Aggregate Demand and Micro Behavior: A New Perspective on Keynesian Macroeconomics

We analyze the microfoundations for Keynesian aggregate demand effects by considering the link between aggregate demand and firm production decisions under monopolistic competition. Macroeconomic equilibrium is characterized in a simple graphical framework that facilitates comparison of several major approaches to modeling Keynesian microfoundations, including equilibrium theories, "new Keynesian" sticky price models, and more traditional sticky wage approaches. We use this framework to develop an original perspective on aggregate demand effects according to which aggregate demand shocks directly affect the demand conditions and production choices of individual firms. The results require neither nominal rigidity nor expectation errors. Nominal disinflation is ineffective in offsetting the real effects of demand shocks if aggregate demand is insensitive to nominal prices.