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7.8 New Keynesian Business Cycle Theory

New Keynesian economists accept that the source of shocks which generate

aggregate disturbances can arise from the supply side or the demand side.

However, new Keynesians argue that there are frictions and imperfections

within the economy which will amplify these shocks so that large fluctuations

in real output and employment result. The important issue for new

Keynesians is not so much the source of the shocks but how the economy

responds to them.

Within new Keynesian economics there have been two strands of research

relating to the issue of aggregate fluctuations. The predominant

approach has emphasized the importance of nominal rigidities. The second

approach follows Keynes (1936) and Tobin (1975), and explores the potentially

destabilizing impact of wage and price flexibility. We will examine

each in turn. Consider Figure 7.8. In panel (a) we illustrate the impact of a

decline in the money supply which shifts aggregate demand from AD0 to

AD1. If a combination of menu costs and real rigidities makes the price

level rigid at P0, the decline in aggregate demand will move the economy

from point E0 to point E1 in panel (a). The decline in output reduces the

effective demand for labour. In panel (c) the effective labour demand curve

(DLe) shows how much labour is necessary to produce different levels of

output. As the diagram shows, L1 amount of labour is required to produce Y1

amount of output. With prices and the real wage fixed at P0 and w0, respectively,

firms move off the notional demand curve for labour, DL, operating

instead along their effective labour demand curve indicated by NKL1 in

panel (d). At the rigid real wage of w0, firms would like to hire L0 workers,

Figure 7.8 The impact of an aggregate demand shock in the new Keynesian


but they have no market for the extra output which would be produced by

hiring the extra workers. The aggregate demand shock has produced an

increase in involuntary unemployment of L0 – L1. The new Keynesian shortrun

aggregate supply curve SRAS (P0) is perfectly elastic at the fixed price

level. Eventually downward pressure on prices and wages would move the

economy from point E1 to E2 in panel (a), but this process may take an

unacceptably long period of time. Therefore new Keynesian economists,

like Keynes, advocate measures which will push the aggregate demand

curve back towards E0. In the new Keynesian model, monetary shocks

clearly have non-neutral effects in the short run, although money remains

neutral in the long run, as indicated by the vertical long-run aggregate

supply curve (LRAS).

The failure of firms to cut prices even though this would in the end benefit

all firms is an example of a ‘coordination failure’. A coordination failure

occurs when economic agents reach an outcome that is inferior to all of them

because there are no private incentives for agents to jointly choose strategies

that would produce a much better (and preferred) result (see Mankiw, 2003).

The inability of agents to coordinate their activities successfully in a decentralized

system arises because there is no incentive for a single firm to cut

price and increase production, given the assumed inaction of other agents.

Because the optimal strategy of one firm depends on the strategies adopted by

other firms, a strategic complementary is present, since all firms would gain

if prices were reduced and output increased (Alvi, 1993). To many Keynesian

economists the fundamental causes of macroeconomic instability relate to

problems associated with coordination failure (see Ball and Romer, 1991;

Leijonhufvud, 1992).

The second brand of new Keynesian business cycle theorizing suggests

that wage and price rigidities are not the main problem. Even if wages and

prices were fully flexible, output and employment would still be very unstable.

Indeed, price rigidities may well reduce the magnitude of aggregate

fluctuations, a point made by Keynes in Chapter 19 of the General Theory,

but often neglected (see Chapter 2 above, and General Theory, p. 269). A

reconsideration of this issue followed Tobin’s (1975) paper (see Sheffrin,

1989, for a discussion of this debate). Tobin himself remains highly critical

of new Keynesian theorists who continue to stress the importance of nominal

rigidities (Tobin, 1993), and Greenwald and Stiglitz have been influential in

developing new Keynesian models of the business cycle which do not rely on

nominal price and wage inertia, although real rigidities play an important


In the Greenwald and Stiglitz model (1993a, 1993b) firms are assumed to

be risk-averse. Financial market imperfections generated by asymmetric information

constrain many firms from access to equity finance. Equity-rationed

firms can only partially diversify out of the risks they face. Their resultant

dependence on debt rather than new equity issues makes firms more vulnerable

to bankruptcy, especially during a recession when the demand curve

facing most firms shifts to the left. Faced with such a situation, a risk-averse

equity-constrained firm prefers to reduce its output because the uncertainties

associated with price flexibility are much greater than those from quantity

adjustment. As Stiglitz (1999b) argues, ‘the problem of price-wage setting

should be approached within a standard dynamic portfolio model, one that

takes into account the risks associated with each decision, the nonreversibilities,

as well as the adjustment costs associated with both prices and


Greenwald and Stiglitz argue that, as a firm produces more, the probability

of bankruptcy increases, and since bankruptcy imposes costs these will be

taken into account in firms’ production decisions. The marginal bankruptcy

cost measures the expected extra costs which result from bankruptcy. During

a recession the marginal bankruptcy risk increases and risk-averse firms react

to this by reducing the amount of output they are prepared to produce at each

price (given wages). Any change in a firm’s net worth position or in their

perception of the risk they face will have a negative impact on their willingness

to produce and shifts the resultant risk-based aggregate supply curve to

the left. As a result, demand-induced recessions are likely to induce leftward

shifts of the aggregate supply curve. Such a combination of events could

leave the price level unchanged, even though in this model there are no

frictions preventing adjustment. Indeed, price flexibility, by creating more

uncertainty, would in all likelihood make the situation worse. In the

Greenwald–Stiglitz model aggregate supply and aggregate demand are interdependent

and ‘the dichotomy between “demand” and “supply” side shocks

may be, at best, misleading’ (Greenwald and Stiglitz, 1993b, p. 103; Stiglitz,


In Figure 7.9 we illustrate the impact of an aggregate demand shock which

induces the aggregate supply curve to shift to the left. The price level remains

at P0, even though output falls from Y0 to Y1. A shift of the aggregate supply

curve to the left as the result of an increase in perceived risk will also shift the

demand curve of labour to the left. If real wages are influenced by efficiency

wage considerations, involuntary unemployment increases without any significant

change in the real wage.

In addition to the above influences, new Keynesians have also examined the

consequences of credit market imperfections which lead risk-averse lenders to

respond to recessions by shifting their portfolio towards safer activities. This

behaviour can magnify an economic shock by raising the real costs of intermediation.

The resulting credit squeeze can convert a recession into a depression

as many equity-constrained borrowers find credit expensive or difficult to

Figure 7.9 The risk-based aggregate supply curve

obtain, and bankruptcy results. Because high interest rates can increase the

probability of default, risk-averse financial institutions frequently resort to

credit rationing. Whereas the traditional approach to analysing the monetary

transmission mechanism focuses on the interest rate and exchange rate channels,

the new paradigm emphasizes the various factors that influence the ability

of financial institutions to evaluate the ‘creditworthiness’ of potential borrowers

in a world of imperfect information. Indeed, in the new paradigm, banks are

viewed as risk-averse firms that are constantly engaged in a process of screening

and monitoring customers. In a well-known paper, Bernanke (1983) argues

that the severity of the Great Depression was in large part due to the breakdown

of the economy’s credit facilities, rather than a decline in the money supply

(see Jaffe and Stiglitz, 1990, and Bernanke and Gertler, 1995, for surveys of the

literature on credit rationing; see also Stiglitz and Greenwald, 2003, who

champion what they call ‘the new paradigm’ in monetary economics).

Some new Keynesians have also incorporated the impact of technology

shocks into their models. For example, Ireland (2004) explores the link

between the ‘current generation of new Keynesian models and the previous

generation of real business cycle models’. To identify what is driving aggregate

instability, Ireland’s model combines technology shocks with shocks to

household preferences, firm’s desired mark-ups, and the central bank’s monetary

policy rule. Ireland finds that monetary shocks are a major source of

real GDP instability, particularly before 1980. Technology shocks play only a

‘modest role’, accounting for less than half of the observed instability of

output in the post-1980 period.