This chapter introduces a perfectly competitive model of aggregate fluctuations, in which there is no capital accumulation.
This is a DSGE model, based on optimizing households and firms; flexible wages and prices; and fully competitive product, labor, and financial markets. Fluctuations are caused by real shocks to productivity, but we abstract from capital accumulation, which propagates the dynamic effects of such shocks in the stochastic growth model of chapter 13.
This simplified model is introduced without capital, so that we can study the properties of a more tractable new classical model, comparable to the new Keynesian models that we analyze in subsequent chapters. By comparing these models, one gets a better understanding of the similarities and differences between the new classical and the new Keynesian approaches to aggregate fluctuations.
The impulses that generate aggregate fluctuations in this model are also real (i.e., shocks to productivity). However, we also analyze the role of monetary shocks and monetary policy. We will see that monetary shocks have no real effects on output, employment, and other real variables in this model. They only affect real money balances and nominal variables, such as the price level, inflation, and nominal wages and interest rates. Thus, the role of monetary policy in this new classical model is simply to stabilize inflation in the presence of monetary and real shocks.
The short-run neutrality of money implied by new classical models was troublesome for some of their proponents, as these models were not compatible with the evidence suggesting the existence of a positive short-run relation between inflation and employment. Lucas [1972] responded by developing a new classical model, based on imperfect information, which was consistent with a positive short-run relation between inflation and employment even under rational expectations. This model was subsequently analyzed by Barro [1976] and extended to include competitive labor markets by Alogoskoufis [1983].
It was based on the assumption that firms and workers do not have full information about the price level at the time they make their production and employment decisions, and they attribute part of any change in the price level to a change in the relative price of their product or their real wage. Thus, when inflation is unexpectedly high, all producers rationally think that the relative price of their product has gone up, and thus increase production and employment. The opposite happens when inflation is unexpectedly low.1However, this new classical explanation of the short-run relation between inflation and output and employment was still not compatible with involuntary unemployment. It could only account for temporary deviations of output and employment from their “natural” levels, due to intertemporal substitution in labor supply and unanticipated inflation. Its basic premise—that the positive relation between unanticipated inflation and employment is due to misperceptions of actual inflation by workers and producers—was also challenged as a counterfactual assumption, although it has made a comeback through recent models of costly information acquisition in decentralized economies.
14.1