3 The New Neoclassical Synthesis and Monetary Policy 3.1 Monopolistic Competition and Aggregate Demand Externalities Up to now we considered dynamic macro models with flexible prices. 1) Standard Growth Models: Consumption smoothing; capital accumulation 2) Models with Money: In that model, tax distortion (inflation tax) creates inefficiency. Friedman rule as solution: zero nominal rate of interest or payment of interest on money The welfare cost of inflation in these models (welfare triangle under the money demand function) is rather small (empirically: money balances small) Monetary policy is not only concerned with long run aspects, but also with short run fluctuations. The standard Keynesian view considered Monetary and fiscal policy as instruments to stabilise the economy [IS/LM model]. This view came under attack with the rational expectation revolution by Lucas /Sargent/ Wal- lace: They are argued that systematic stabilisation policy is ineffective. In this Real Business Cycle view, fluctuations are seen as an efficient response to real shocks. In contrast, the New Keynesian Economics re-established a role for monetary policy in the presence of coordination failures/sticky prices in models with rational expectations. In order to try to understand the role of price rigidities, we need a model which allows for explicit price setting. The first generation of models to introduce mo- nopolistic competition was the static model of Blanchard /Kiyotaki. We first look at this setting in the absence of nominal rigidities and show how imperfect competition creates aggregate demand externalities on the macro level. When introducing sticky prices, we can look at the effects of nominal money and shocks, to understand the effects on output and welfare. If firms have monopoly power, they may want to accommodate shifts in demand as long as price exceeds marginal cost. So movements in demand, both positive or negative, will have an effect on output, at least within some range (as long as MC < P). Section 3.3, looks at the implications of fluctuations for monetary policy in a simple stylized setup. Section 3.4 discusses designs for credible monetary policy. Much of the macro research during the last 10 years has integrated key elements of these Keynesian features into the dynamic model we have developed until now, with explicit modelling choices for consumption, saving, money holding and leisure in a dynamic stochastic environment with sticky price setting. In the last part of the lecture (section 3.5), we will derive the current workhorse if macro, which incorporates all these aspects, known as the “New Keynesian" model or The New Neoclassical Synthesis. In that context, we will analyse the effects of dynamic price staggering and reexamine implications for monetary and fiscal policy. 88 Note: The intertemporal versions of IS/AS Model based on explicit microfoun- dations with dynamic optimisation are fairly sophisticated models with forward looking behaviour. At the same time, however, they are drastically simplified to allow for explicit solutions (such as: assume Constant Elasticity of Substitution; abstract from capital formation; focus on specific price setting assumptions, rep- resentative agent type models (despite heterogeneity). General equilibrium with specific preferences, designed to give explicit solu- tions (allow for approximation to linear functions) Key features: Monopolistic competition (price setting); heterogenous goods; representative agent models with aggregate externalities (aggregation) This approach provides some important general insights: a) Forward looking behaviour allows to analyse impact of change in policies b) Captures realistic features of current monetary policy: Under what condi- tions yield interest rate rules stable solutions? c) Helps to understand the role of institutions (independent, credible central bank) d) Allows for welfare analysis e) Empirical analysis: Allows to confront theory with data Some key features of the new generation dynamic models can be more easily captured in the static set up of the first generation of New Keynesian models. Therefore we start first with a simpler (static) approach to gain intuition for some insights: A) Systematic, anticipated stabilisation policy can be quite effective in the presence of price rigidities B) When market equilibrium is inefficient, a surprise in monetary policy may be welfare improving (nature of aggregate demand externalities) C) But it is not possible to implement a policy of systematic surprise → there is the problem of dynamic inconsistency, calling for credible commitment mechanisms. 89 Rational expectation equilibrium revolution: Lucas-Critique of Keynesian Approach: You may fool all of the people some time, and you can fool some people all of the time, but you can't fool all of the people all of the time. Key Argument: Private Agents react consciously to changes in policy – seem- ingly stable relations may break down → Proper modelling of economic policy has to be based on sound microeconomic foundations Policy Conclusions in Lucas type models: 1) Ineffectiveness of a policy of systematic stabilisation Monetary policy can have real effects only if it tries to fool 2) Fooling is welfare reducing, since it distorts optimal rational choice. But these policy conclusions are based on two special conditions: 1) In the absence of intervention, market will reach equilibrium with flexi- ble prices (no price rigidities; no disequilibrium) 2) Market equilibrium is socially efficient (no externalities)) (1) does not hold in the presence of price rigidities [see Stanley Fisher (1977) and John Taylor (1980)]; Monetary policy as a public good in the presence of coordination failure, if nominal contracts have to be arranged before ob- serving shocks): after the realisation of shocks, monetary policy as central coordination mechanism allows for a smoother reversion to the flexible price outcome, saving on private adjustment and coordination costs (Summer time analogy). (2) In the presence of aggregate demand externalities, market equilibrium is at best constrained efficient. Due to structural inefficiencies, the market out- come is below the efficient level. 90 Intuition behind aggregate demand externality: Blanchard /Kiyotaki (1987) We first analyse a one-period problem without uncertainty. [Later, we will add (a) uncertainty (shocks) and (b) will consider a dynamic ver- sion with bonds and money]. For the moment, we also abstract from nominal rigidities. The objective of the representative household is to M Max U= u(;)() C j − v N j j j P j st. per period budget constraint: M j+T j+ PC j= Y j where nominal 1 income is Yj= w N j +∫ ∏ j () i di + M j . 0 1 This budget constraint is a short cut for a dynamic budget constraint. α 1−α ⎛ CMPj ⎞ ⎛ j / ⎞ 1 1+γ For U we use the specification: ⎜ ⎟ ⎜ ⎟ − N n j ⎜ ⎟ ⎜ ⎟ j ⎝ α⎠ ⎝ 1− α ⎠ 1+ γ n Note: This model specification is designed to separate intratemporal problem and intertemporal problem to allow for straightforward ag- gregation for demand for composite goods. Among the advantages of this specification will be a very simple relation between consumption and real money balances, and constant marginal utility of income. Each household gets utility out of consuming a consumption basket, composed of all goods produced (Dixit Stiglitz version of monopolis- tic competition – heterogenous producers with market power, derived from preferences with constant elasticity of substitution). Here, we consider the continuous case (see Blanchard/Kiyotaki for discrete ver- sion): θ θ −1 ⎡1 ⎤θ −1 θ Cj= ⎢∫ c j () i di⎥ ⎣⎢0 ⎦⎥ 1 1 ⎡ 1−θ ⎤1−θ with Dixit Stiglitz price index: P= ∫ p() i di . ⎢⎣0 ⎦⎥ 1 Note: In a dynamic setting, we should only include the opportunity cost for real money bal- ances in the per period budget constraint (see Woodford)! 91 Production: Each firm produces a differentiated good using labor with a constant returns technology y()() i = A N i . A is the level of technology. We can think of movements in A as technological shocks. We have to derive the demand curve each firm is facing for its prod- uct from the demand for the good by all consumers. To characterize the equilibrium, proceed in 4 steps: 1) Given spending on consumption, derive consumption de- mands for each good by each household. 2) Derive of the relation between aggregate consumption and aggregate real money balances. 3) Derive labour supply 4) Derive the demand curve facing each firm, and its pricing decision 5) Characterise the general equilibrium The households problem is α 1−α ⎛ CMP⎞ ⎛ / ⎞ 1 U = ⎜ j ⎟ ⎜ j ⎟ − N1+γ with j ⎜ ⎟ ⎜ ⎟ j ⎝ α⎠ ⎝ 1− α ⎠ 1+ γ θ θ −1 ⎡1 ⎤θ −1 θ Cj= ⎢∫ c j () i di⎥ ⎣⎢0 ⎦⎥ 1 subject to ∫ p()() i cj i di+ Mj = Y j = w N j + Π j + M j 0 We solve the problem step by step: 1) Choose optimal cj () i for a given budget X j spent on the consumption −θ −θ ⎛ p() i ⎞ X j ⎛ p( i) ⎞ basket: cj () i = ⎜ ⎟ = ⎜ ⎟ C j with P C j= X j ⎝ p ⎠ p ⎝ p ⎠ 2) Choose optimal mix between C j and M j for given total income Yj: α 1−α ⎛ CMPj ⎞ ⎛ j / ⎞ 1 1+γ U = ⎜ ⎟ ⎜ ⎟ − N s.t. PCMYM+ = + j ⎜ ⎟ ⎜ ⎟ j j j j j ⎝ α ⎠ ⎝ 1−α ⎠ 1+ γ 92 M j 1−α This gives as FOC: = C , so P α j Πj +w N j + M j M j Π j+ w N j+ M j C = α [ ]; =(1 −α ) [ ] j P P P −θ 1 ⎛ p() i ⎞ t and Note that Pt C t= ∫ p t()() i c t i di since cj() i= C j ⎜ ⎟ 0 ⎝ Pt ⎠ 1−θ 1−θ pt = ∫ ( pt ( i )) di From the FOC we get as indirect utility: 1 Y j 1 1+γ w 1 1+γ 1 ⎡ ⎤ U j = − N j =NNj − j +⎢∫ ∏ j ()i di+ M j ⎥ P 1+ γ P 1+ γ P ⎣0 ⎦ 3) So it is straightforward to characterise labour supply as