Keynesian Economics

Introduction

• Macroeconomics development is explored over the last century
• Dropped into the story in the 1930s with John Maynard Keynes's General Theory of Employment, Interest, and Money

Keynes's Challenge to Classical Economics

• Keynes challenged classical economic assumptions derived from theoretical microeconomics
• Prevailing beliefs aligned with principles taught in economics classes today
• Prices were flexible and adjusted immediately to the Invisible Hand
• Quantity supplied always equals quantity demanded
• Belief was markets always cleared and money was neutral
• A country's money supply affects only nominal prices, leaving 'real' prices unchanged
• Implied the economy was largely supply driven
• Keynes asserted dynamics are wrong, particularly for short-run market behavior
• Argued aggregate demand was the true driver, and inadequate demand leads to prolonged unemployment
• Wages and prices are rigid or 'sticky' downwards
• Monetary policy (manipulating money supply, exchange/interest rates, transmission mechanisms) most effectively controls economic health

Keynesian Economics and Theories

• Macroeconomics led to theories like the Phillips Curve, emphasizing the tradeoff between inflation and unemployment
• Keynes's consumption function suggests aggregate consumption and output are linearly related: C = a + bY, b ∈ (0,1)
• Around 1940, John Hicks and Alvin Hansen proposed the investment-savings-liquidity-money (IS-LM) curve
• IS-LM illustrates economy behavior through central bank manipulation of money supply and interest rates
• Aggregate demand sloped downwards, but debate existed between Classicals and Keynesians about the aggregate supply curve's slope

Keynesian Critiques and Monetarist Theory

• Milton Friedman critiqued Keynes' views, insisting there was "more to the story"
• Friedman proposed the Natural Rate Hypothesis
• Economy has a natural unemployment rate conditional on its characteristics
• Fluctuations around the natural rate are due to macroeconomic conditions
• Permanent Income Hypothesis
• Income consists of lifetime and transitory components
• Key determinant of consumption was lifetime income, not current income
• Fluctuations due to transitory income spread out in small bits
• Consumption smoothing
• Views known as monetarist macroeconomic theory
• Monetarist thinking essentially asserted markets clear, but money isn't neutral
• Monetary policy (and nominal demand shocks) can affect real variables
• Keynesian vs. Monetarist theory became topics of hot debate

Breakdown of the Consensus

• Views remained popular until around the 1970s when the United States experienced stagflation (high inflation AND high unemployment)
• Stagflation violated both the Keynesian Phillips curve and the Monetarist natural rate hypothesis
• Robert Lucas put forth the Lucas critique, stating change in policy will systematically alter the structure of econometric models
• Models needed to incorporate agents' expectations to be truly structural
• Agents are rational up to their expectations conditional on their information
• Ignited rational expectations revolution and propagated change throughout macro

Lucas' Island Model

• Lucas demonstrated this concept through the Island model
• Considers a population of individuals that can't communicate, only trade, and considers prices to be composed of sector specific (T) shocks and economy wide (σ) shocks
• shows that production decision (y) is a function of the difference in price vs expected price from 1-period ago: Yj,t= (T2/ (72 + σ2)) (Pj,t)
• (T2/ (72 + σ2)) can be interpreted as the signal-to-noise ratio
• Effectively models aggregate supply (output having a positive relationship with the price level Y = bP)
• Shows the supply curve is steeper (flatter) - meaning supply is more elastic (inelastic)
• Sector-specific (economy wide) shocks are more prevalent in the economy
• Lucas verified this result with his empirical cross-regime test (ΔΥ = βο + β1 · ΔΧ), where ΔΧ was a proxy for demand shocks
• In this framework, in equilibrium, systematic monetary policy has no effect on output, only unexpected monetary policy shocks (the Sargent-Wallace result)
• Quantity Y is a function of price opposite of what we see in undergrad graphs hence the relationships are reversed

Critiques of the Lucas Model

• The model was not without critique
• (1) it could not explain the Volcker deflation (a pre-announced systemic monetary policy change still had a significant (negative) effect on output)
• (2) In places with higher average inflation, nominal contracts would be shorter, meaning less nominal rigidity - not more
• (3) Assumes a large elasticity of supply, contradicting empirical data
• (4) has minor modeling critiques
• All implied imperfect information and rational expectations are necessary but not sufficient assumptions as well as nominal rigidities

Nominal Rigidities from Wage Contracts

• Wage contracts are explored as a reason for nominal rigidities
• Stanley Fisher and John Taylor's wage contract models show monetary policy can affect output for 'sufficiently long' wage contracts
• Requires just two periods of wage rigidity to show monetary policy effectiveness for a significant population
• No wage rigidity implies a vertical (inelastic) AS curve = ineffective monetary policy
• Effect is limited; monetary policy has at most a second-order effect on output
• Can only influence output variance, not average, playing a stabilization role
• Pinning monetary policy to counter the most recent shock is the most effective strategy

Optimal Wage Indexation

• Jo Anna Gray explores this in her wage indexation model.
• Given 0 = degree of wage indexation to the price level: Var(Lt) = ((α(1 – θ))/(1 + αβ(1 – 0)))* σ2Nominal + ((αθ)/(1 + αβ(1 – θ)))* σ2Real
• Presence of two shocks (systemic, nominal demand shocks and idiosyncratic, real productivity shocks), only one tool (wage indexation) isn't enough to fully stabilize the effects of the two shocks (Tinbergen Rule: Number of Policy Tools Needed to Address Shocks = Number of Shocks)

Imperfections in Wage Contracts

• Wage contracts were not perfect
• Fisher's wage contract setup results in counter-cyclical real wages (demand shock raises prices, but wages are stuck)
• Empirical data shows real wages to be acyclical or slightly procyclical
• Monetary policy effects only last the duration of the wage contract, but history shows monetary policy effects reverberate longer
• John Taylor and Guillermo Calvo put forth the idea of pre-fixed prices
• Fisher/Gray: contracts are pre-determined conditional on expectations
• Taylor/Calvo: equal and set conditional on the expectation of the current price level, showing staggered price adjustment

Strategic Complementarity

• Taylor introduces a model showing that with staggered price adjustment, pre-fixed contracts, and strategic complementarity (the decisions of two players mutually reinforce each other) via firms caring about their relative price
• When modeled in this context, firms don't necessarily adjust prices 1-1 with shocks, and monetary policy lasts longer than the duration of wage contracts

Nominal Rigidities from Menu Costs

• Another possible explanation for sticky prices is through the perspective of menu costs
• Require monopolistic competition where firms are price-makers but still face a downward sloping demand curve
• Gregory Mankiw's Partial Equilibrium model illustrates how firms may not adjust prices in response to demand shocks citing profit maximizing behavior, which leads to a loss of consumer surplus, but only a 2nd order effect on firms profits

Blanchard and Kiyotaki Model

• Olivier Blanchard and Nobuhiro Kiyotaki more elaborates general equilibrium model, borrowing the Dixit-Stiglitz setup
• Monopolistic (p ≥ MC) competition (atomistic firms cannot individually affect P, free entry and exit implies LR profit = 0 (though SR does not)) with differentiated goods (CES utility gives a natural reason why output may not be at the natural level
• Model shows demand drives output (so demand shocks affect employment), and the labor market may not be competitive
• Without menu cost money is neutral, but with menu costs money is non-neutral and prices are sticky due to firms exerting an AD externality on each other

Further Insights on Menu Costs

• Laurence Ball and David Romer point out that since a small change in the labor supply given fixed prices leads to a large change in the real wage, leading to a decrease in MC for firms which they could then use to lower prices without losing surplus
• Results in cases that menu costs are inexplicably huge and real wages have to be sticky to preserve monetary non-neutrality

Dynamics of Price Adjustment

• Taking nominal rigidity as given, here, the goal is to reconcile microeconomic evidence of price-changing frequency with the high persistence of the effect of monetary policy
• Considers two methods of adjustment: state-contingent (Caplin-Spulber) and time-contingent (Calvo)

State-Contingent Adjustment: The Caplin-Spulber Model

• Model features an s-S setup (canonical model of infrequent and discrete action)
• Used to explain inertia in durable goods, investment, money demand, and cash management, and to provide microfoundations for price stickiness and the real effects of money
• In the model, fixed costs make small adjustments impractical and agents allow their state to drift in response to shocks until it reaches an adjustment trigger before setting it to a target value
• Firms assumed heterogeneous with each facing a fixed menu cost and an initial uniform distribution of prices
• Profit-maximizing behavior suggests changing prices isn't always optimal until a shock to the money supply sends Mt to, moving the entire interval, and only then would those firms whose pit fell outside of the interval change their price
• Firms set prices based on expectations of the future path of M, not just its current level
• Firms opt for large but infrequent price adjustments in the presence of a steadily increasing money supply
• Model was very stylized and did not consider convex adjustment costs, different shocks, uniform distribution of prices
• Produced money neutrality with individual price stickiness

Time-Contingent Adjustment: The Calvo Model

• Time-contingent adjustment mechanisms mainly focus on Guillermo Calvo's model of price adjustment
• Model aimed to model aggregate supply which embodied price rigidity due to pre-fixed pricing and monopolistic competition
• Price changing process is now stochastic: specifically, the opportunity to adjust prices arrives according to an exogenous Poisson process, where in each period, the probability that firms will change their price is given by 1-0, where 0 measures the degree of price rigidity

The New Keynesian Phillips Curve

• In the Calvo pricing model, firms maximize profit by minimizing expected loss from price adjustment with produces an optimal price setting rule
• Aggregating and taking the first difference leads to the equation: πτ= βΕτπτ+1+Xyt
• Became known as the New Keynesian Phillips Curve

Labor Markets, Real Rigidities, and Efficiency Wages

• Ball and Romer critique pointed out a small change in labor supply would lead to a large change in the real wage, lowering marginal costs for firms
• This prompts the question of how could menu costs generate monetary non-neutrality and can be from real rigidities
• Plausible causes for real rigidities of wages are implicit contract design, union-negotiated wages, searching and matching dynamics, and efficiency-wage theory
• Begins by exploring the assumption that the real wage is stuck above the equilibrium level and attempt to find a microfounded with explanation supports

Shapiro and Stiglitz Efficiency Wage Model

• Main mechanisms are imperfect monitoring and wage setting as a moral hazard (+limited liability) problem
• Principal-employer wishes to induce a certain level of effort from the agent-worker (here, assume effort is binary
• Model accounts for various dynamics and seeks to set out a steady-state equilibrium at which employment is constant: w* = e + ((p+b)/q) ((L-L)/N)

Modeling Labor Market Frictions: The McCall Job Search Model

• John McCall's job search model.
• Features a new (in regards to Econ literature) technique called dynamic programming, and models an agent's job search process as an optimal stopping problem
• Costly job search process in this setup results in an equilibrium reservation wage which defines the minimum wage at which a worker will accept the job offer and cease their job search

Diamond-Mortenssen-Pissarides Search Model

• Dismisses all issues with the McCall search model
• Was offered and still retained similar features to the McCall and gave rise to the Diamond-Mortenssen-Pissarides search model

Consumption, Savings, and Investment

• Another subject of great interest in macro literature is the behavior of aggregate consumption
• Startters, consumption is the largest component of GDP

Consumption Modeling Eras

• Pre-Rational Expectations: Keynes (consumption function C = a + bY), , Modigliani (Life-cycle hypothesis, consumption smoothing) and Friedman (Permanent Income Hypothesis)
• Uncertainty and RE: stochastic models(Hall's RW Hypothesis), dynamic programming (to deal with expectations), linearization and certainty equivalence
• Post Hall: 2nd order effects, Equity Premium Puzzle, Asset Pricing Models

Consumption Euler equation

• Is the consumption Euler equation, showing the consumption behavior is critical to economic modeling
• Empirically, there cannot be excess sensitivity in future consumption to current expected future income growth

C-CAPM and The Equity Premium Puzzle

• This equation is important because it relates the covariance of the return and growth rate of consumption to the expected return of an asset

Financial Frictions

• There's a theory that monetary policy impacts the credit channel through
• The focus is on monetary policy transmission mechanisms

Financial Friction Models

• Not all sources of finances are the same; bank vs non-bank, internal vs external (i.e. limited liability of borrowers vs sole proprietors) .
• Quantity constraints on borrowing because the market is illiquid, perfect information

Bernanke-Gertler (Costly State Verification)

• The model is an optimal contract/mechanism design problem. There are two periods, t = 0,1. There is a risk-neutral entrepreneur who can invest in a project and receives payoff in t = 1
• D = ῶ* RκΚ. is the deadweight loss from bankruptcy is μῶρκ Κ.

Diamond-Dybvig

• One contract can give rise to this with the bank needing to have an optimal quantity

• Autark: If you go with the long term project, then the late consumers will reinvest the safe deposit

• As utility is increasing in i if pR > 1 and decreasing if pR < 1, it must be the case that in equilibrium, p = 1/R. The allocation is then

  CFM =1 and CFM = R C₁ C₂

• SP You see that c1 = cFM < c$P < c CSP<C2FM = R