DP5284 Keynesian Economics, Monetary Policy and the Business Cycle - New and Old

Author(s): Alex Cukierman

Publication Date: October 2005

Keyword(s): Relative variability of actual and potential output under flexible versus sticky prices and wages , welfare ranking of sticky versus flexible prices and wages under monopolistic competition

JEL(s): E3 , E4 , E5 , E6

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP5284.asp

After a brief review of the main differences between New and Old Keynesian economics from the 1960s this paper focuses on a tension between traditional sluggish measures of potential output commonly used by policy-makers and the New Keynesian (NK) notion of this variable which conceptualizes it as the level of output that would have been produced under perfect competition had all prices and wages been flexible. The paper shows that, under monopolistic competition, NK potential output is often more volatile than the level of output produced under sticky prices and wages implying either of the following. Real life policy-makers mistakenly target smooth versions of output or (since actual economies are monopolistically rather than perfectly competitive) the flexible price and wage equilibrium does not necessarily maximize welfare. The paper shows, that depending on the shape of the utility function and of the distribution of productivity shocks either case is possible and proposes a criterion for discriminating between them.