of

the

new

classical

macroeconomists
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The main critique at this kind of models is that the nominal rigidities are imposed
exogenously to the model
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Even if this may be a realistic assumption it
does not come from the optimal behaviour of firms and workers
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3

The most relevant costs of changing prices are the Menu Costs (costs of printing new
menus, mailing new catalogues, etc
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Menu costs are FIXED costs, if the firm changes its price, then it must pay the cost
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Notice what the objective of introducing the idea of menu costs is
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However, in those models we assumed that prices were
fixed
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Here, by
introducing the idea of menu costs we introduce a theoretical foundation for prices to
be fixed in the short-run
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If each
firm faces menu costs, then each firm may not change its price as the economic
environment changes and this will create the aggregate price to be sticky as well
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Consider an economy with many firms producing slightly differentiated goods
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We need that because
we are interested in the optimal choice a firms of not changing prices
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A typical firm chooses the price for its product in order to maximise its profits
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Now suppose that the aggregate demand is at level Y0 , everything else constant
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This increase in

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aggregate demand, everything else constant, will increase the profit function since the
firm is facing a higher demand and in principle can obtain high profits for each price
level
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The firm chooses the price that maximises that profit function
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That is the price associated with point a in the profit
function that is the point where the profits reach a maximum
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If the firm maximises that profit function
will choose a price associated with point b in the graph
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What is the loss in profits by not changing the price?
The answer is given by the difference (the vertical difference) between point d and
point c in the graph
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This turns out to be a general feature and not only a feature of the particular graph we
did use
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Now, the important thing here is that if the firm does not change the price after the

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aggregate demand has changed, the loss in profits is going to be small
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Without menu costs, if prices are flexible,
the firm will simply maximise the new profit function and will simply adjust its price
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Why small menu costs can have big impact in the economy? The Aggregate
Demand Externality
Blanchard and Kiyotaki (1987) American Economic Review provide an interesting
interpretation about the fact that the macroeconomic effects of nominal rigidity differ
from the private costs because rigidity has an "aggregate demand externality
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Suppose that the aggregate demand Y is given by the quantity theory:
Y=

M
P

where M is the money supply
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Suppose that the firm faces a menu cost and decides not to adjust its price (in this case
it should decrease the price)
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Therefore, the fact that firm i does not change its price contributes to the rigidity of
the aggregate price level
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Therefore, we can have price stickiness at the aggregate level
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This is the essence of what is called an
Aggregate Demand Externality
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What matters is that since there is this Aggregate Demand Externality, small menu
costs can have a bog impact on the overall economy
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This will be true also if firms have rational expectations
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Main critique to Menu Costs
Menu costs are normally small costs
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In this case it is optimal for firms to pay the
menu cost and to adjust prices and so this change in aggregate demand will simply
affect prices and not real production
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How large are menu costs in reality?
A 1997 study1 using data from supermarket chains calculate the costs of changing
prices including:
a) labor cost of changing shelf tags
b) costs of printing, delivering new tags
c) cost of supervising this process
All those components are part of the menu costs
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7% of revenue and 35% of net profits
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1

Levy D
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Bergen, S
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Venable (1997) “The Magnitude of Menu Costs: Direct

Evidence from Large U
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Supermarket Chains”, Quarterly Journal of Economics, vol
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791825

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