Keynesian Economics, Monetary Policy and the Business Cycle

After a brief review of the main differences between New and Old Keynesian economics from the sixties this paper focusses on a tension between traditional sluggish measures of potential output commonly used by policymakers and the New Keynesian (NK) notion of this variable which conceptualizes it as the level of output that would have been produced under perfect competition had all prices and wages been flexible. The paper shows that, under monopolistic competition, NK potential output is often more volatile than the level of output produced under sticky prices and wages implying either of the following. Real life policymakers mistakenly target smooth versions of output or (since actual economies are monopolistically rather than perfectly competitive) the flexible price and wage equilibrium does not necessarily maximize welfare. The paper shows, that depending on the shape of the utility function and of the distribution of productivity shocks either case is possible and proposes a criterion for discriminating between them