<p>The solution to your question is price stickiness, or as the author calls it staggered pricing. Let's assume a typical question in the <strong>Basic New Kenesian DSGE Model</strong>: What happens when a technological shock hits the economy?</p>
<p>More productive firms can produce cheaper but may not be able
to lower their prices due to price rigidities thus demand from the households stays at a lower level. The market clearing condition is supply equals demand and since demand won't increase output in the economy will be constraint (your paper uses determined but this might be the source of confusion) by the demand side. In this scenario one speaks from a negative output gap (Output is depressed in comparison to a world with flexible prices). In a flexible price scenario firms can lower their prices and thus household simultaneously increase demand, as firms want to increase production.</p>
<p>If you want to know more about price stickiness the basic DSGE models often implement the form suggested by: Calvo, Guillermo, “Staggered prices in a utility-maximizing framework,” Journal
of Monetary Economics, 1983, 12 (3), 383–398.</p>

CC BY-SA 4.0
2021-01-03T20:59:37.723Z
Thanks, for your answer. I think I understand what you're saying and it makes sense... However, it seems to me that I can only conclude the way you have after completely defining the model, and solving it for $y_t$. 

From the equations the author had shown so far, this could not be deduced, I think. Or am I wrong?
An old man in the sea.
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2021-01-03T21:04:35.237Z
I solved one of this models by hand a time ago and im am sure the IS curve is a result of solving this model. One has to solve the model than log lin for the steady state. After this you need to rewrite the Euler condition from the household in terms of the output gap. The endresult of this process will be your IS curve. However I do not own this book and i cant tell you if the author showed all the necessary steps.
Levittstyle
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2021-01-03T21:26:54.187Z
Yes, the author does show how to reach that version of the IS. I think I expressed myself in a wrong way. What I meant was, in which equation do you see that $y_t = \text{aggregate demand}$?
An old man in the sea.
CC BY-SA 4.0
2021-01-03T21:47:34.687Z
The market clearing condition:  y (output) = consumption (demand) =  production (supply). This holds true in all cases. In the sticky price scenario consumption is the binding component thus the author only tells you that production y_t is determined by aggregate demand. The IS is a combined version from market clearing condition and households supply. In fact you will first derive the household demand and than just simply set c = y and then after some rearangements you will get the IS curve.
Levittstyle
CC BY-SA 4.0
2021-01-03T22:05:59.133Z
Thanks. I need to think it over. Either way, I've accepted your answer, since it already satisfies my question, at least in a way. Thanks for the help. ;)
An old man in the sea.
CC BY-SA 4.0
2021-01-03T22:10:53.950Z
You are welcome. Take your time and if something stays unclear we can keep chatting in the comments :).
Levittstyle
CC BY-SA 4.0
2021-01-04T11:05:12.540Z
Let us [continue this discussion in chat](https://chat.stackexchange.com/rooms/118008/discussion-between-an-old-man-in-the-sea-and-armenthus).
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2021-01-03T20:34:15.460Z
2021-01-03T20:42:18.203Z
2021-01-03T20:42:18.203Z
Levittstyle
<p>The New Keynesian IS curve can be described by the following (log-linearisation around the steady-state):<span class="math-container">$$y_t=E_t(y_{t+1})- \frac{1}{\theta}(i_t - E_t\pi_{t+1}-\rho)$$</span>
where <span class="math-container">$\displaystyle\frac{1}{\theta}$</span> is the intertemporal elasticity of substitution in consumption, <span class="math-container">$\rho$</span> the discount rate,  and the remaining terms have their usual interpretation.</p>
<p>In the book Dynamic Macroeconomics, by Alogoskoufis, in chapter 16 (page 461), the author states:</p>
<blockquote>
<p>Recall that this is nothing more than the Euler equation for
consumption, supplemented by the assumption that all output is
consumed, and the same relation was derived in the new classical model [it's eq. 14.10]
of chapter14. However, in contrast to the new classical model, where
output is determined by aggregate supply, in this model, because of
staggered pricing, output is determined by aggregate demand. Thus, it
is the IS curve that drives output ﬂuctuations.</p>
</blockquote>
<p>I do not understand in what way is the output being determined by aggregate supply in the free price setting, nor by the aggregate demand in the sticky prices one.</p>

<new-keynesian-economics><aggregate-demand><aggregate-supply>
The new Keynesian IS curve: What determines output?
An old man in the sea.
# The new Keynesian IS curve: What determines output?

(Asked by: username_0 on 2021-01-03)

The New Keynesian IS curve can be described by the following (log-linearisation around the steady-state):$$y\_t=E\_t(y\_{t+1})- \frac{1}{\theta}(i\_t - E\_t\pi\_{t+1}-\rho)$$
where $\displaystyle\frac{1}{\theta}$ is the intertemporal elasticity of substitution in consumption, $\rho$ the discount rate, and the remaining terms have their usual interpretation.

In the book Dynamic Macroeconomics, by Alogoskoufis, in chapter 16 (page 461), the author states:

> Recall that this is nothing more than the Euler equation for
> consumption, supplemented by the assumption that all output is
> consumed, and the same relation was derived in the new classical model [it's eq. 14.10]
> of chapter14. However, in contrast to the new classical model, where
> output is determined by aggregate supply, in this model, because of
> staggered pricing, output is determined by aggregate demand. Thus, it
> is the IS curve that drives output ﬂuctuations.

I do not understand in what way is the output being determined by aggregate supply in the free price setting, nor by the aggregate demand in the sticky prices one.

**Tags:** new-keynesian-economics, aggregate-demand, aggregate-supply


---

## 1 answers

### Answer by username_1 on 2021-01-03. Score: 2 | Accepted answer

The solution to your question is price stickiness, or as the author calls it staggered pricing. Let's assume a typical question in the **Basic New Kenesian DSGE Model**: What happens when a technological shock hits the economy?

More productive firms can produce cheaper but may not be able
to lower their prices due to price rigidities thus demand from the households stays at a lower level. The market clearing condition is supply equals demand and since demand won't increase output in the economy will be constraint (your paper uses determined but this might be the source of confusion) by the demand side. In this scenario one speaks from a negative output gap (Output is depressed in comparison to a world with flexible prices). In a flexible price scenario firms can lower their prices and thus household simultaneously increase demand, as firms want to increase production.

If you want to know more about price stickiness the basic DSGE models often implement the form suggested by: Calvo, Guillermo, “Staggered prices in a utility-maximizing framework,” Journal
of Monetary Economics, 1983, 12 (3), 383–398.

> **Comments:**
> **username_0**: Thanks, for your answer. I think I understand what you're saying and it makes sense... However, it seems to me that I can only conclude the way you have after completely defining the model, and solving it for $y_t$.   From the equations the author had shown so far, this could not be deduced, I think. Or am I wrong?  
> **username_1**: I solved one of this models by hand a time ago and im am sure the IS curve is a result of solving this model. One has to solve the model than log lin for the steady state. After this you need to rewrite the Euler condition from the household in terms of the output gap. The endresult of this process will be your IS curve. However I do not own this book and i cant tell you if the author showed all the necessary steps.  
> **username_0**: Yes, the author does show how to reach that version of the IS. I think I expressed myself in a wrong way. What I meant was, in which equation do you see that $y_t = \text{aggregate demand}$?  
> **username_1**: The market clearing condition:  y (output) = consumption (demand) =  production (supply). This holds true in all cases. In the sticky price scenario consumption is the binding component thus the author only tells you that production y_t is determined by aggregate demand. The IS is a combined version from market clearing condition and households supply. In fact you will first derive the household demand and than just simply set c = y and then after some rearangements you will get the IS curve.  
> **username_0**: Thanks. I need to think it over. Either way, I've accepted your answer, since it already satisfies my question, at least in a way. Thanks for the help. ;)  
> **username_1**: You are welcome. Take your time and if something stays unclear we can keep chatting in the comments :).  
> **username_0**: Let us [continue this discussion in chat](https://chat.stackexchange.com/rooms/118008/discussion-between-an-old-man-in-the-sea-and-armenthus).  

---

