New Keynesian Macroeconomics

• N Gregory Mankiw and David Romer are the prominent pillar of New Keynesian
model.
• They published two volume of collection of articles.
• Book named, New Keynesian Economics(1991),MIT Press.
• Various surveys are made on the New Keynesian economics:
➢ What is New Keynesian Economics?-Robert J. Gordon(1990),Journal of
Economic Literature.
➢The New Keynesian Synthesis-David Romer(1993),Journal of economic
perspective.
➢Staggered Price and Wage Setting in Macroeconomics- John B. Taylor(1998),
Handbook of Macroeconomics.
• Economists working within the Keynesian tradition have pursued
additional explanations of involuntary unemployment. Wage-price
rigidity is the central to the Keynesian system which arise from the
behaviour of optimizing agents.
• The new researches is response to the new classical critique of the
older Keynesian models.
• The new classical economists argued that the Keynesian economics
was theoretically inadequate, that macroeconomics must be built on a
firm microeconomic foundation.
• The new Keynesian literature is characterized by dizzying diversity
approach which have the following elements:
i) Imperfect competition is assumed for the product market instead of
perfect competition.
ii) Product price rigidity instead of nominal rigidity in the money wage.
iii) Real rigidity instead of money wage rigidity.
Richard T. Froyen( Macroeconomics, 10 th edition, 2019) has
elaborated three types of new Keynesian models that go ………
 New Keynesian Models

1. Menu cost models

• The menu cost models is also known as sticky price models.
• The costs of adjusting prices are called the menu costs. Changing
prices requires the use of resources by a firm. It has to print new price
lists (menus), catalogues, and other printed material. A super market
has to reliable all products and shelves with the new prices. A hotel
and a restaurant have to reprint its menu with new prices. Meetings,
phone calls, and trips by representatives of a firm to renegotiate with
suppliers, all fall under the category of menu costs.
• If these perceived costs of price changes are high enough, price
stickiness will exist. Such cost of price changes are called menu costs.
• Decline in AD will result in falls in output and employment, not price
reduction.
• In the menu costs approach to sticky prices, it is profitable for firms to
react to small changes in demand by keeping prices constant over a
short period and responding with changes in output.
• If the perceived cost to changing prices that overweighted the benefit
of the price cut, the firms would hold the prices constant even as
demand fell.
• A crucial element in new Keynesian sticky price models is that the
firm must not be a perfect competitor.
• Monopolistic competitors and oligopolies have some control over the
price of their products. If all firms hold to the initial price no
individual firm will loose sales to its competitors.
• Profit maximizing price of the firms in imperfect competition may
decline in the face of a fall in demand but there will be a small gain.
 2. Sticky Real Wages:
• The new Keynesian theories focus on the real wage rigidity where
workers are not paid market-clearing wage and involuntary
unemployment exists even in the long run.
There are four main approaches to real wage rigidities. They are:
(a) asymmetric information model,
(b) implicit contract theory,
(c) insider-outsider theory, and
(d) efficiency wage theory.
 Asymmetric Information Model

• They assumed that managers know more about the interests of the firm
than do the workers. Given this better knowledge, it is possible and
profitable for managers to deceive the workers about the real position
of the firm.
• They enter into contracts with workers for employment commitments
whereby the firm pays them rigid real wages. However, there is an
employment commitment in this model that tends to increase the
amount of employment in the firm.
 Implicit Contract Theory

• Usually employment contracts between workers and firms are explicit

agreements. But often there are other dimensions that are not written
in the actual contracts.
• These dimensions are called implicit contracts. Workers and firms
enter into implicit contracts concerning job insurance and income
because workers are risk-averse with respect to income. Workers
dislike the risk arising from income and fluctuations of employment
more than the firms.
 Insiders and Outsiders theory

• Insiders are those workers who already have jobs and outsiders are
those who are unemployed in the labour market. Insiders are
represented by unions who have more to say in wage bargaining than
the outsiders. Unions negotiate the real wage with firms and set it
higher than the market-clearing level so that the outsiders are excluded
from jobs leading to involuntary unemployment in the presence of fall
in aggregate demand.
• Unions use their bargaining power to negotiate wages through
turnover costs. Turnover costs relate to the costs of firing, hiring and
retaining of new workers. These costs prevent the firms to employ
outsiders in place of insiders.
• Unions can also prevent the entry of outsiders for jobs threatening
strikes and work-to-rule. Insiders can also use these costs against
outsiders to achieve a higher negotiated wage than the wage at which
the outsiders are prepared to work.
 Efficiency Wage Theory

• In new Keynesian economics, payment of efficiency wages leads to

real wage rigidity and the failure of market-clearing mechanism. High
wages increase efficiency and productivity of workers.
• In 1974, Henry Ford instituted the five dollar per day for his worker as
against 2 -3 dollar of going rates.
• He found it improved workers absenteeism, morale and productivity.
• Hence, the efficiency of workers depends positively on the real wage
they are paid.
• Efficiency wage model implies that forms will set the real wage above
the market clearing level.
• The efficiency wage idea can be formalized by defining an index of
worker efficiency, or productivity, such that
e=e( W/P)………………….(1),where e implies productivity
of workers, W/P implies real wage.
Worker’s efficiency is a positive function of the real wage. Now
aggregate production function be

Y =F [𝐾,eN]………………………..(2)
As per (2), the goals of the firms is to set the real wage so that the cost
of an efficiency unit of labour is minimized.
• This goal is accomplished by increasing the real wage to the point
where the elasticity of the efficiency index [e(W/P)] w.r. to real wage
is equal to 1.
• So, condition that determines the optimal level of the real wage, which
is called efficiency wage,(W/P)* is

𝑊
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑒( 𝑃 )
𝑊 =1……………….(3)
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 ( 𝑃 )
• Notice that the real wage is fixed on the efficiency ground (3).
• Efficiency wage models explain a real rigidity.
• If there was a fall in nominal aggregate demand resulting from a
decline in the money supply, firms could lower their prices sufficiently
to keep output unchanged and lower the money wage by the same
amount to keep the real wage at the efficiency wage,(W/P)* .
• If firms do not lower the price because of the menu costs, then to keep
the real wage at the efficiency wage requires the money wage also to
be fixed.
 3. conclusion

• New Keynesian economics is an attempt to improve the

microeconomic foundations of the traditional Keynesian models, not
to challenge their major premises.
• Applicable in imperfect market structure.
• Sticky price premise rather that wage-price rigidity.
• Menu cost is determining factor to remain at the current price even in
the economic slow down.
• Efficiency in labour boosts up the productivity. So firms would be
ready to pay for wage bill for the shake of increased out put resulted
from improved productivity.
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