New and Old Keynesians

The purpose of this paper is to describe one strand of New Keynesian literature which explores how increased flexibility of wages and prices might exacerbate the economy's downturn, and to contrast it with other strands of New Keynesian literature. This strand of literature holds that even if wages and prices were perfectly flexible, output and employment would be highly volatile. It sees the economy as amplifying the shocks that it experiences and making their effects persist. It identifies incomplete contracts, and, in particular, imperfect indexing, as central market failures, and it attempts both to explain the causes and consequences of these market failures. The models described here contain three basic ingredients: risk-averse firms; a credit allocation mechanism in which credit-rationing, risk-averse banks play a central role; and new labor market theories, including efficiency wages and insider-outsider models. These building blocks should help to explain how price flexibility contributes to macroeconomic fluctuations and to unemployment. In particular, the first two building blocks will explain why small shocks to the economy can give rise to large changes in output, while the new labor market theories will explain why those changes in output (with their associated changes in the demand curve for labor) result in unemployment.