4. New Keynesian Macroeconomics

This chapter presents stylized New Keynesian model, allowing a share of prices to be sticky. We derive two core equations of the New Keynesian model from individual optimization. The Euler equation provides a microfoundation for the New Keynesian IS curve or aggregate demand curve. Price setting behavior of individual firms generates a traditional upward sloping aggregate supply curve when some share of firms is not able to adjust prices. Once prices have been set, shocks disturb the economy, shifting it away from long-run equilibrium. The model allows to analyze the impact of various shocks on all variables determining general equilibrium. We consider shocks to aggregate demand—shifting only the AD curve (pure demand shocks, like a change in the time preference parameter), aggregate supply (like shocks on technology and leisure) and so called mark-up or cost-push shocks. Whereas supply shocks affect both potential and efficient level of production in the same way, mark-up shocks shift the AS curve, but do not affect the efficient level of production. We show that these shocks will shift the economy away from natural output and the target price level if the central bank does not respond to shocks, keeping the nominal interest rate unchanged. Active interest rate policy, trying to stabilize the real interest rate at its natural rate, is needed in order to stabilize the economy. We show that the appropriate response crucially depends on the specific nature of underlying shock.