What Is New Keynesian Economics?
New Keynesian economics is a school of thought within macroeconomics that emerged to provide microeconomic foundations for traditional Keynesian economics. It seeks to explain how and why economic output and employment can deviate from their potential levels in the short run, even with rational agents. The core of New Keynesian economics posits that imperfections in markets, particularly "sticky" prices and wages, prevent the economy from immediately adjusting to shocks. These rigidities mean that changes in aggregate demand can have real effects on output and employment, not just on prices.
History and Origin
New Keynesian economics developed in the 1980s as a response to criticisms of traditional Keynesian macroeconomics by the New Classical school, particularly regarding the lack of explicit microeconomic foundations for price and wage stickiness. New Classical economists, such as Robert Lucas and Thomas Sargent, highlighted that the stagflation of the 1970s was inconsistent with older Keynesian models, which often assumed flexible prices and wages13.
In the 1980s, New Keynesian economists began to integrate concepts like menu costs and imperfect competition to explain why prices and wages might not adjust instantaneously. A significant development was the Calvo staggered contracts model, which provided a microeconomic basis for sticky prices by assuming firms adjust prices at random intervals. This framework allowed New Keynesian economics to explain how monetary policy could influence real economic activity in the short run. By the early 1990s, elements of New Keynesian economics, specifically dynamic aspects with imperfect competition and nominal rigidities, were combined with Real Business Cycle Theory to form what became known as the New Neoclassical Synthesis, which now serves as the theoretical foundation for mainstream macroeconomics.
Key Takeaways
- New Keynesian economics integrates microeconomic principles to explain macroeconomic phenomena.
- It emphasizes the importance of market imperfections, such as sticky prices and wages, in causing short-run economic fluctuations.
- New Keynesian models suggest that government intervention through fiscal policy and central bank actions via monetary policy can help stabilize the economy.
- Unlike New Classical economics, New Keynesianism asserts that money is not neutral in the short run, meaning changes in the money supply can affect real output and employment.
- The concepts of menu costs, efficiency wages, and staggered contracts are central to explaining nominal rigidities within New Keynesian frameworks.
Interpreting New Keynesian Economics
New Keynesian economics is interpreted as a framework for understanding how an economy can operate below its full potential due to various market rigidities. For example, if companies face menu costs (the cost of changing prices), they may be reluctant to adjust prices frequently in response to minor changes in demand or costs. This price stickiness can lead to situations where a decrease in aggregate demand results in reduced production and employment, rather than just a proportional fall in prices.
Similarly, wage stickiness, perhaps due to factors like efficiency wages (where firms pay above-market wages to boost productivity or morale), can prevent the labor market from clearing immediately. This can lead to involuntary unemployment during economic downturns. Therefore, New Keynesian economics suggests that policy interventions, such as those by a central bank, can be effective in mitigating these inefficiencies and guiding the economy back toward full employment and stable prices.
Hypothetical Example
Consider a hypothetical economy facing a sudden drop in consumer confidence, leading to a significant decrease in consumer spending. According to New Keynesian economics, if prices and wages were perfectly flexible, firms would immediately lower their prices and wages, stimulating demand and avoiding a downturn.
However, in this New Keynesian scenario, firms face menu costs and are hesitant to frequently adjust their prices. Workers, too, resist immediate wage cuts. As a result, when demand falls, businesses find themselves with excess inventory and reduced sales. Instead of instantly lowering prices and wages, they respond by cutting production and laying off workers, leading to a rise in unemployment.
In response, the central bank might implement an expansionary monetary policy, such as lowering the federal funds rate. This reduces borrowing costs for businesses and consumers, encouraging investment and spending. Because prices are sticky, the increased money supply translates into higher real aggregate demand, stimulating production and gradually reducing unemployment. This intervention aims to bridge the gap until prices and wages can fully adjust, illustrating how New Keynesian principles justify active stabilization policies.
Practical Applications
New Keynesian economics provides the theoretical underpinnings for many real-world monetary and fiscal policy decisions. Central banks, like the Federal Reserve, often utilize New Keynesian models to analyze economic conditions and formulate interest rate policies aimed at achieving price stability and full employment11, 12. The models help policymakers understand how changes in the nominal interest rate can influence inflation and output in the short run, given various nominal rigidities.
Furthermore, these models are used by international organizations such as the International Monetary Fund (IMF) to assess the impact of different policy interventions and to offer guidance to member countries on managing economic volatility and achieving sustainable growth10. For instance, New Keynesian frameworks are applied to study the effects of foreign exchange intervention and the role of financial markets in transmitting shocks through the economy9.
Limitations and Criticisms
Despite its widespread acceptance in mainstream macroeconomics, New Keynesian economics faces several limitations and criticisms. One significant critique is that while it incorporates microeconomic foundations, some argue that these foundations still do not fully capture the complexities of real-world economic behavior, particularly regarding collective irrationality during economic upswings or crises8.
Some critics also point out that the empirical evidence for certain aspects of New Keynesian models, such as the canonical New Keynesian Phillips curve, has been found to perform poorly in describing macroeconomic dynamics, particularly regarding price movements and output dynamics7. There are arguments that the models may not fully account for large-scale economic events like the Great Recession, and that the assumed rigidities might not be sufficient explanations for persistent unemployment or demand-driven economies6. Furthermore, certain elements like the "cashless model," where no outside money is held in equilibrium, can be puzzling for monetary economists5.
New Keynesian Economics vs. Keynesian Economics
New Keynesian economics builds upon and refines traditional Keynesian economics, but with key distinctions:
| Feature | Keynesian Economics (Traditional) | New Keynesian Economics |
|---|---|---|
| Microfoundations | Lacked explicit microeconomic foundations for rigidities. | Integrates microeconomic foundations (e.g., menu costs, efficiency wages) to explain rigidities. |
| Rational Expectations | Often did not explicitly assume rational expectations. | Generally assumes agents have rational expectations, similar to New Classical economics. |
| Market Imperfections | Implied market failures but did not rigorously model them. | Explicitly models market imperfections like imperfect competition and sticky prices/wages. |
| Policy Implications | Advocates for active government intervention (fiscal and monetary) to stabilize demand. | Advocates for active stabilization policies, but grounded in how rigidities cause deviations from potential output. |
| Short-Run Effects | Money can be non-neutral in the short run due to various factors. | Money is non-neutral in the short run specifically because of nominal rigidities. |
| Long-Run Outlook | Less emphasis on automatic return to full employment. | Generally accepts that the economy tends toward a natural rate of unemployment in the long run. |
While both schools advocate for government and central bank intervention to mitigate economic fluctuations, New Keynesian economics provides a more rigorous, micro-founded explanation for why such interventions are necessary and effective in the short run. Traditional Keynesian economics focused more broadly on aggregate demand's influence on output and inflation without delving into the specific micro-level behaviors that lead to rigidities4.
FAQs
What is the main difference between New Keynesian and New Classical economics?
The primary difference lies in their assumptions about price and wage flexibility. New Keynesian economics assumes wages and prices are "sticky" or inflexible in the short run due to market imperfections, allowing monetary policy to affect real economic activity. New Classical economics, conversely, assumes wages and prices are flexible and markets clear quickly, leading to the conclusion that monetary policy is neutral in its effects on real variables3.
Why is price stickiness important in New Keynesian models?
Price stickiness is crucial because it explains why changes in aggregate demand can have real effects on output and employment. If prices adjusted instantly, a drop in demand would only lead to lower prices, not reduced production or job losses. Sticky prices mean that firms respond to demand shocks by adjusting quantities (output and employment) in the short run, rather than just prices2.
What are some examples of "sticky prices" in the real world?
Examples of sticky prices include the relatively infrequent adjustment of catalog prices, restaurant menus, or the prices of many consumer goods. Firms incur "menu costs" associated with changing prices, such as printing new labels or updating digital systems, which can make them reluctant to adjust prices continuously in response to minor economic fluctuations.
How does New Keynesian economics view monetary policy?
New Keynesian economics views monetary policy as an effective tool for stabilizing the economy in the short run. Because prices and wages are sticky, a central bank can influence real variables like output and employment by adjusting interest rates and the money supply. This allows policy to counteract the effects of demand shocks and guide the economy toward its potential output1.
Does New Keynesian economics support government intervention?
Yes, New Keynesian economics generally supports government intervention through both fiscal and monetary policy. It argues that market failures, such as sticky prices and wages, can lead to inefficient macroeconomic outcomes (like recessions or high unemployment) that can be improved through active stabilization policies by the government and the central bank.