New Keynesian Model - Essay Example

A major advantage of the NKPC compared with the traditional Phillips curve is said to be that the latter is a reduced-form relationship; whereas, NKPC model has a clear structural interpretation so that it can be useful for interpreting the impact of structural changes on inflation (Gali and Gertler 1999). The key New Keynesian models of incomplete nominal adjustment Dynamic Stochastic general equilibrium (DSGE) is a new Keynesian economic model whose foundation is hinged on the microeconomics elements.

The key purpose of the DGSE model is to integrate monetary policies and theories with real business cycles impacting the economies. The model acknowledges and specifies preferences of economic agents such as individuals and firms who wish to maximize utility ad profits respectively. The DGSE model depends on the current choices of economic agents to predict future economic outcomes. It also allows stochastic disruption on the technology of production and applies the competition principle to compute equilibrium price and quantities under the function of preferences, tastes, technology and random shocks (Geweke 2009).

There are many assumptions that are made in the DSGE model. The first assumption is that the model relies on complete markets. Complete markets allow competitive monopolistic economic agents (firms) to set prices in response to market conditions. The set prices cannot be adjusted instantly without incurring some additional costs. Second assumption is that prices and wages are sticky. Economic processes are influenced by various factors that delay price and wage adjustments making it difficult to attain full equilibrium.

Such factors include failure of firms to reduce prices even if marginal cost decreases in order to increase their level of profits. If demands fall, firms are likely to hold prices constant and reduce production rather than reduce the prices of goods or services. Thirdly, the model assumes that economic agents are rational. This means that economic agents choose appropriate consumption paths that maximize utility and production paths that maximize profits. Fourthly, resources are fully utilized in each period.

This means that there are no resources spilling to the next budget period. Fifth, input decisions are determined by people who decide how much time they work, the quantity of goods and services they consume as well as the amount of income they save and invest in line with costs associated to those decisions. Sixth, the economy is closed. This indicates that they are no international goods or services that flow in or out of the economy. Seventh, money markets do not exist in the economy. Finally, the eight assumption of DGSE model is that people know policies that affect them a next in advance.

For example, people know the exact tax policy that affects them in the coming year. These are policies that are likely to be sustained though they are likely to experience stochastic disturbances. The model takes into consideration random shocks such as technological change, fluctuations in price of oil and errors in macroeconomic models. Though the model is considered superior, it has been criticized that it was not useful in analyzing the financial crisis of 2007-2010. It is also considered as too stylish