# New Keynesian economics

Last updated

New Keynesian economics is a school of macroeconomics that strives to provide microeconomic foundations for Keynesian economics. It developed partly as a response to criticisms of Keynesian macroeconomics by adherents of new classical macroeconomics.

## Contents

Two main assumptions define the New Keynesian approach to macroeconomics. Like the New Classical approach, New Keynesian macroeconomic analysis usually assumes that households and firms have rational expectations. However, the two schools differ in that New Keynesian analysis usually assumes a variety of market failures. In particular, New Keynesians assume that there is imperfect competition [1] in price and wage setting to help explain why prices and wages can become "sticky", which means they do not adjust instantaneously to changes in economic conditions.

Wage and price stickiness, and the other market failures present in New Keynesian models, imply that the economy may fail to attain full employment. Therefore, New Keynesians argue that macroeconomic stabilization by the government (using fiscal policy) and the central bank (using monetary policy) can lead to a more efficient macroeconomic outcome than a laissez faire policy would.

New Keynesianism became part of the new neoclassical synthesis that incorporated parts of both it and new classical macroeconomics, and forms the theoretical basis of mainstream macroeconomics today. [2] [3] [4] [5]

## Development of New Keynesian economics

### 1970s

The first wave of New Keynesian economics developed in the late 1970s. The first model of Sticky information was developed by Stanley Fischer in his 1977 article, Long-Term Contracts, Rational Expectations, and the Optimal Money Supply Rule. [6] He adopted a "staggered" or "overlapping" contract model. Suppose that there are two unions in the economy, who take turns to choose wages. When it is a union's turn, it chooses the wages it will set for the next two periods. This contrasts with John B. Taylor's model where the nominal wage is constant over the contract life, as was subsequently developed in his two articles: one in 1979, "Staggered wage setting in a macro model", [7] and one in 1980, "Aggregate Dynamics and Staggered Contracts". [8] Both Taylor and Fischer contracts share the feature that only the unions setting the wage in the current period are using the latest information: wages in half of the economy still reflect old information. The Taylor model had sticky nominal wages in addition to the sticky information: nominal wages had to be constant over the length of the contract (two periods). These early new Keynesian theories were based on the basic idea that, given fixed nominal wages, a monetary authority (central bank) can control the employment rate. Since wages are fixed at a nominal rate, the monetary authority can control the real wage (wage values adjusted for inflation) by changing the money supply and thus affect the employment rate. [9]

### 1980s

In the 1980s the key concept of using menu costs in a framework of imperfect competition to explain price stickiness was developed. [10] The concept of a lump-sum cost (menu cost) to changing the price was originally introduced by Sheshinski and Weiss (1977) in their paper looking at the effect of inflation on the frequency of price-changes. [11] The idea of applying it as a general theory of nominal price rigidity was simultaneously put forward by several economists in 1985–86. George Akerlof and Janet Yellen put forward the idea that due to bounded rationality firms will not want to change their price unless the benefit is more than a small amount. [12] [13] This bounded rationality leads to inertia in nominal prices and wages which can lead to output fluctuating at constant nominal prices and wages. Gregory Mankiw took the menu-cost idea and focused on the welfare effects of changes in output resulting from sticky prices. [14] Michael Parkin also put forward the idea. [15] Although the approach initially focused mainly on the rigidity of nominal prices, it was extended to wages and prices by Olivier Blanchard and Nobuhiro Kiyotaki in their influential article "Monopolistic Competition and the Effects of Aggregate Demand". [16] Huw Dixon and Claus Hansen showed that even if menu costs applied to a small sector of the economy, this would influence the rest of the economy and lead to prices in the rest of the economy becoming less responsive to changes in demand. [17]

While some studies suggested that menu costs are too small to have much of an aggregate impact, Laurence M. Ball and David Romer showed in 1990 that real rigidities could interact with nominal rigidities to create significant disequilibrium. [18] Real rigidities occur whenever a firm is slow to adjust its real prices in response to a changing economic environment. For example, a firm can face real rigidities if it has market power or if its costs for inputs and wages are locked-in by a contract. [19] Ball and Romer argued that real rigidities in the labor market keep a firm's costs high, which makes firms hesitant to cut prices and lose revenue. The expense created by real rigidities combined with the menu cost of changing prices makes it less likely that firm will cut prices to a market clearing level. [20]

Even if prices are perfectly flexible, imperfect competition can affect the influence of fiscal policy in terms of the multiplier. Huw Dixon and Gregory Mankiw developed independently simple general equilibrium models showing that the fiscal multiplier could be increasing with the degree of imperfect competition in the output market. [21] [22] The reason for this is that imperfect competition in the output market tends to reduce the real wage, leading to the household substituting away from consumption towards leisure. When government spending is increased, the corresponding increase in lump-sum taxation causes both leisure and consumption to decrease (assuming that they are both a normal good). The greater the degree of imperfect competition in the output market, the lower the real wage and hence the more the reduction falls on leisure (i.e. households work more) and less on consumption. Hence the fiscal multiplier is less than one, but increasing in the degree of imperfect competition in the output market. [23]

#### The Calvo staggered contracts model

In 1983 Guillermo Calvo wrote "Staggered Prices in a Utility-Maximizing Framework". [24] The original article was written in a continuous time mathematical framework, but nowadays is mostly used in its discrete time version. The Calvo model has become the most common way to model nominal rigidity in new Keynesian models. There is a probability that the firm can reset its price in any one period h (the hazard rate), or equivalently the probability (1 h) that the price will remain unchanged in that period (the survival rate). The probability h is sometimes called the "Calvo probability" in this context. In the Calvo model the crucial feature is that the price-setter does not know how long the nominal price will remain in place, in contrast to the Taylor model where the length of contract is known ex ante.

#### Coordination failure

Coordination failure was another important new Keynesian concept developed as another potential explanation for recessions and unemployment. [26] In recessions a factory can go idle even though there are people willing to work in it, and people willing to buy its production if they had jobs. In such a scenario, economic downturns appear to be the result of coordination failure: The invisible hand fails to coordinate the usual, optimal, flow of production and consumption. [27] Russell Cooper and Andrew John's 1988 paper "Coordinating Coordination Failures in Keynesian Models" expressed a general form of coordination as models with multiple equilibria where agents could coordinate to improve (or at least not harm) each of their respective situations. [25] [28] Cooper and John based their work on earlier models including Peter Diamond's 1982 coconut model, which demonstrated a case of coordination failure involving search and matching theory. [29] In Diamond's model producers are more likely to produce if they see others producing. The increase in possible trading partners increases the likelihood of a given producer finding someone to trade with. As in other cases of coordination failure, Diamond's model has multiple equilibria, and the welfare of one agent is dependent on the decisions of others. [30] Diamond's model is an example of a "thick-market externality" that causes markets to function better when more people and firms participate in them. [31] Other potential sources of coordination failure include self-fulfilling prophecies. If a firm anticipates a fall in demand, they might cut back on hiring. A lack of job vacancies might worry workers who then cut back on their consumption. This fall in demand meets the firm's expectations, but it is entirely due to the firm's own actions.

#### Labor market failures: Efficiency wages

New Keynesians offered explanations for the failure of the labor market to clear. In a Walrasian market, unemployed workers bid down wages until the demand for workers meets the supply. [32] If markets are Walrasian, the ranks of the unemployed would be limited to workers transitioning between jobs and workers who choose not to work because wages are too low to attract them. [33] They developed several theories explaining why markets might leave willing workers unemployed. [34] The most important of these theories, new Keynesians was the efficiency wage theory used to explain long-term effects of previous unemployment, where short-term increases in unemployment become permanent and lead to higher levels of unemployment in the long-run. [35]

In efficiency wage models, workers are paid at levels that maximize productivity instead of clearing the market. [36] For example, in developing countries, firms might pay more than a market rate to ensure their workers can afford enough nutrition to be productive. [37] Firms might also pay higher wages to increase loyalty and morale, possibly leading to better productivity. [38] Firms can also pay higher than market wages to forestall shirking. Shirking models were particularly influential. [39] Carl Shapiro and Joseph Stiglitz's 1984 paper "Equilibrium Unemployment as a Worker Discipline Device" created a model where employees tend to avoid work unless firms can monitor worker effort and threaten slacking employees with unemployment. [40] [41] If the economy is at full employment, a fired shirker simply moves to a new job. [42] Individual firms pay their workers a premium over the market rate to ensure their workers would rather work and keep their current job instead of shirking and risk having to move to a new job. Since each firm pays more than market clearing wages, the aggregated labor market fails to clear. This creates a pool of unemployed laborers and adds to the expense of getting fired. Workers not only risk a lower wage, they risk being stuck in the pool of unemployed. Keeping wages above market clearing levels creates a serious disincentive to shirk that makes workers more efficient even though it leaves some willing workers unemployed. [43]

### 1990s

#### The new neoclassical synthesis

In the early 1990s, economists began to combine the elements of new Keynesian economics developed in the 1980s and earlier with Real Business Cycle Theory. RBC models were dynamic but assumed perfect competition; new Keynesian models were primarily static but based on imperfect competition. The new neoclassical synthesis essentially combined the dynamic aspects of RBC with imperfect competition and nominal rigidities of new Keynesian models. Tack Yun was one of the first to do this, in a model that used the Calvo pricing model. [44] Goodfriend and King proposed a list of four elements that are central to the new synthesis: intertemporal optimization, rational expectations, imperfect competition, and costly price adjustment (menu costs). [45] [46] Goodfriend and King also find that the consensus models produce certain policy implications: whilst monetary policy can affect real output in the short-run, but there is no long-run trade-off: money is not neutral in the short-run but it is in the long-run. Inflation has negative welfare effects. It is important for central banks to maintain credibility through rules based policy like inflation targeting.

#### Taylor Rule

In 1993, [47] John B Taylor formulated the idea of a Taylor rule , which is a reduced form approximation of the responsiveness of the nominal interest rate, as set by the central bank, to changes in inflation, output, or other economic conditions. In particular, the rule describes how, for each one-percent increase in inflation, the central bank tends raise the nominal interest rate by more than one percentage point. This aspect of the rule is often called the Taylor principle. Although such rules provide concise, descriptive proxies for central bank policy, they are not, in practice, explicitly proscriptively considered by central banks when setting nominal rates.

Taylor's original version of the rule describes how the nominal interest rate responds to divergences of actual inflation rates from target inflation rates and of actual gross domestic product (GDP) from potential GDP:

${\displaystyle i_{t}=\pi _{t}+r_{t}^{*}+a_{\pi }(\pi _{t}-\pi _{t}^{*})+a_{y}(y_{t}-y_{t}^{*}).}$

In this equation, ${\displaystyle \,i_{t}\,}$ is the target short-term nominal interest rate (e.g. the federal funds rate in the US, the Bank of England base rate in the UK), ${\displaystyle \,\pi _{t}\,}$ is the rate of inflation as measured by the GDP deflator, ${\displaystyle \pi _{t}^{*}}$ is the desired rate of inflation, ${\displaystyle r_{t}^{*}}$ is the assumed equilibrium real interest rate, ${\displaystyle \,y_{t}\,}$ is the logarithm of real GDP, and ${\displaystyle y_{t}^{*}}$ is the logarithm of potential output, as determined by a linear trend.

#### The New Keynesian Phillips curve

The New Keynesian Phillips curve was originally derived by Roberts in 1995, [48] and has since been used in most state-of-the-art New Keynesian DSGE models. [49] The new Keynesian Phillips curve says that this period's inflation depends on current output and the expectations of next period's inflation. The curve is derived from the dynamic Calvo model of pricing and in mathematical terms is:

${\displaystyle \pi _{t}=\beta E_{t}[\pi _{t+1}]+\kappa y_{t}}$

The current period t expectations of next period's inflation are incorporated as ${\displaystyle \beta E_{t}[\pi _{t+1}]}$, where ${\displaystyle \beta }$ is the discount factor. The constant ${\displaystyle \kappa }$ captures the response of inflation to output, and is largely determined by the probability of changing price in any period, which is ${\displaystyle h}$:

${\displaystyle \kappa ={\frac {h[1-(1-h)\beta ]}{1-h}}\gamma }$

.

The less rigid nominal prices are (the higher is ${\displaystyle h}$), the greater the effect of output on current inflation.

#### The science of monetary policy

The ideas developed in the 1990s were put together to develop the new Keynesian dynamic stochastic general equilibrium used to analyze monetary policy. This culminated in the three-equation new Keynesian model found in the survey by Richard Clarida, Jordi Gali, and Mark Gertler in the Journal of Economic Literature . [50] [51] It combines the two equations of the new Keynesian Phillips curve and the Taylor rule with the dynamic IS curve derived from the optimal dynamic consumption equation (household's Euler equation).

${\displaystyle y_{t}=E_{t}y_{t+1}-{\frac {1}{\sigma }}(i_{t}-E_{t}\pi _{t+1})+v_{t}}$

These three equations formed a relatively simple model which could be used for the theoretical analysis of policy issues. However, the model was oversimplified in some respects (for example, there is no capital or investment). Also, it does not perform well empirically.

### 2000s

In the new millennium there have been several advances in new Keynesian economics.

#### The introduction of imperfectly competitive labor markets

Whilst the models of the 1990s focused on sticky prices in the output market, in 2000 Christopher Erceg, Dale Henderson and Andrew Levin adopted the Blanchard and Kiyotaki model of unionized labor markets by combining it with the Calvo pricing approach and introduced it into a new Keynesian DSGE model. [52]

#### The development of complex DSGE models

To have models that worked well with the data and could be used for policy simulations, quite complicated new Keynesian models were developed with several features. Seminal papers were published by Frank Smets and Rafael Wouters [53] [54] and also Lawrence J. Christiano, Martin Eichenbaum and Charles Evans [55] The common features of these models included:

• Habit persistence. The marginal utility of consumption depends on past consumption.
• Calvo pricing in both output and product markets, with indexation so that when wages and prices are not explicitly reset, they are updated for inflation.
• Capital adjustment costs and variable capital use.
• New shocks
• Demand shocks, which affect the marginal utility of consumption
• Markup shocks that influence the desired markup of price over marginal cost.
• Monetary policy is represented by a Taylor rule.
• Bayesian estimation methods.

#### Sticky information

The idea of sticky information found in Fischer's model was later developed by Gregory Mankiw and Ricardo Reis. [56] This added a new feature to Fischer's model: there is a fixed probability that a worker can replan their wages or prices each period. Using quarterly data, they assumed a value of 25%: that is, each quarter 25% of randomly chosen firms/unions can plan a trajectory of current and future prices based on current information. Thus if we consider the current period: 25% of prices will be based on the latest information available; the rest on information that was available when they last were able to replan their price trajectory. Mankiw and Reis found that the model of sticky information provided a good way of explaining inflation persistence.

Sticky information models do not have nominal rigidity: firms or unions are free to choose different prices or wages for each period. It is the information that is sticky, not the prices. Thus when a firm gets lucky and can re-plan its current and future prices, it will choose a trajectory of what it believes will be the optimal prices now and in the future. In general, this will involve setting a different price every period covered by the plan. This is at odds with the empirical evidence on prices. [57] [58] There are now many studies of price rigidity in different countries: the United States, [59] the Eurozone, [60] the United Kingdom [61] and others. These studies all show that whilst there are some sectors where prices change frequently, there are also other sectors where prices remain fixed over time. The lack of sticky prices in the sticky information model is inconsistent with the behavior of prices in most of the economy. This has led to attempts to formulate a "dual stickiness" model that combines sticky information with sticky prices. [58] [62]

### 2010s

The 2010s saw the development of models incorporating household heterogeneity into the standard New Keynesian framework, commonly referred as 'HANK' models (Heterogeneous Agent New Keynesian). In addition to sticky prices, a typical HANK model features uninsurable idiosyncratic labor income risk which gives rise to a non-degenerate wealth distribution. The earliest models with these two features include Oh and Reis (2012), [63] McKay and Reis (2016) [64] and Guerrieri and Lorenzoni (2017). [65]

The name "HANK model" was coined by Greg Kaplan, Benjamin Moll and Gianluca Violante in a 2018 paper [66] that additionally models households as accumulating two types of assets, one liquid and the other illiquid. This translates into rich heterogeneity in portfolio composition across households. In particular, the model fits empirical evidence by featuring a large share of households holding little liquid wealth: the 'hand-to-mouth' households. Consistent with empirical evidence, [67] about two-thirds of these households hold non-trivial amounts of illiquid wealth, despite holding little liquid wealth. These households are known as wealthy hand-to-mouth households, a term introduced in a 2014 study of fiscal stimulus policies by Kaplan and Violante. [68]

The existence of wealthy hand-to-mouth households in New Keynesian models matters for the effects of monetary policy, because the consumption behavior of those households is strongly sensitive to changes in disposable income, rather than variations in the interest rate (i.e. the price of future consumption relative to current consumption). The direct corollary is that monetary policy is mostly transmitted via general equilibrium effects that work through the household labor income, rather than through intertemporal substitution, which is the main transmission channel in Representative Agent New Keynesian (RANK) models.

There are two main implications for monetary policy. First, monetary policy interacts strongly with fiscal policy, because of the failure of Ricardian Equivalence due to the presence of hand-to-mouth households. In particular, changes in the interest rate shift the Government's budget constraint, and the fiscal response to this shift affects households' disposable income. Second, aggregate monetary shocks are not distributional neutral since they affect the return on capital, which affects households with different levels of wealth and assets differently.

## Policy implications

New Keynesian economists agree with New Classical economists that in the long run, the classical dichotomy holds: changes in the money supply are neutral. However, because prices are sticky in the New Keynesian model, an increase in the money supply (or equivalently, a decrease in the interest rate) does increase output and lower unemployment in the short run. Furthermore, some New Keynesian models confirm the non-neutrality of money under several conditions. [69] [70]

Nonetheless, New Keynesian economists do not advocate using expansive monetary policy for short run gains in output and employment, as it would raise inflationary expectations and thus store up problems for the future. Instead, they advocate using monetary policy for stabilization. That is, suddenly increasing the money supply just to produce a temporary economic boom is not recommended as eliminating the increased inflationary expectations will be impossible without producing a recession.

However, when the economy is hit by some unexpected external shock, it may be a good idea to offset the macroeconomic effects of the shock with monetary policy. This is especially true if the unexpected shock is one (like a fall in consumer confidence) which tends to lower both output and inflation; in that case, expanding the money supply (lowering interest rates) helps by increasing output while stabilizing inflation and inflationary expectations.

Studies of optimal monetary policy in New Keynesian DSGE models have focused on interest rate rules (especially 'Taylor rules'), specifying how the central bank should adjust the nominal interest rate in response to changes in inflation and output. (More precisely, optimal rules usually react to changes in the output gap, rather than changes in output per se.) In some simple New Keynesian DSGE models, it turns out that stabilizing inflation suffices, because maintaining perfectly stable inflation also stabilizes output and employment to the maximum degree desirable. Blanchard and Galí have called this property the 'divine coincidence'. [71]

However, they also show that in models with more than one market imperfection (for example, frictions in adjusting the employment level, as well as sticky prices), there is no longer a 'divine coincidence', and instead there is a tradeoff between stabilizing inflation and stabilizing employment. [72] Further, while some macroeconomists believe that New Keynesian models are on the verge of being useful for quarter-to-quarter quantitative policy advice, disagreement exists. [73]

Alves (2014) [74] showed that the divine coincidence does not necessarily hold in the non-linear form of the standard New-Keynesian model. This property would only hold if the monetary authority is set to keep the inflation rate at exactly 0%. At any other desired target for the inflation rate, there is an endogenous trade-off, even under the absence real imperfections such as sticky wages, and the divine coincidence no longer holds.

## Relation to other macroeconomic schools

Over the years, a sequence of 'new' macroeconomic theories related to or opposed to Keynesianism have been influential. [75] After World War II, Paul Samuelson used the term neoclassical synthesis to refer to the integration of Keynesian economics with neoclassical economics. The idea was that the government and the central bank would maintain rough full employment, so that neoclassical notions—centered on the axiom of the universality of scarcity—would apply. John Hicks' IS/LM model was central to the neoclassical synthesis.

Later work by economists such as James Tobin and Franco Modigliani involving more emphasis on the microfoundations of consumption and investment was sometimes called neo-Keynesianism. It is often contrasted with the post-Keynesianism of Paul Davidson, which emphasizes the role of fundamental uncertainty in economic life, especially concerning issues of private fixed investment.

New Keynesianism was a response to Robert Lucas and the new classical school. [76] That school criticized the inconsistencies of Keynesianism in the light of the concept of "rational expectations". The new classicals combined a unique market-clearing equilibrium (at full employment) with rational expectations. The New Keynesians used "microfoundations" to demonstrate that price stickiness hinders markets from clearing. Thus, the rational expectations-based equilibrium need not be unique.

Whereas the neoclassical synthesis hoped that fiscal and monetary policy would maintain full employment, the new classicals assumed that price and wage adjustment would automatically attain this situation in the short run. The new Keynesians, on the other hand, saw full employment as being automatically achieved only in the long run, since prices are "sticky" in the short run. Government and central-bank policies are needed because the "long run" may be very long.

Ultimately, the differences between new classical macroeconomics and New Keynesian economics were resolved in the new neoclassical synthesis of the 1990s, which forms the basis of mainstream economics today, [2] [3] [4] and the Keynesian stress on the importance of centralized coordination of macroeconomic policies (e.g., monetary and fiscal stimulus), international economic institutions such as the World Bank and International Monetary Fund (IMF), and of the maintenance of a controlled trading system was highlighted during the 2008 global financial and economic crisis. This has been reflected in the work of IMF economists [77] and of Donald Markwell. [78]

## Related Research Articles

Macroeconomics is a branch of economics dealing with performance, structure, behavior, and decision-making of an economy as a whole. For example, using interest rates, taxes, and government spending to regulate an economy's growth and stability. This includes regional, national, and global economies. According to a 2018 assessment by economists Emi Nakamura and Jón Steinsson, economic "evidence regarding the consequences of different macroeconomic policies is still highly imperfect and open to serious criticism."

In economics, stagflation or recession-inflation is a situation in which the inflation rate is high or increasing, the economic growth rate slows, and unemployment remains steadily high. It presents a dilemma for economic policy, since actions intended to lower inflation may exacerbate unemployment.

IS–LM model, or Hicks–Hansen model, is a two-dimensional macroeconomic tool that shows the relationship between interest rates and assets market. The intersection of the "investment–saving" (IS) and "liquidity preference–money supply" (LM) curves models "general equilibrium" where supposed simultaneous equilibria occur in both the goods and the asset markets. Yet two equivalent interpretations are possible: first, the IS–LM model explains changes in national income when the price level is fixed in the short-run; second, the IS–LM model shows why an aggregate demand curve can shift. Hence, this tool is sometimes used not only to analyse economic fluctuations but also to suggest potential levels for appropriate stabilisation policies.

The Phillips curve is an economic model, named after William Phillips hypothesizing a correlation between reduction in unemployment and increased rates of wage rises within an economy. While Phillips himself did not state a linked relationship between employment and inflation, this was a trivial deduction from his statistical findings. Paul Samuelson and Robert Solow made the connection explicit and subsequently Milton Friedman and Edmund Phelps put the theoretical structure in place.

Nominal rigidity, also known as price-stickiness or wage-stickiness, is a situation in which a nominal price is resistant to change. Complete nominal rigidity occurs when a price is fixed in nominal terms for a relevant period of time. For example, the price of a particular good might be fixed at \$10 per unit for a year. Partial nominal rigidity occurs when a price may vary in nominal terms, but not as much as it would if perfectly flexible. For example, in a regulated market there might be limits to how much a price can change in a given year.

Ricardo A. M. R. Reis is a Portuguese economist and the A. W. Phillips professor of economics at the London School of Economics. In a 2013 ranking of young economists by Glenn Ellison, Reis was considered the top economist with a PhD between 1996 and 2004., and in 2016 he won the Germán Bernácer Prize for top European-born economist researching macroeconomics and finance. He writes a weekly op-ed for the Portuguese newspaper Jornal de Notícias and Expresso, and participates frequently in economic debates in Portugal.

John Brian Taylor is the Mary and Robert Raymond Professor of Economics at Stanford University, and the George P. Shultz Senior Fellow in Economics at Stanford University's Hoover Institution.

The policy-ineffectiveness proposition (PIP) is a new classical theory proposed in 1975 by Thomas J. Sargent and Neil Wallace based upon the theory of rational expectations, which posits that monetary policy cannot systematically manage the levels of output and employment in the economy.

In economics, the menu cost is a cost that a firm incurs due to changing its prices. It is one microeconomic explanation of the price-stickiness of the macroeconomy put by New Keynesian economists. The term originated from the cost when restaurants print new menus to change the prices of items. However economists have extended its meaning to include the costs of changing prices more generally. Menu costs can be broadly classed into costs associated with informing the consumer, planning for and deciding on a price change and the impact of consumers potential reluctance to buy at the new price. Examples of menu costs include updating computer systems, re-tagging items, changing signage, printing new menus, mistake costs and hiring consultants to develop new pricing strategies. At the same time, companies can reduce menu costs by developing intelligent pricing strategies, thereby reducing the need for changes.

Dynamic stochastic general equilibrium modeling is a macroeconomic method which is often employed by monetary and fiscal authorities for policy analysis, explaining historical time-series data, as well as future forecasting purposes. DSGE econometric modelling applies general equilibrium theory and microeconomic principles in a tractable manner to postulate economic phenomena, such as economic growth and business cycles, as well as policy effects and market shocks.

The neoclassical synthesis (NCS), neoclassical–Keynesian synthesis, or just neo-Keynesianism was a neoclassical economics academic movement and paradigm in economics that worked towards reconciling the macroeconomic thought of John Maynard Keynes in his book The General Theory of Employment, Interest and Money (1936). It was formulated most notably by John Hicks (1937), Franco Modigliani (1944), and Paul Samuelson (1948), who dominated economics in the post-war period and formed the mainstream of macroeconomic thought in the 1950s, 60s, and 70s.

New classical macroeconomics, sometimes simply called new classical economics, is a school of thought in macroeconomics that builds its analysis entirely on a neoclassical framework. Specifically, it emphasizes the importance of rigorous foundations based on microeconomics, especially rational expectations.

The AD–AS or aggregate demand–aggregate supply model is a macroeconomic model that explains price level and output through the relationship of aggregate demand (AD) and aggregate supply (AS).

David Hibbard Romer is an American economist, the Herman Royer Professor of Political Economy at the University of California, Berkeley, and the author of a standard textbook in graduate macroeconomics as well as many influential economic papers, particularly in the area of New Keynesian economics. He is also the husband and close collaborator of Council of Economic Advisers former Chairwoman Christina Romer.

Macroeconomic theory has its origins in the study of business cycles and monetary theory. In general, early theorists believed monetary factors could not affect real factors such as real output. John Maynard Keynes attacked some of these "classical" theories and produced a general theory that described the whole economy in terms of aggregates rather than individual, microeconomic parts. Attempting to explain unemployment and recessions, he noticed the tendency for people and businesses to hoard cash and avoid investment during a recession. He argued that this invalidated the assumptions of classical economists who thought that markets always clear, leaving no surplus of goods and no willing labor left idle.

In macroeconomics, rigidities are real prices and wages that fail to adjust to the level indicated by equilibrium or if something holds one price or wage fixed to a relative value of another. Real rigidities can be distinguished from nominal rigidities, rigidities that do not adjust because prices can be sticky and fail to change value even as the underlying factors that determine prices fluctuate. Real rigidities, along with nominal, are a key part of new Keynesian economics. Economic models with real rigidities lead to nominal shocks having a large impact on the economy.

The new neoclassical synthesis (NNS), which is now generally referred to as New Keynesian economics, and occasionally as the New Consensus, is the fusion of the major, modern macroeconomic schools of thought – new classical macroeconomics/real business cycle theory and early New Keynesian economics – into a consensus view on the best way to explain short-run fluctuations in the economy. This new synthesis is analogous to the neoclassical synthesis that combined neoclassical economics with Keynesian macroeconomics. The new synthesis provides the theoretical foundation for much of contemporary mainstream macroeconomics. It is an important part of the theoretical foundation for the work done by the Federal Reserve and many other central banks.

In economics, divine coincidence refers to the property of New Keynesian models that there is no trade-off between the stabilization of inflation and the stabilization of the welfare-relevant output gap for central banks. This property is attributed to a feature of the model, namely the absence of real imperfections such as real wage rigidities. Conversely, if New Keynesian models are extended to account for these real imperfections, divine coincidence disappears and central banks again face a trade-off between inflation and output gap stabilization. The definition of divine coincidence is usually attributed to the seminal article by Olivier Blanchard and Jordi Galí in 2007.

The Taylor contract or staggered contract was first formulated by John B. Taylor in his two articles, in 1979 "Staggered wage setting in a macro model". and in 1980 "Aggregate Dynamics and Staggered Contracts". In its simplest form, one can think of two equal sized unions who set wages in an industry. Each period, one of the unions sets the nominal wage for two periods. This means that in any one period, only one of the unions can reset its wage and react to events that have just happened. When the union sets its wage, it sets it for a known and fixed period of time. Whilst it will know what is happening in the first period when it sets the new wage, it will have to form expectations about the factors in the second period that determine the optimal wage to set. Although the model was first used to model wage setting, in new Keynesian models that followed it was also used to model price-setting by firms.

A Calvo contract is the name given in macroeconomics to the pricing model that when a firm sets a nominal price there is a constant probability that a firm might be able to reset its price which is independent of the time since the price was last reset. The model was first put forward by Guillermo Calvo in his 1983 article "Staggered Prices in a Utility-Maximizing Framework". The original article was written in a continuous time mathematical framework, but nowadays is mostly used in its discrete time version. The Calvo model is the most common way to model nominal rigidity in new Keynesian DSGE macroeconomic models.

## References

1. Dixon, Huw. "Chapter 4: The role of imperfect competition in new Keynesian economics" (PDF). Surfing Economics.
2. Woodford, Michael. Convergence in Macroeconomics: Elements of the New Synthesis. January 2008.
3. Mankiw, N. Greg (May 2006). The Macroeconomist as Scientist and Engineer. pp. 14–15.
4. Goodfriend, Marvin and King, Robert G. (June 1997). The New Neoclassical Synthesis and The Role of Monetary Policy. Federal Reserve Bank of Richmond. Working papers. No. 98–5.
5. Galí, Jordi (2018). "The State of New Keynesian Economics: A Partial Assessment". Journal of Economic Perspectives. 32 (3): 87–112. doi:10.1257/jep.32.3.87. hdl:. ISSN   0895-3309. S2CID   158736462.
6. Fischer, S. (1977). "Long-Term Contracts, Rational Expectations, and the Optimal Money Supply Rule" (PDF). Journal of Political Economy . 85 (1): 191–205. doi:10.1086/260551. hdl:. JSTOR   1828335. S2CID   36811334.
7. Taylor, John B (1979). "Staggered wage setting in a macro model". American Economic Review. 69 (2): 108–113.
8. Taylor, John B (1980). "Aggregate Dynamics and Staggered Contracts". Journal of Political Economy. 88 (1): 1–23. doi:10.1086/260845. S2CID   154446910.
9. Mankiw, N. Gregory (1990). "A Quick Refresher Course in Macroeconomics". Journal of Economic Literature. 28: 1645–1660 [1658]. doi:. S2CID   56101250.
10. Dixon, Huw (2001). "The Role of imperfect competition in new Keynesian economics" (PDF). Surfing Economics: Essays for the Inquiring Economist. New York: Palgrave. ISBN   978-0333760611.
11. Sheshinski, Eytan; Weiss, Yoram (1977). "Inflation and Costs of Price Adjustment". Review of Economic Studies . 44 (2): 287–303. doi:10.2307/2297067. JSTOR   2297067.
12. Akerlof, George A.; Yellen, Janet L. (1985). "Can Small Deviations from Rationality Make Significant Differences to Economic Equilibria?". American Economic Review . 75 (4): 708–720. JSTOR   1821349.
13. Akerlof, George A.; Yellen, Janet L. (1985). "A Near-rational Model of the Business Cycle, with Wage and Price Inertia". The Quarterly Journal of Economics . 100 (5): 823–838. doi:10.1093/qje/100.Supplement.823.
14. Mankiw, N. Gregory (1985). "Small Menu Costs and Large Business Cycles: A Macroeconomic Model of Monopoly". The Quarterly Journal of Economics . 100 (2): 529–538. doi:10.2307/1885395. JSTOR   1885395.
15. Parkin, Michael (1986). "The Output-Inflation Trade-off When Prices Are Costly to Change". Journal of Political Economy . 94 (1): 200–224. doi:10.1086/261369. JSTOR   1831966. S2CID   154048806.
16. Blanchard, O.; Kiyotaki, N. (1987). "Monopolistic Competition and the Effects of Aggregate Demand". American Economic Review . 77 (4): 647–666. JSTOR   1814537.
17. Dixon, Huw; Hansen, Claus (1999). "A Mixed Industrial Structure Magnifies the Importance of Menu Costs". European Economic Review . 43 (8): 1475–1499. doi:10.1016/S0014-2921(98)00029-4.
18. Ball, L. and Romer, D. (1990). "Real Rigidities and the Non-neutrality of Money". Review of Economic Studies. Volume 57. pp. 183–203
19. Romer, David (2005). Advanced Macroeconomics. New York: McGraw-Hill. ISBN   978-0-07-287730-4. pp 380–381.
20. Mankiw, N. Gregory (1990).
21. Huw Dixon (1987). "A simple model of imperfect competition with Walrasian features". Oxford Economic Papers 39, pp. 134–160.
22. Gregory Mankiw (1988). "Imperfect competition and the Keynesian cross". Economics Letters 26, pp. 7–13
23. Costa, L.; Dixon, H. (2011). "Fiscal Policy Under Imperfect Competition with Flexible Prices: An Overview and Survey". Economics: The Open-Access, Open-Assessment e-Journal. 5 (1): 2011–2013. doi:. S2CID   6931642.
24. Calvo, Guillermo A (1983). "Staggered Prices in a Utility-Maximizing Framework". Journal of Monetary Economics. 12 (3): 383–398. doi:10.1016/0304-3932(83)90060-0.
25. Cooper, Russel; John, Andrew (1988). "Coordinating Coordination Failures in Keynesian Models" (PDF). The Quarterly Journal of Economics. 103 (3): 441–463 [446]. doi:10.2307/1885539. JSTOR   1885539.
26. Mankiw, N. Gregory (2008). "New Keynesian Economics". The Concise Encyclopedia of Economics. Library of Economics and Liberty.
27. Howitt, Peter (2002). "Coordination failures". In Snowdon, Brian; Vane, Howard (eds.). An Encyclopedia of Macroeconomics. Cheltenham, UK: Edward Elgar Publishing. ISBN   978-1-84064-387-9. pp. 140–41.
28. Howitt (2002), p. 142
29. Diamond, Peter A. (1982). "Aggregate Demand Management in Search Equilibrium". Journal of Political Economy. 90 (5): 881–894. doi:10.1086/261099. hdl:. JSTOR   1837124. S2CID   53597292.
30. Cooper and John (1988), pp. 452–53.
31. Mankiw, N. Gregory; Romer, David (1991). New Keynesian economics 1. Cambridge, Massachusetts: MIT Press. ISBN   0-262-13266-4. p. 8
32. Romer (2005), p. 438
33. Romer (2005) pp. 437–439
34. Romer 2005, p. 437.
35. Snowdon, Brian; Vane, Howard (2005). Modern Macroeconomics. Cheltenham, UK: Edward Elgar. ISBN   978-1-84542-208-0. p. 384
36. Froyen, Richard (1990). Macroeconomics, Theories and Policies (3rd ed.). New York: Macmillan. ISBN   978-0-02-339482-9. p. 357
37. Romer (2005), p. 439
38. Froyen (1990), p. 358
39. Romer (2005), p. 448
40. Shapiro, C.; Stiglitz, J. E. (1984). "Equilibrium Unemployment as a Worker Discipline Device". The American Economic Review. 74 (3): 433–444. JSTOR   1804018.
41. Snowden and Vane (2005), p. 390
42. Romer (2005), p. 453.
43. Snowden and Vane (2005), p. 390.
44. Yun, Tack (April 1996). "Nominal price rigidity, money supply endogeneity, and business cycles". Journal of Monetary Economics 37(2–3). Elsevier. pp. 345–370.
45. Goodfriend, Marvin; King, Robert G (1997). "The New Neoclassical Synthesis and the Role of Monetary Policy". NBER Macroeconomics Annual. NBER Chapters (National Bureau of Economic Research) 12: 231–83, JSTOR   3585232.
46. Snowden and Vane 2005, p. 411
47. Taylor, John B. (1993). "Discretion versus Policy Rules in Practice" (PDF). Carnegie-Rochester Conference Series on Public Policy. 39: 195–214. doi:10.1016/0167-2231(93)90009-L. (The rule is introduced on page 202.)
48. Roberts, John M. (1995). "New Keynesian Economics and the Phillips Curve". Journal of Money, Credit and Banking . 27 (4): 975–984. doi:10.2307/2077783. JSTOR   2077783.
49. Romer, David (2012). "Dynamic Stochastic General Equilibrium Models of Fluctuation". Advanced Macroeconomics. New York: McGraw-Hill Irwin. pp. 312–364. ISBN   978-0-07-351137-5.
50. Clarida, Galí, and Gertler (2000)
51. Clarida, Richard; Galí, Jordi; Gertler, Mark (2000). "Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory". The Quarterly Journal of Economics . 115 (1): 147–180. CiteSeerX  . doi:10.1162/003355300554692. S2CID   5448436.
52. Erceg, C., Henderson, D. and Levin, A. (2000). "Optimal monetary policy with staggered wage and price contracts". Journal of Monetary Economics 46. pp. 281–313.
53. Smets, Frank; Wouters, Raf (2003). "An Estimated Dynamic Stochastic General Equilibrium Model of the Euro Area". Journal of the European Economic Association. 1 (5): 1123–1175. doi:10.1162/154247603770383415. hdl:.
54. Frank Smets & Rafael Wouters (June 2007). "Shocks and Frictions in US Business Cycles: A Bayesian DSGE Approach". American Economic Review 97(3). American Economic Association. pp. 586–606.
55. Christiano, Lawrence; Eichenbaum, Martin; Evans, Charles (2005). "Nominal rigidities and the dynamic effects of a shock to monetary policy" (PDF). Journal of Political Economy. 113 (1): 1–45. CiteSeerX  . doi:10.1086/426038. S2CID   158727660.
56. Mankiw, N. G.; Reis, R. (2002). "Sticky Information Versus Sticky Prices: A Proposal To Replace The New Keynesian Phillips Curve". Quarterly Journal of Economics . 117 (4): 1295–1328. doi:10.1162/003355302320935034. S2CID   1146949.
57. Chari, V. V.; Kehoe, Patrick J.; McGrattan, Ellen R. (2008). "New Keynesian Models: Not Yet Useful for Policy Analysis" (PDF). Federal Reserve Bank of Minneapolis Research Department Staff Report 409.
58. Knotec, Edward S. II (2010). "A Tale of Two Rigidities: Sticky Prices in a Sticky-Information Environment". Journal of Money, Credit and Banking. 42 (8): 1543–1564. doi:10.1111/j.1538-4616.2010.00353.x.
59. Klenow, Peter J.; Kryvtsov, Oleksiy (2008). "State-Dependent or Time-Dependent Pricing: Does It Matter For Recent U.S. Inflation?". The Quarterly Journal of Economics . 123 (3): 863–904. CiteSeerX  . doi:10.1162/qjec.2008.123.3.863.
60. Álvarez, Luis J.; Dhyne, Emmanuel; Hoeberichts, Marco; Kwapil, Claudia; Le Bihan, Hervé; Lünnemann, Patrick; Martins, Fernando; Sabbatini, Roberto; Stahl, Harald; Vermeulen, Philip; Vilmunen, Jouko (2006). "Sticky Prices in the Euro Area: A Summary of New Micro-Evidence" (PDF). Journal of the European Economic Association . 4 (2–3): 575–584. doi:10.1162/jeea.2006.4.2-3.575. S2CID   56011601.
61. Bunn, Philip; Ellis, Colin (2012). "Examining The Behaviour Of Individual UK Consumer Prices". The Economic Journal . 122 (558): F35–F55. doi:10.1111/j.1468-0297.2011.02490.x. S2CID   153322174.
62. Dupor, Bill; Kitamura, Tomiyuki; Tsuruga, Takayuki (2010). "Integrating Sticky Prices and Sticky Information". Review of Economics and Statistics . 92 (3): 657–669. CiteSeerX  . doi:10.1162/REST_a_00017. S2CID   57569783.
63. Oh, Hyunseung; Reis, Ricardo (February 2011). "Targeted Transfers and the Fiscal Response to the Great Recession". doi:10.3386/w16775.{{cite journal}}: Cite journal requires |journal= (help)
64. McKay, Alisdair; Reis, Ricardo (June 2016). "Optimal Automatic Stabilizers". doi:10.3386/w22359. S2CID   27044134.{{cite journal}}: Cite journal requires |journal= (help)
65. Guerrieri, Veronica; Lorenzoni, Guido (1 August 2017). "Credit Crises, Precautionary Savings, and the Liquidity Trap". The Quarterly Journal of Economics. 132 (3): 1427–1467. doi:10.1093/qje/qjx005. ISSN   0033-5533. S2CID   7951907.
66. Kaplan, Greg; Moll, Benjamin; Violante, Giovanni L. (March 2018). "Monetary Policy According to HANK". American Economic Review. 108 (3): 697–743. doi:10.1257/aer.20160042. ISSN   0002-8282. S2CID   31927674.
67. "Brookings Institution" (PDF).
68. Kaplan, Greg; Violante, Giovanni L. (2014). "A Model of the Consumption Response to Fiscal Stimulus Payments" (PDF). Econometrica. 82 (4): 1199–1239. doi:10.3982/ECTA10528. ISSN   1468-0262. S2CID   15993790.
69. Benchimol, J.; Fourçans, A. (2012). "Money and risk in a DSGE framework: A Bayesian application to the Eurozone". Journal of Macroeconomics . 34: 95–111.
70. Benchimol, J. (2015). "Money in the production function: a new Keynesian DSGE perspective". Southern Economic Journal . 82 (1): 152–184.
71. Blanchard, Olivier; Galí, Jordi (2007). "Real wage rigidities and the New Keynesian model" (PDF). Journal of Money, Credit, and Banking. 39 (1): 35–65. doi:10.1111/j.1538-4616.2007.00015.x.
72. Blanchard, Olivier; Galí, Jordi (2007). "A New Keynesian model with unemployment" (PDF). CFS working paper 2007/08. Center for Financial Studies, Goethe University, Frankfurt.
73. Federal Reserve Bank of Minneapolis (July 2008). "New Keynesian Models: Not Yet Useful for Policy Analysis".
74. Alves, S. A. L. (2014). "Lack of Divine Coincidence in New-Keynesian Models". Journal of Monetary Economics (67): 33–46.
75. Woodford, Michael (1999). "Revolution and evolution in 20th century macroeconomics" (PDF). mimeo. Columbia University.
76. Gali, Jordi (2015). Monetary Policy, Inflation and the Business Cycle: An Introduction to the New Keynesian Framework and Its Applications (2nd ed.). Princeton and Oxford: Princeton University Press. pp. 5–6. ISBN   978-0-691-16478-6.
77. Antonio Spilimbergo, Steve Symansky, Olivier Blanchard, and Carlo Cottarelli (29 December 2008). "Fiscal Policy for the Crisis". IMF Fiscal Affairs and Research Departments.
78. Markwell, Donald (2006). John Maynard Keynes and International Relations: Economic Paths to War and Peace. Oxford University Press.