In the New Keynesian Macroeconomics business cycles are driven by demand shocks, while in the New...

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Economics

In the New Keynesian Macroeconomics business cycles are drivenby demand shocks, while in the New Classical Macroeconomics theyare driven by supply shocks. Explain this statement using yourknowledge of the AD-AS model.

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Answer New keynesian model by demand shocks Demand shocks likely play a key role in driving business cycles However in the standard new keynesian model the monetary policy reaction to these shocks have a supply side effect The change in real rate affects the marginal utility of consumption generating an income effect on labor supply Wages inflation and through monetary policy aggregate demand will increaseThis supply side effect have a surprising importance for the model especially when the sensitivity of aggregate demand to interest rate is low A demand shock will have a large impact close to one on output but a very small one on the output gap The limited monetary policy movement induced by the taylor rule See Answer

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