![]() Similarly, to the extent that wages and prices are sticky, some stabilization is possible because policymakers can count on some output response to their policies. EMP (and EFP) can therefore increase Y* over Y nrl, although less than if the policy were unanticipated (although, of course, at the cost of higher P* the long-term analysis of the AS-AD model still holds).Unlike the new classical macroeconomic model, however, it posits significant wage and price stickiness (basically long-term contracts) that prevents the AS curve from shifting immediately and completely, regardless of the expectations of economic actors.Like the new classical macroeconomic model, it is post-Lucas and hence realizes that expectations are important to policy outcomes. ![]() The new Keynesian model leaves more room for discretionary monetary policy.Eventually market participants figured out what was going on and adjusted their expectations, returning Y* to Y nrl and stopping further big increases in P*. The result was that prices went up somewhat while output fell. The AS curve shifted hard left, while the AD curve did not shift as far right as expected. As a result, the happy conclusions of the new classical macroeconomic model did not hold. But the Fed and the Bank of England did get tough by raising overnight interest rates to very high levels (about 20 percent!). That, of course, ran directly counter to claims about fighting inflation, which were not credible and hence not anticipated. Tax cuts plus increased defense spending meant larger budget deficits, which spells EFP and a rightward shift in AD. In both countries, sharp recessions with high unemployment occurred, but the inflation beast was eventually slain. Prime Minister Margaret Thatcher announced the same set of policies: tax cuts, more defense spending, and anti-inflationary monetary policy. And there is still a chance that policies will backfire if wages and prices are not as sticky as people believe, or if expectations and actual policy implementation differ greatly. The Takeaway is that an EMP, even if it is anticipated, can have positive economic effects (Y* > Y nrl for some period of time), but it is better if the central bank initiates unanticipated policies. If that is the case, as Figure 26.2 "Effect of an EMP in the new Keynesian model" shows, anticipated policy can and does affect Y*, although not as much as an unanticipated policy move of the same type, timing, and magnitude would. In short, wages and prices are “sticky” and hence adjustments are slow, not instantaneous as assumed by Lucas and company. Similarly, companies often sign multiyear fixed-price contracts with their suppliers and/or distributors, effectively preventing them from acting on new expectations of P*. New hires might be brought in at lower wages, but if turnover is low, that process could take years to play out. ![]() Firms are also reluctant to lower wages even when unemployment is high because doing so may exacerbate the principal-agent problem in the form of labor strife, everything from slacking to theft, to strikes. Workers in the first year of a three-year labor contract, for example, can’t push their wages higher no matter their expectations. That model directly refutes the notion that wages and prices respond immediately and fully to expected changes in P*. The result was renewed research that led to the development of what is often called the new Keynesian model. The activists could not stand idly by but neither could they ignore the implications of Lucas’s critique of prerational expectations macroeconomic theories. The new classical macroeconomic model aids the cause of nonactivists, economists who believe that policymakers should have as little discretion as possible, because it suggests that policymakers are more likely to make things (especially P* and Y*) worse rather than better.
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