Keynesian Coordination Failure Strategic Complementarities Production and Supply Goods Market Cycles and Policy
Keynesian theory has traditionally emphasized (i) Non-market clearing (fixed wages/prices) (ii) Market Failures • (i) and (ii) are not necessarily the same. • Coordination Failure (CF) model assumes market-clearing and failure. • Some policy conclusions are similar to traditional Keynesian theory.
Strategic Complementarities • Pioneered by P. Diamond (1982) and R. Cooper- A. John (1988). • Strategic complementarities (SC) – an individual’s willingness to participate in an activity depends upon the number of others engaged in that activity. * Social interactions (party!), Software- hardware industry, labor markets. • SC implies that aggregate production function can have increasing returns.
Example • Suppose the labor in one industry directly affects the productivity of another: • Each industry has (i) Diminishing returns. (ii) Downward sloping ND curve. • But aggregate ND curve will be upward sloping: • Aggregate production function has increasing returns:
Increasing returns: (1) Aggregate production function is convex (2) MPN increases with more labor. (3) ND curve is upward sloping! (4) Output supply curve (Ys) downward sloping.
Goods Market Equilibrium • Both Ys and Yd are downward sloping. (1) There maybe just one equilibrium (2) There maybe multiple (two) equilibria.
Two Equilibria: (1) Business cycles are fluctuations between YLand YH. (2) BC are caused by coordination failures and self-fulfilling expectations. (3) Importance of non-fundamental (speculative/human) factors affecting consumer-business sentiment (“sunspots” – variables that matter just because it is believed to matter).
Business Cycle Facts (i) C,I are procyclical (ii) N is procyclical (iii) (Y/N) is procyclical (iv) P is countercyclical (?)
Policy and BC • Monetary Policy * In general Ms is neutral. * However, if Ms is a sunspot variable: High Ms consumer optimism YH Low Ms consumer optimism YL *Notice that r decreases with high M and P maybe fixed or “sticky”. * Monetary policy can be used to coordinate economy.
Fiscal Policy/Government Purchases * An increase in G shifts Yd right but Ysleft! (negative income effect increases Ns, creates excess labor supply, decreases w* and N*) * Can create more instability. Low G may eliminate BC. * The YH equilibrium may lead to higher household welfare if r is low enough.
Table 11.3 Data Versus Predictions of the Coordination Failure Model
Shortcomings: * Evidence of increasing returns to scale in aggregate production function is mixed. Weak at best. * Difficulty measuring expectations makes it difficult to implement model in practice.