New Keynesian Economics is a contemporary evolution of Keynesian economics, explicitly focusing on the short-term rigidity of prices and wages. This incomplete adjustment to economic changes is crucial for understanding phenomena such as involuntary unemployment and the efficacy of government intervention.
Key Insights
- New Keynesian Economics provides a modern refinement of classical Keynesian thought, explaining economic fluctuations through price and wage stickiness.
- Proponents argue that slow adjustment of prices and wages can cause prolonged unemployment, providing a rationale for active monetary policy.
- This school of macroeconomic thought significantly influenced academia and policy-making from the 1990s until the 2008 financial crisis.
Understanding New Keynesian Economics
The Great Depression inspired British economist John Maynard Keynes with the idea that increased government spending and tax cuts could boost demand and recover the global economy. This evolved to become the dominant approach for much of the 20th century. However, the stagflation of the 1970s challenged these traditional models.
In 1978, the publication of After Keynesian Macroeconomics by Robert Lucas and Thomas Sargent shed light on the shortcomings of classical Keynesian models. They argued that stagflation couldn’t be explained within the existing framework, proposing that micr©oeconomic principles, such as price and wage rigidity, had macroeconomic implications. This synthesis evolved into what is now identified as New Keynesian Economics.
The Evolution and Core Principles
New Keynesian theorists maintain that nominal issues such as price and wage rigidity can’t be ignored. These factors contribute to market failures and can momentarily justify government intervention. Stressed government policies, like expansionary monetary approaches, aim to stimulate savings and investment over immediate consumption and growth. However, this remains controversial among economists.
Critiques and Challenges of New Keynesian Economics
Criticism arose primarily after the inability to foresee the Great Recession and the ensuing secular stagnation. A significant issue involves explaining why aggregate price levels persist in their ‘sticky’ state. Competitive companies focus on output rather than prices, whereas, in New Keynesian economics, firms set prices and fix sales as a constant constraint.
Two predominant arguments within the New Keynesian framework attempt to address this issue. Firstly, it assumes that economic agents possess rational expectations. However, individual perceptions are flawed and adapt slowly due to asymmetric information and imperfect competition. Consequently, without reason to believe in others changing their prices, agents retain old expectations, indirectly fostering price rigidity.
Price-setting behavior showcases how misinformation and slow adaptation reflect in prolonged unemployment and highlight the necessity for dynamic economic policies resting on New Keynesian principles.
Related Terms: Keynesian Economics, Monetary Policy, Price Stickiness, Wage Rigidity, Output Gap.
References
- The Business Professor. “New Keynesian Economics - Explained”.
- Federal Reserve Bank of New York. “Inflation in the Great Recession and New Keynesian Models”.
- International Monetary Fund. “What Is Keynesian Economics?”
- Lucas, Jr., Robert E. and Thomas J. Sargent. After Keynesian Macroeconomics. Federal Reserve Bank of Minneapolis Quarterly Review, volume 3, issue 2, Spring 1979, pp. 1–16.
- Policonomics. “New Keynesian Economics”.
