What Are New Keynesian Economic Models?
New Keynesian economic models are a school of thought within modern macroeconomics that integrates core principles of traditional Keynesian economics with microeconomic foundations. These models explain how phenomena such as inflation and unemployment can persist even when individuals and firms act rationally. A central tenet is the concept of nominal rigidities, particularly sticky prices and sticky wages, which prevent immediate adjustments to changes in aggregate demand or aggregate supply. This allows for short-run deviations from full employment and output, implying that stabilization policies, such as monetary policy and fiscal policy, can be effective in guiding the economy.
History and Origin
New Keynesian economic models emerged in the 1980s as a response to criticisms leveled against traditional Keynesian economics by the New Classical economics school. During the 1970s, traditional Keynesian models struggled to explain the phenomenon of stagflation—simultaneous high inflation and high unemployment—which challenged the established macroeconomic consensus. New Classical economists, like Robert Lucas and Thomas Sargent, introduced concepts such as rational expectations, arguing that economic agents fully use available information to form their expectations, which would render predictable government policies ineffective in influencing real economic outcomes.
In8 response, New Keynesian economists sought to provide microeconomic underpinnings for Keynesian ideas, explaining why markets might not clear instantaneously despite rational behavior. Key developments included the introduction of "menu costs" (the costs associated with changing prices) and "staggered contracts" (where not all wages and prices are adjusted at the same time). This theoretical work provided a rigorous explanation for wage and price stickiness, justifying the short-run effectiveness of macroeconomic stabilization policies. The Federal Reserve Bank of St. Louis highlights that New Keynesian theories "rely on this stickiness of wages and prices to explain why involuntary unemployment exists and why monetary policy has such a strong influence on economic activity." Ear7ly pioneers in this field include Stanley Fischer, John B. Taylor, and N. Gregory Mankiw, who integrated microfoundations into macroeconomic models.
Key Takeaways
- New Keynesian economic models build on Keynesian principles by providing microeconomic explanations for aggregate economic phenomena.
- A cornerstone of New Keynesianism is the concept of nominal rigidities, such as sticky prices and sticky wages, which explain why prices and wages do not adjust instantly to changes in economic conditions.
- These models emphasize that market imperfections can lead to short-run deviations from full employment and output, validating the potential effectiveness of government stabilization policies.
- The New Keynesian Phillips Curve is a crucial component, linking inflation to output gaps and expectations, and is widely used by central bank models for forecasting and policy analysis.
- New Keynesianism has become a foundational framework for mainstream macroeconomics, particularly in guiding monetary policy decisions.
Interpreting the New Keynesian Economic Models
New Keynesian economic models are primarily interpreted as frameworks for understanding how real economic variables, such as output and employment, deviate from their long-run equilibrium levels in the short to medium term. The models suggest that because prices and wages are "sticky," shocks to the economy (e.g., changes in consumer confidence or technological advancements) can have real effects on output and employment for a period, rather than being immediately absorbed by price adjustments.
Policy makers, especially central bankers, use these models to forecast how policy actions might influence inflation and output, guiding decisions on interest rates. For example, if a model predicts that an economic shock will lead to a significant downturn and increased unemployment, New Keynesian analysis supports the use of expansionary monetary or fiscal policies to mitigate these effects. Conversely, if inflationary pressures are building, the models inform decisions on how to tighten policy to bring inflation back to target. Advanced versions of these models, known as DSGE models, are routinely used by central banks to analyze complex dynamics and predict the evolution of economic cycles.
Hypothetical Example
Consider an economy experiencing a sudden drop in consumer confidence, leading to a decrease in overall spending. In a New Keynesian economic model, this reduction in aggregate demand would not immediately lead to a proportional fall in prices and wages across the entire economy. Instead, due to factors like existing contracts, the costs firms face to change prices (menu costs), or concerns about employee morale if wages are cut, prices and wages remain "sticky."
For instance, a restaurant facing lower demand might initially choose to serve fewer customers and reduce staff hours rather than immediately lowering meal prices. If many businesses behave similarly, this collective stickiness prevents the economy from quickly adjusting to the lower demand. As a result, firms reduce production and lay off workers, leading to higher unemployment and a decline in economic output. This scenario can result in a period akin to stagflation if supply shocks are also present, demonstrating how nominal rigidities can translate demand-side shocks into real economic contractions. The New Keynesian framework provides tools to model this short-run disequilibrium and suggests how policy interventions could stabilize the economy.
Practical Applications
New Keynesian economic models have significant practical applications in guiding macroeconomic policy and analysis, particularly within central banks and international financial institutions.
- Monetary Policy Formulation: Central banks widely use New Keynesian frameworks, often in the form of Dynamic Stochastic General Equilibrium (DSGE) models, to analyze the impact of interest rate changes on inflation and economic activity. These models help policymakers forecast future economic conditions and design optimal monetary policy responses to achieve price stability and maximum sustainable employment. Michael Woodford notes that the New Keynesian model has been a "key framework for academic research in monetary economics, and bedrock for research and policymaking at central banks worldwide.",
- 6 5 Fiscal Policy Analysis: While often emphasizing monetary policy, New Keynesian models also provide a rationale for the effectiveness of fiscal policy, especially in situations where monetary policy might be constrained (e.g., during a liquidity trap). They help evaluate how government spending and taxation can influence aggregate demand and output in the presence of nominal rigidities.
- Business Cycle Analysis: These models are instrumental in understanding and explaining the fluctuations observed in economic cycles. By incorporating realistic frictions like sticky prices and wages, they offer a more nuanced explanation for why economies experience booms and busts than models based solely on real business cycle theory.
- International Policy Coordination: Institutions like the International Monetary Fund (IMF) use New Keynesian models to analyze global economic interdependencies and coordinate policies among member countries, helping to understand how economic shocks transmit across borders and how policies in one country might affect others. The IMF publishes research on this framework, describing it as a means to understand "why stabilization policies matter."
##4 Limitations and Criticisms
Despite their widespread adoption, New Keynesian economic models face several limitations and criticisms.
One primary critique revolves around the assumption of rational expectations. While New Keynesian models incorporate market imperfections, they still typically assume that economic agents—households and firms—make decisions based on all available information and unbiased forecasts of the future. Critics argue that this assumption may not reflect real-world behavior, where individuals and firms often operate with imperfect information, behavioral biases, or limited rationality. Any dev3iation from purely rational expectations can significantly affect the predicted outcomes of policies derived from these models.
Another area of criticism emerged during and after the 2008 global financial crisis. Many economists argued that New Keynesian models failed to adequately predict the crisis or explain its severe and prolonged impact, particularly concerning financial markets and their interplay with the real economy. These models traditionally focused less on financial sector imperfections and more on price and wage rigidities in the goods and labor markets. J. Bradford DeLong, in an article for Project Syndicate, suggested that New Keynesian models often do not provide "persuasive accounts of the relative strengths of the policy levers they endorse."
Additi2onally, some critiques point to the "ad hoc" nature of some of the nominal rigidities incorporated, questioning whether "menu costs" or staggered contracts are quantitatively significant enough to explain large, persistent economic fluctuations. While economists generally agree that sticky prices exist, there is ongoing debate about the extent to which these rigidities explain observed macroeconomic phenomena and justify substantial policy interventions.
New1 Keynesian Economic Models vs. New Classical Economics
New Keynesian economic models and New Classical economics are two prominent schools of thought in modern macroeconomics, both incorporating microfoundations and rational expectations. However, their fundamental disagreement lies in their assumptions about the flexibility of prices and wages and, consequently, the role and effectiveness of government intervention.
| Feature | New Keynesian Economic Models | New Classical Economics |
|---|---|---|
| Price/Wage Adjust. | Sticky: Prices and wages adjust slowly due to market imperfections (e.g., menu costs, staggered contracts, efficiency wages). | Flexible: Prices and wages adjust quickly and fully to clear markets. |
| Market Equilibrium | Deviations from full employment/output are possible in the short run due to nominal rigidities. | Markets always clear; economy is always at or quickly returns to full employment/output equilibrium. |
| Role of Policy | Active role: Monetary and fiscal policies can effectively stabilize the economy in the short run by influencing aggregate demand. | Limited role: Predictable policies are ineffective in influencing real variables (policy ineffectiveness proposition); focus on supply-side policies. |
| Unemployment | Explains involuntary unemployment as a result of rigidities. | Unemployment is primarily voluntary or frictional. |
New Classical economics emphasizes the self-correcting nature of markets, arguing that without unforeseen shocks, predictable stabilization policies have little to no effect on real variables like output or employment. In contrast, New Keynesian models acknowledge market imperfections and therefore provide a theoretical basis for active monetary policy and fiscal policy to address short-run economic fluctuations and guide the economy toward a more desirable outcome.
FAQs
What is the main difference between New Keynesian and Old Keynesian economics?
The primary difference lies in the microeconomic foundations. Old Keynesian economics focused on empirical relationships and lacked explicit micro-level explanations for phenomena like wage and price stickiness. New Keynesian economic models, conversely, provide explicit microeconomic theories (e.g., menu costs, staggered contracts, efficiency wages) to explain why prices and wages are "sticky" and why government intervention can be effective.
Why are sticky prices important in New Keynesian models?
Sticky prices are crucial because they explain how nominal shocks (like changes in the money supply or aggregate demand) can have real effects on output and employment in the short run. If prices adjusted instantly, changes in nominal variables would only affect nominal prices, leaving real variables unchanged. The stickiness means that when demand falls, firms reduce output and employment instead of immediately lowering prices, leading to recessions.
How do New Keynesian economic models explain unemployment?
New Keynesian economic models explain persistent unemployment by emphasizing nominal rigidities in both wage and price setting. If wages do not adjust downward quickly enough in response to a fall in labor demand, firms may reduce employment rather than cut wages. Similarly, if prices for goods and services are sticky, firms may reduce production and lay off workers when demand declines, rather than lowering prices to clear markets.
Do New Keynesian models support government intervention?
Yes, New Keynesian economic models generally support government intervention, especially through monetary policy, to stabilize the economy. Because of nominal rigidities, these models suggest that the economy can deviate from its full employment equilibrium in the short run. Therefore, active policies, such as interest rate adjustments by a central bank or targeted government spending, can help mitigate economic fluctuations and guide the economy back to its potential.
What are DSGE models in the context of New Keynesian economics?
DSGE models (Dynamic Stochastic General Equilibrium models) are a class of macroeconomic models used in modern economics, including within the New Keynesian framework. They are characterized by their microeconomic foundations, explicitly deriving aggregate relationships from the optimizing behavior of households and firms. In the New Keynesian context, DSGE models incorporate nominal rigidities and other market imperfections to analyze business cycles and the effects of monetary and fiscal policy.