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.


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.

  • $\begingroup$ 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? $\endgroup$ – An old man in the sea. Jan 3 at 20:59
  • $\begingroup$ 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. $\endgroup$ – Armenthus Jan 3 at 21:04
  • $\begingroup$ 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 $y_t = \text{aggregate demand}$? $\endgroup$ – An old man in the sea. Jan 3 at 21:26
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    $\begingroup$ 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. $\endgroup$ – Armenthus Jan 3 at 21:47
  • $\begingroup$ 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. ;) $\endgroup$ – An old man in the sea. Jan 3 at 22:05

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