Monthly Archives: March 2010

New keynesian or New classical?

For quite some time now I have been struggling with the question of what is the appropriate theoretical framework for macroeconomic analysis. The new Keynesian framework assumes that prices are rigid, whereas the new classical framework assumes that prices are flexible and hence markets always clear. Which one is the right assumption?

There has been significant amount of research done about price flexibility in reality starting with the seminal paper by Bills and Klenow (2005). In a more recent paper by Klenow and Malin(2010), the authors summarize this research and try to give us a clear picture on the evidence concerning frequency of price changes. One of their important conclusions is that the prices change at least once a year with temporary price changes and discounts taking up most of this change.  After excluding these short term changes, they conclude that prices change close to once a year. Of course there is significant variation in frequency of price changes across goods with prices of more cyclical goods changing with a higher frequency than others. But more importantly,  there exist strong linkages between price changes and wage changes.

How does this evidence bear on the question of relevant macroeconomic framework? It certainly seems that prices are actually much more flexible than what we would like to believe.  Given the lagged effect of any policy change, be it fiscal of monetary, it would certainly be true that on an average prices would have changed at least once before the effect materializes.  If this holds then prices have to be treated as flexible for policy analysis purposes and hence the appropriate macroeconomic framework would definitely be the new classical one! At least that is how I would like to think about the issue. Any thoughts on it?

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Filed under current economic issues, macroeconomics