A Response to Mankiw’s “Symposium on Keynesian Economics Today”

Keynesian economics assumed that all micreconomic data/markets could be aggregated to come up with a macro-level picture of the economy.  However, the Keynesians were criticized for this very notion, that is, these economists were criticized for not building their theory of aggregate demand off of microfoundations.  As Mankiw stated in the “Symposium,” the Phillips curve phenomenon seemed to disappear with the evidence of stagflation in the 1970s.  As we learned in class early on, Keynesian theory focused on shifts in aggregate demand–either during a recession or a growth period, but never both parts of the business cycle.  That is where the RBC models were able to better explain the paths of the economy.  Though unable to best predict the path, through parameterization, RBC economists were able to constantly tweak the model to come up with the path of the economy where it’s achieving its optimal point.

Nevertheless, the 1970s and early 1980s is when supply-side economics became big with President Reagan behind it.  As we learned in class, the only reason why Reagonomics became prevalent and in the forefront was because it offered something different.  Though Reaganomics and RBC models were at the forefront, few people who became New Keynesians were able to accept the new classical assumptions that firms operate in a perfectly competitive market and all markets clear in time period t.  Rather, firms aren’t assumed to be perfectly competitive and not all markets will clear in one time period.  James Tobin, who argued against markets clearing in one time period, said the reason was because of macro market failures.  This is furthered by the example that the goods market may be in equilibrium, but not the labor market.  Therefore, New Keynesians couldn’t build off the assumptions of Keynesians–that macro is simply aggregated micro–because you really can’t aggregate microeconomic markets since not all markets are clearing in one time period as assumed by the new classicals.  This suggests that there are unforeseen market forces (i.e. externalities) that are multiplied, rather than simply arithmetically added through industries, which is why micro cannot be simply added up.  Mankiw points out that these market failures are felt to the extreme when the economy is going through recessions and depressions.  The 1970s, as mentioned earlier, brought about high levels of unemployment.  The new classicals viewed this unemployment as voluntary whereas the New Keynesians did not.

Bringing this blog back to the beginning statements, New Keynesians had to build a model that was developed from microfoundations–that is, the goods market, labor market, and capital market.  The whole point of a firm is to maximize profit and utility.  From this, they were able to make claims as to why markets didn’t clear in one time period.  Disequilbrium occurs because of sticky prices and wages.  David Romer discusses this price rigidity in which he says that because firms are “imperfectly competitive” they face small barriers that have large macroeconomic effects (once again, this is referring to the unforseen externalities and the spillover effect from one industry into another industry).  James Tobin, however, feels that the New Keynesians aren’t “asking the right questions” and feels that the role of price rigidities have been exaggerated.  As learned in class, though, the business cycle is the reason why we experience sticky prices, all of which come from micreconomic elements.

Mankiw’s “Symposium” ends with some rhetorical questions as to what the New Keynesian line of thinking will do for the field of macroeconomic theory.  Will it be long and arduous or will it be the theory from which other models will build?  Obviously, Mankiw didn’t have the answers, but I still am unclear as to what the differences are between nominal and real rigidity.  It was discussed in the “Symposium” and I was looking through my notes.  I have that nominal rigidity means that nominal prices are sticky (i.e. labor contracts).  Thus, even if we go into a recession and the prices change, the labor contract holds true.  Therefore, the nominal price (i.e. what is spelled out on the contract) will remain unchanged.  However, then my notes discuss real rigidity, which is looking at the rigidity of relative prices.  How does the example of a monopsony condition with one employer fit with relative rigidity?  I understand that nominal prices are increasing at the same rate as the price level, but how does that fit with the issue of rigidity?

Source: Mankiw, N. Gregory.  1993.  Symposium on Keynesian economics today.  The Journal of Economic Perspectives 7, no. 1 (Winter): 3-4.

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