Editing New Keynesian economics (section)

===1980s===

====Menu costs and imperfect competition====

In the 1980s the key concept of using menu costs in a framework of [[imperfect competition]] to explain price stickiness was developed.<ref>{{cite book |author-link=Huw Dixon |first=Huw |last=Dixon |chapter-url=http://huwdixon.org/SurfingEconomics/chapter4.pdf |year=2001 |chapter=The Role of imperfect competition in new Keynesian economics |title=Surfing Economics: Essays for the Inquiring Economist |location=New York |publisher=Palgrave |isbn=978-0333760611 }}</ref> The concept of a lump-sum cost (menu cost) to changing the price was originally introduced by Sheshinski and Weiss (1977) in their paper looking at the effect of inflation on the frequency of price-changes.<ref>{{cite journal |last1=Sheshinski |first1=Eytan |last2=Weiss |first2=Yoram |year=1977 |title=Inflation and Costs of Price Adjustment |journal=[[Review of Economic Studies]] |volume=44 |issue=2 |pages=287–303 |jstor=2297067 |doi=10.2307/2297067}}</ref> The idea of applying it as a general theory of [[Nominal rigidity|nominal price rigidity]] was simultaneously put forward by several economists in 1985–86. [[George Akerlof]] and [[Janet Yellen]] put forward the idea that due to [[bounded rationality]] firms will not want to change their price unless the benefit is more than a small amount.<ref>{{cite journal |last1=Akerlof |first1=George A. |last2=Yellen |first2=Janet L. |year=1985 |title=Can Small Deviations from Rationality Make Significant Differences to Economic Equilibria? |journal=[[American Economic Review]] |volume=75 |issue=4 |pages=708–720 |jstor=1821349 }}</ref><ref>{{cite journal |last1=Akerlof |first1=George A. |last2=Yellen |first2=Janet L. |year=1985 |title=A Near-rational Model of the Business Cycle, with Wage and Price Inertia |journal=[[The Quarterly Journal of Economics]] |volume=100 |issue=5 |pages=823–838 |doi=10.1093/qje/100.Supplement.823 }}</ref> This [[bounded rationality]] leads to inertia in nominal prices and wages which can lead to output fluctuating at constant nominal prices and wages. [[Gregory Mankiw]] took the menu-cost idea and focused on the welfare effects of changes in output resulting from [[sticky prices]].<ref>{{cite journal |last=Mankiw |first=N. Gregory |year=1985 |title=Small Menu Costs and Large Business Cycles: A Macroeconomic Model of Monopoly |journal=[[The Quarterly Journal of Economics]] |volume=100 |issue=2 |pages=529–538 |jstor=1885395 |doi= 10.2307/1885395}}</ref> Michael Parkin also put forward the idea.<ref>{{cite journal |first=Michael |last=Parkin |year=1986 |title=The Output-Inflation Trade-off When Prices Are Costly to Change |journal=[[Journal of Political Economy]] |volume=94 |issue=1 |pages=200–224 |doi= 10.1086/261369|jstor=1831966 |s2cid=154048806 |url=https://ir.lib.uwo.ca/economicsresrpt/782 }}</ref> Although the approach initially focused mainly on the rigidity of nominal prices, it was extended to wages and prices by [[Olivier Blanchard]] and [[Nobuhiro Kiyotaki]] in their influential article "Monopolistic Competition and the Effects of Aggregate Demand".<ref>{{cite journal |last1=Blanchard |first1=O. |last2=Kiyotaki |first2=N. |year=1987 |title=Monopolistic Competition and the Effects of Aggregate Demand |journal=[[American Economic Review]] |volume=77 |issue=4 |pages=647–666 |jstor=1814537 }}</ref> [[Huw Dixon]] and Claus Hansen showed that even if menu costs applied to a small sector of the economy, this would influence the rest of the economy and lead to prices in the rest of the economy becoming less responsive to changes in demand.<ref>{{cite journal |first1=Huw |last1=Dixon |first2=Claus |last2=Hansen |title=A Mixed Industrial Structure Magnifies the Importance of Menu Costs |journal=[[European Economic Review]] |year=1999 |volume=43 |issue=8 |pages=1475–1499 |doi=10.1016/S0014-2921(98)00029-4 }}</ref>

While some studies suggested that menu costs are too small to have much of an aggregate impact, [[Laurence M. Ball]] and [[David Romer]] showed in 1990 that [[real rigidities]] could interact with nominal rigidities to create significant disequilibrium.<ref>Ball, L. and Romer, D. (1990). "Real Rigidities and the Non-neutrality of Money". ''Review of Economic Studies''. Volume 57. pp. 183–203</ref> Real rigidities occur whenever a firm is slow to adjust its real prices in response to a changing economic environment. For example, a firm can face real rigidities if it has market power or if its costs for inputs and wages are locked-in by a contract.<ref>Romer, David (2005). ''Advanced Macroeconomics''. New York: McGraw-Hill. {{ISBN|978-0-07-287730-4}}. pp 380–381.</ref> Ball and Romer argued that real rigidities in the labor market keep a firm's costs high, which makes firms hesitant to cut prices and lose revenue. The expense created by real rigidities combined with the menu cost of changing prices makes it less likely that firm will cut prices to a market clearing level.<ref>Mankiw, N. Gregory (1990).</ref>

Even if prices are perfectly flexible, imperfect competition can affect the influence of fiscal policy in terms of the multiplier. Huw Dixon and Gregory Mankiw developed independently simple general equilibrium models showing that the fiscal multiplier could be increasing with the degree of imperfect competition in the output market.<ref>Huw Dixon (1987). "A simple model of imperfect competition with Walrasian features". ''Oxford Economic Papers'' 39, pp. 134–160.</ref><ref>Gregory Mankiw (1988). "Imperfect competition and the Keynesian cross". ''Economics Letters'' 26, pp. 7–13</ref> The reason for this is that [[imperfect competition]] in the output market tends to reduce the [[real wage]], leading to the household substituting away from [[Consumption (economics)|consumption]] towards [[leisure]]. When [[government spending]] is increased, the corresponding increase in [[Taxation|lump-sum taxation]] causes both leisure and consumption to decrease (assuming that they are both a normal good). The greater the degree of imperfect competition in the output market, the lower the [[real wage]] and hence the more the reduction falls on leisure (i.e. households work more) and less on consumption. Hence the [[fiscal multiplier]] is less than one, but increasing in the degree of imperfect competition in the output market.<ref>{{cite journal | last1 = Costa | first1 = L. | last2 = Dixon | first2 = H. | year = 2011 | title = Fiscal Policy Under Imperfect Competition with Flexible Prices: An Overview and Survey | journal = Economics: The Open-Access, Open-Assessment e-Journal | volume = 5 | issue = 1 | pages = 2011–2013 | doi = 10.5018/economics-ejournal.ja.2011-3 | s2cid = 6931642 | doi-access = free }}</ref>

====Calvo staggered contracts model====

In 1983 [[Guillermo Calvo]] wrote "Staggered Prices in a Utility-Maximizing Framework".<ref>{{cite journal | last1 = Calvo | first1 = Guillermo A | year = 1983 | title = Staggered Prices in a Utility-Maximizing Framework | journal = Journal of Monetary Economics | volume = 12 | issue = 3| pages = 383–398 | doi = 10.1016/0304-3932(83)90060-0 }}</ref> The original article was written in a [[Discrete time and continuous time|continuous time]] mathematical framework, but nowadays is mostly used in its [[Discrete time and continuous time|discrete time]] version. The Calvo model has become the most common way to model nominal rigidity in new Keynesian models. There is a probability that the firm can reset its price in any one period {{mvar|h}} (the [[hazard rate]]), or equivalently the probability ({{math|1 &minus; {{var|h}}}}) that the price will remain unchanged in that period (the survival rate). The probability {{mvar|h}} is sometimes called the "Calvo probability" in this context. In the Calvo model the crucial feature is that the price-setter does not know how long the nominal price will remain in place, in contrast to the Taylor model where the length of contract is known ''ex ante''.

==== Coordination failure ====
[[File:Coordination failure chart.svg|class=skin-invert-image|thumb|right|alt=Chart showing an equilibrium line at 45 degrees intersected three times by an s-shaped line.|In this model of coordination failure, a representative firm {{math|{{var|e}}{{sub|{{var|i}}}}}} makes its output decisions based on the average output of all firms ({{mvar|ē}}). When the representative firm produces as much as the average firm ({{math|1={{var|e}}{{sub|{{var|i}}}} = {{var|ē}}}}), the economy is at an equilibrium represented by the 45-degree line. The decision curve intersects with the equilibrium line at three equilibrium points. The firms could coordinate and produce at the optimal level of point B, but, without coordination, firms might produce at a less efficient equilibrium.<ref name="Cooper, Russel 1988 page 446">{{cite journal | last1 = Cooper | first1 = Russel | last2 = John | first2 = Andrew | year = 1988 | title = Coordinating Coordination Failures in Keynesian Models | url = http://cowles.yale.edu/sites/default/files/files/pub/d07/d0745-r.pdf| journal = The Quarterly Journal of Economics | volume = 103 | issue = 3| pages = 441–463 [446] | doi = 10.2307/1885539 | jstor = 1885539 }}</ref>]]
[[Coordination failure (economics)|Coordination failure]] was another important new Keynesian concept developed as another potential explanation for recessions and unemployment.<ref>Mankiw, N. Gregory (2008). "New Keynesian Economics". ''The Concise Encyclopedia of Economics''. Library of Economics and Liberty.<!--Access date removed – meaningless without a URL--></ref> In recessions a factory can go idle even though there are people willing to work in it, and people willing to buy its production if they had jobs. In such a scenario, economic downturns appear to be the result of coordination failure: The invisible hand fails to coordinate the usual, optimal, flow of production and consumption.<ref>Howitt, Peter (2002). "Coordination failures". In Snowdon, Brian; Vane, Howard (eds.). ''An Encyclopedia of Macroeconomics''. Cheltenham, UK: Edward Elgar Publishing. {{ISBN|978-1-84064-387-9}}. pp. 140–41.</ref> [[Russell W. Cooper (economist)|Russell Cooper]] and Andrew John's 1988 paper "Coordinating Coordination Failures in Keynesian Models" expressed a general form of coordination as models with multiple equilibria where agents could coordinate to improve (or at least not harm) each of their respective situations.<ref name="Cooper, Russel 1988 page 446"/><ref>Howitt (2002), p. 142</ref> Cooper and John based their work on earlier models including [[Peter A. Diamond|Peter Diamond]]'s 1982 [[Diamond coconut model|coconut model]], which demonstrated a case of coordination failure involving [[Matching theory (macroeconomics)|search and matching theory]].<ref>{{cite journal | last1 = Diamond | first1 = Peter A. | year = 1982 | title = Aggregate Demand Management in Search Equilibrium | journal = Journal of Political Economy | volume = 90 | issue = 5| pages = 881–894 | doi = 10.1086/261099 | jstor = 1837124 | hdl = 1721.1/66614 | s2cid = 53597292 | hdl-access = free }}</ref> In Diamond's model producers are more likely to produce if they see others producing. The increase in possible trading partners increases the likelihood of a given producer finding someone to trade with. As in other cases of coordination failure, Diamond's model has multiple equilibria, and the welfare of one agent is dependent on the decisions of others.<ref>Cooper and John (1988), pp. 452–53.</ref> Diamond's model is an example of a "thick-market [[externality]]" that causes markets to function better when more people and firms participate in them.<ref>Mankiw, N. Gregory; Romer, David (1991). ''New Keynesian economics 1''. Cambridge, Massachusetts: MIT Press. {{ISBN|0-262-13266-4}}. p. 8</ref> Other potential sources of coordination failure include [[self-fulfilling prophecies]]. If a firm anticipates a fall in demand, they might cut back on hiring. A lack of job vacancies might worry workers who then cut back on their consumption. This fall in demand meets the firm's expectations, but it is entirely due to the firm's own actions.

==== Labor market failures: Efficiency wages ====

New Keynesians offered explanations for the failure of the labor market to clear. In a Walrasian market, unemployed workers bid down wages until the demand for workers meets the supply.<ref>Romer (2005), p. 438</ref> If markets are Walrasian, the ranks of the unemployed would be limited to workers transitioning between jobs and workers who choose not to work because wages are too low to attract them.<ref>Romer (2005) pp. 437–439</ref> They developed several theories explaining why markets might leave willing workers unemployed.{{sfn|Romer|2005|p=437}} The most important of these theories was the [[efficiency wages|efficiency wage theory]] used to explain [[hysteresis (economics)|long-term effects of previous unemployment]], where short-term increases in unemployment become permanent and lead to higher levels of unemployment in the long-run.<ref>Snowdon, Brian; Vane, Howard (2005). ''Modern Macroeconomics''. Cheltenham, UK: Edward Elgar. {{ISBN|978-1-84542-208-0}}. p. 384</ref>

[[File:Efficiency wage Shapiro Stiglitz.svg|class=skin-invert-image|thumb|right|alt=Chart showing the relationship of the non-shirking condition and full employment|In the Shapiro-Stiglitz model workers are paid at a level where they do not shirk, preventing wages from dropping to full employment levels. The curve for the no-shirking condition (labeled NSC) goes to infinity at full employment.]]
In efficiency wage models, workers are paid at levels that maximize productivity instead of clearing the market.<ref>Froyen, Richard (1990). ''Macroeconomics, Theories and Policies'' (3rd ed.). New York: Macmillan. {{ISBN|978-0-02-339482-9}}. p. 357</ref> For example, in developing countries, firms might pay more than a market rate to ensure their workers can afford enough nutrition to be productive.<ref>Romer (2005), p. 439</ref> Firms might also pay higher wages to increase loyalty and morale, possibly leading to better productivity.<ref>Froyen (1990), p. 358</ref> Firms can also pay higher than market wages to forestall shirking. Shirking models were particularly influential.<ref>Romer (2005), p. 448</ref>[[Carl Shapiro]] and [[Joseph Stiglitz]]'s 1984 paper "Equilibrium Unemployment as a Worker Discipline Device" created a model where employees tend to avoid work unless firms can monitor worker effort and threaten slacking employees with unemployment.<ref>{{cite journal | last1 = Shapiro | first1 = C. | last2 = Stiglitz | first2 = J. E. | year = 1984 | title = Equilibrium Unemployment as a Worker Discipline Device | journal = The American Economic Review | volume = 74 | issue = 3| pages = 433–444 | jstor = 1804018 }}</ref><ref>Snowden and Vane (2005), p. 390</ref> If the economy is at full employment, a fired shirker simply moves to a new job.<ref>Romer (2005), p. 453.</ref> Individual firms pay their workers a premium over the market rate to ensure their workers would rather work and keep their current job instead of shirking and risk having to move to a new job. Since each firm pays more than market clearing wages, the aggregated labor market fails to clear. This creates a pool of unemployed laborers and adds to the expense of getting fired. Workers not only risk a lower wage, they risk being stuck in the pool of unemployed. Keeping wages above market clearing levels creates a serious disincentive to shirk that makes workers more efficient even though it leaves some willing workers unemployed.<ref>Snowden and Vane (2005), p. 390.</ref>