How does the new Keynesian model differ from the new classical
macroeconomic model?
The new classical macroeconomic model aids the cause of
nonactivists, economists who believe that policymakers should have
as little discretion as possible, because it suggests that
policymakers are more likely to make things (especially P* and Y*)
worse rather than better. The activists could not stand idly by but
neither could they ignore the implications of Lucas’s critique of
prerational expectations macroeconomic theories. The result was
renewed research that led to the development of what is often
called the new Keynesian model. That model directly refutes the
notion that wages and prices respond immediately and fully to
expected changes in P*. Workers in the first year of a three-year
labor contract, for example, can’t push their wages higher no
matter their expectations. Firms are also reluctant to lower wages
even when unemployment is high because doing so may exacerbate the
principal-agent problem in the form of labor strife, everything
from slacking to theft, to strikes. New hires might be brought in
at lower wages, but if turnover is low, that process could take
years to play out. Similarly, companies often sign multiyear
fixed-price contracts with their suppliers and/or distributors,
effectively preventing them from acting on new expectations of P*.
In short, wages and prices are “sticky” and hence adjustments
are slow, not instantaneous as assumed by Lucas and
company.
If that is the case, as Figure 26.2 shows,
anticipated policy can and does affect Y*, although not as much as
an unanticipated policy move of the same type, timing, and
magnitude would. The Takeaway is that an EMP, even if it is
anticipated, can have positive economic effects (Y* >
Ynrl for some period of time), but it is better if the
central bank initiates unanticipated policies. And there is still a
chance that policies will backfire if wages and prices are not as
sticky as people believe, or if expectations and actual policy
implementation differ greatly.
Adherents of the new classical macroeconomic model believe that
stabilization policy, the attempt to keep output fluctuations to a
minimum, is likely to aggravate changes in Y* as policymakers and
economic agents attempt to outguess each other—policymakers by
initiating unanticipated policies and economic agents by
anticipating them! New Keynesians, by contrast, believe that some
stabilization is possible because even anticipated policies have
some short-run effects due to wage and price stickiness.
Stop and Think Box
In the early 1980s, U.S. President
Ronald Reagan and U.K. Prime Minister Margaret Thatcher announced
the same set of policies: tax cuts, more defense spending, and
anti-inflationary monetary policy. In both countries, sharp
recessions with high unemployment occurred, but the inflation beast
was eventually slain. Why did that particular outcome occur?
Tax cuts plus increased defense
spending meant larger budget deficits, which spells EFP and a
rightward shift in AD. That, of course, ran directly counter to
claims about fighting inflation, which were not credible and hence
not anticipated. But the Fed and the Bank of England did get tough
by raising overnight interest rates to very high levels (about 20
percent!). As a result, the happy conclusions of the new classical
macroeconomic model did not hold. The AS curve shifted hard left,
while the AD curve did not shift as far right as expected. The
result was that prices went up somewhat while output fell.
Eventually market participants figured out what was going on and
adjusted their expectations, returning Y* to Ynrl and
stopping further big increases in P*.
key takeaways
The new Keynesian model leaves more room for discretionary
monetary policy.
Like the new classical macroeconomic model, it is post-Lucas
and hence realizes that expectations are important to policy
outcomes.
Unlike the new classical macroeconomic model, however, it
posits significant wage and price stickiness (basically long-term
contracts) that prevents the AS curve from shifting immediately and
completely, regardless of the expectations of economic actors.
EMP (and EFP) can therefore increase Y* over Ynrl,
although less than if the policy were unanticipated (although, of
course, at the cost of higher P*; the long-term analysis of the
AS-AD model still holds). Similarly, to the extent that wages and
prices are sticky, some stabilization is possible because
policymakers can count on some output response to their
policies.
The new Keynesian model is more pessimistic about curbing
inflation, however, because the stickiness of the AS curve prevents
prices and wages from completely and instantaneously adjusting to a
credible commitment.
Output losses, however, will be smaller than an unanticipated
move to squelch inflation. Some economists think it is possible to
minimize the output losses further by essentially reducing the
stickiness of the AS by credibly committing to slowly reducing
inflation.