New Keynesian Economics

New Keynesian Economics

What is the new Keynesian economy?

New Keynesian Economics is a modern macroeconomic school of thought from the classic Keynesian economy. This revised theory differs from classic Keynesian thinking in terms of how quickly prices and wages adjust.

New Keynesian advocates argue that prices and wages are “sticky”, which means they adapt more slowly to short-term economic fluctuations. This, in turn, explains economic factors such as involuntary unemployment and the impact of federal monetary policies.

Key points to remember

  • New Keynesian Economics is a modern version of macroeconomic doctrine based on the classic principles of Keynesian economics.
  • Economists have argued that prices and wages are “sticky”, so that involuntary unemployment and monetary policy have a significant impact on the economy.
  • This way of thinking became the dominant force in academic macroeconomics from the 1990s to the 2008 financial crisis.

Understanding the new Keynesian economy

British economist John Maynard Keynes’ idea after the Great Depression that rising public spending and lower taxes can boost demand and lift the global economy out of a recession has become the main way of thinking for much of the 20e century. That slowly started to change in 1978 when “After Keynesian Economics” has been published.

In the document, the new classical economists Robert Lucas and Thomas Sargent pointed out that the stagflation experienced in the 1970s was incompatible with traditional Keynesian models.

Lucas, Sargent and others have sought to build on Keynes’ original theory by adding microeconomic foundations to it. The two main areas of microeconomics that can have a significant impact on macroeconomics, they said, are the rigidity of prices and wages. These concepts intertwine with social theory, canceling out the pure theoretical models of classical Keynesianism.

Important

The new Keynesian economy became the dominant force in academic macroeconomics from the 1990s to the 2008 financial crisis.

New Keynesian theory attempts to address, among other things, sluggish price behavior and its cause, and how market failures could be caused by inefficiencies and could justify government intervention. The benefits of government intervention remain a flashpoint for debate. New Keynesian economists have argued for an expansionary monetary policy, arguing that deficit spending encourages savings, rather than increasing demand or economic growth.

Criticism of the New Keynesian Economy

The New Keynesian Economy has been criticized in some quarters for not having seen the Great Recession coming and for not having explained precisely the period of secular stagnation that followed.

The main problem with this economic doctrine is to explain why changes in overall price levels are “sticky”. Under the new classical macroeconomics, competitive firms taking prices make choices about the quantity of production to produce, and not at what price, while in the New Keynesian Economics, monopolistically competitive firms set their prices and accept the level of sales as a constraint.

From the New Keynesian Economics point of view, two main arguments try to understand why aggregate prices fail to imitate the nominal Evolution of the gross national product (GNP). Mainly, in the two macroeconomic approaches, it is assumed that economic agents, households and businesses have rational expectations.

However, New Keynesian Economics maintains that rational expectations are distorted as the market failure results from asymmetric information and imperfect competition. Since economic agents cannot have the full scope of economic reality, their information will be limited and there will be little reason to believe that other agents will change their prices and therefore keep their expectations unchanged. As such, expectations are a crucial part of pricing; as they remain unchanged, the same will apply to prices, which results in price rigidity.

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