Working Paper: CEPR ID: DP5284
Authors: Alex Cukierman
Abstract: 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.
Keywords: 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 Codes: E3; E4; E5; E6
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| monopolistic competition (L12) | output volatility under flexible prices and wages (E39) |
| flexible price equilibrium (D41) | wider fluctuations in output (E39) |
| output volatility (E23) | welfare losses (D69) |
| flexible prices (P22) | greater fluctuations in output and consumption (E32) |
| sticky prices and wages (E64) | stable consumption and stable leisure (E21) |
| risk aversion of consumers (D11) | welfare superiority of sticky prices and wages (D69) |
| sticky prices and wages (E64) | higher welfare compared to flexible prices and wages (D69) |