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 In keynesian and new keynesian views business cycles are mainly driven by changes in aggre gate demand or demand shocks The intuition is well understood Prices and wages are sticky and firm output is demand determined A rise in aggregate demand will lead to an increase in aggregate supply instead of increasing prices This idea has been backed by a variety of empirical evidences Blanchard and Quah 1989 show in a VAR model with long run restric tions that demand shocks accounts for two third of output variance at three years horizon and more than 85 of the employment variance The recent wave of Bayesian DSGE models also support a prominent role for See Answer

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