Greenwald and Stiglitz are attempting to shed light on the differences between New and Old Keynesians in this article. They propose that they would both agree on three basic assumptions. First, during some periods, an excess supply of labor exists at the prevailing level of real wages. Second, the aggregate level of economic activity fluctuates noticeably no matter how it is measured. Also, these fluctuations are different in size and magnitude than any that might be accounted for by short-run changes in technology, tastes, or demography. Finally, even though monetary policy might be ineffective at times, money does in fact matter. From all of these propositions, they would also agree that government intervention is useful at stabilizing economic activity. These arguments are what set Keynesians, new and old, apart from other schools of thought such as new classicals and real business cycle theorists which believes markets clear and wages and prices quickly adjust.
They say that despite the overarching differences in the two schools, they have also agreed on two methodological premises, that macro has micro foundations and that understanding macro phenomena requires the use of a (simple) general equilibrium model. They show that leaving out certain factors such as diversity among agents is why other models fail and liken it to “leaving Hamlet out of the play.” They also say that a good macro model should be able to explain other things like why variations in number of hours work take place in the form of layoffs as opposed to work sharing. Also, the micro foundations are able to be tested directly. If the micro could be rejected, the derived macro more than likely could be as well. They said that figuring out how to incorporate micro foundations is the new principal task ahead of the new Keynesians.
There are already two different ideologies among new Keynesians about how to explain market imperfection. The first says that nominal price rigidities are the essential way in which market economies differ from the Walrasian Arrow-Debreu model. Without the rigidities prices are free to adjust quickly to whatever shocks it experiences. The second argument is that increased flexibility of wages and prices might exacerbate the economy’s downturn. This says that even if wages and prices were perfectly flexible, the market would be highly volatile and therefore cause the shocks to be amplified and therefore to persist. These two approaches have vastly different implications for what would happen. The first holds that the classical dichotomy breaks down allowing monetary policy to affect things other than the price level. The second holds that monetary policy has real effects even when wages and prices are flexible. New Keynesians also suggest a more complex alternative. First, natural economic forces can magnify shocks that may seem small, and second, existing price rigidities may reduce the magnitude of small fluctuations.
The purpose of this chapter is to explain and contrast the second strand of new Keynesian literature with other Keynesian ideas and other schools of thought. The models contain three basic ingredients: risk averse firms, a credit allocation mechanism in which credit-rationing, risk averse banks play a central role, and new labor market theories including efficiency wages and insider-outsider models. Risk averse firms have a great deal of importance when it comes to imperfections in the equity market. New Keynesians put whether finance comes from equity or debt at the heart of their theory. With equity, the firms share risk with those who provide finance and the firm has no fixed obligation to repay. With debt, the firm has a fixed obligation and if it fails to meet that obligation, it can be forced into bankruptcy. They point out that most firms do not use the equity approach because when they do, their market values tend to decline. The market for equity exists because firms are also operating with imperfect information and are not completely sure of their market value. They move on to discuss further reasons for firms being risk averse including the fact that production itself is risky because it takes time and there are no future markets for the sale of goods. The uncertainty firms face increases with the size of change that they are facing. These this of risk aversion of the firms explains why the aggregate supply curve shifts markedly when the economy enters a recession. The riskiness of the production increases and therefore their willingness to bear that risk has also increased. They enumerate the different aspects of the economy which the theory of risk averse firms helps to explain such as how large redistributions affect the economy and how shocks can have large, real and nominal, effects on the economy.
The effects that operate through the banking system and credit markets provide yet another piece of the puzzle in new Keynesian economics. It also provides more justification for monetary policy as a tool for settling the economy. They take much the same approach as they did with firms as banks being risk averse as well. They find that risk averse lending behavior will cause economic shocks to be magnified and recessions in turn longer and deeper. When the economy worsens, lending becomes increasingly risky and bank’s worth, as well as their ability and willingness to bear risk declines. Monetary policy works at times in this situation. Lowering interest rates stimulates investment which helps to kick start the economy, but also reserve requirements act as a tax on deposits and therefore banks are willing to lend more to keep their worth up. They do admit that at times monetary policy can be pretty powerless.
Labor markets are aspect of old Keynesian economics that were somehow overlooked even though they focused on unemployment. New Keynesians introduce the theory that there is involuntary unemployment due to sticky real wages stemming from efficiency wages, insider-outsider theory, imperfect competition and implicit contracts. They move on to say that other schools of thought are at best incomplete and at worst, flat out wrong. The next section discussed is price rigidities. It is shown that price rigidities are not the only source of economic problems such as volatility and unemployment. For example, some economies facing inflationary pressure still experience unemployment problems. While these rigidities might not be the whole story, they are still worth looking into and explaining. They discuss menu costs and how uncertainty magnifies the costs associated with changing procedures.
Other Keynesians took on areas of concentration other than that of price rigidities. Tobin emphasized risk in his studies. His theories allowed monetary policy to impact the economy through prices and investment. The theory however, had limited empirical success. The Real Business Cycle Theories deny that (involuntary) unemployment exists or that money matters. They focus on the problem of economic volatility. They are criticized for assuming negative technology shocks when they have difficulty explaining how a loss in technical competence would come about. New Classical theory is the closest to New Keynesians and they share several methodological similarities. They go on to tell several of the differences between the two schools such as views on the importance of expectations and changes in price levels effects on the economy.
This was a pretty good article for explaining the new Keynesian school of thought. They were very straightforward with there theory and did not use much notation which made it very easy to follow. I also like how they not only contrasted themselves with old Keynesians, but with other schools of thought as well. It makes it much easier to distinguish between there ideas, and the ideas of others.