Chapter12 - Chapter 12 New Keynesian Economics The two...

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© Sanjay K. Chugh 131 Spring 2008 Chapter 12 New Keynesian Economics The two current leading views of business cycles are Real Business Cycle (RBC) Theory and New Keynesian Economics. Each of these schools of thought has a rich history marked by frequent vigorous debate between them. While a terse summary of their general views does not do them justice, we first briefly highlight the main difference between the two points of view. RBC Theory views periodic expansions and recessions as natural, indeed efficient, responses of the economy to the ups and downs of the state of “technology” of the economy. 63 As such, recessions are not dire events for the economy, but rather natural slowdowns which are preceded by an expansion and which will again be followed by future expansions. In terms familiar from microeconomics, pure RBC Theory maintains that the aggregate economy operates perfectly competitively on both the demand side and the supply side. 64 An important implication of RBC Theory, therefore, is that the government has no role to play in the macroeconomy – that is, neither fiscal policy nor monetary policy can be used to improve the macroeconomic condition. In contrast, New Keynesian Economics adopts the point of view that there are fundamental market failures in the aggregate economy which render business cycle fluctuations, specifically periods of lower-than-potential GDP, inefficient. 65 The important implication of this point of view is that the government may indeed have a role to play in improving macroeconomic conditions. Here we will consider just one strand of New Keynesian theory. As we will see, microeconomic analysis is at the heart of New Keynesian theory. Unlike most of our discussion of representative-agent macroeconomics, however, the focus of New Keynesian theory is not on the microeconomics of consumer behavior but rather on the microeconomics of firm behavior. Differentiated Goods and the Consumption Aggregator In our study of the representative consumer, we supposed that there was only one object (i.e., “all stuff”) which the consumer purchased in order to obtain utility. This was true in both the consumption-leisure model (in which there was literally only one object called 63 “Technology” here is broadly defined – specifically, the Solow Residual (on which we will have more to say when we study RBC theory) is the most often-used measure of technology. 64 Even the most ardent RBC macroeconomist does not literally believe the economy is perfectly competitive in the pure textbook sense, but rather that in aggregate market failures tend not to be so catastrophic as to make perfect competition a terrible approximation. 65 The notion of “efficiency” you should have in mind throughout our discussion here is exactly that from microeconomics: a market (in our case, the entire macroeconomy) is operating efficiently if there is no deadweight loss, which means that no trades between suppliers and demanders which could increase overall utility go unconsummated. Another familiar characterization of economic efficiency is that price equals marginal cost.
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© Sanjay K. Chugh
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Chapter12 - Chapter 12 New Keynesian Economics The two...

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