New Keynesian Economics

What Is New Keynesian Economics?

New Keynesian economics is a modern macroeconomic school of thought that evolved from classical Keynesian economics. This revised theory differs from classical Keynesian thinking in terms of how quickly prices and wages adjust.

New Keynesian advocates maintain that prices and wages are "sticky," meaning they adjust more slowly to short-term economic fluctuations. This, in turn, explains such economic factors as involuntary unemployment and the impact of federal monetary policies.

Understanding New Keynesian Economics

British economist John Maynard Keynes' idea in the aftermath of the Great Depression that increased government expenditures and lower taxes can stimulate demand and pull the global economy out of a downturn became the dominant way of thinking for much of the 20th century. That slowly began to change in 1978 when After Keynesian Economics was published.

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

Lucas, Sargent, and others sought to build on Keynes’ original theory by adding microeconomic foundations to it. The two major areas of microeconomics that may significantly impact the macroeconomy, they said, are price and wage rigidity. These concepts intertwine with social theory, negating the pure theoretical models of classical Keynesianism.

Important

New Keynesian economics became the dominant force in academic macroeconomics from the 1990s through to the financial crisis of 2008.

The new Keynesian theory attempted to address, among other things, the sluggish behavior of prices and its cause, and how market failures could be triggered by inefficiencies and might justify government intervention. The benefits of government intervention remain a flashpoint for debate. New Keynesian economists made a case for expansionary monetary policy, arguing that deficit spending encourages saving, rather than increasing demand or economic growth.

Criticism of New Keynesian Economics

New Keynesian economics was criticized in some quarters for failing to see the Great Recession coming and for not accurately accounting for the period of secular stagnation that followed it.

The main issue of this economic doctrine is explaining why changes in aggregate price levels are “sticky.” Under new classical macroeconomics**,** competitive price-taking companies make choices on how much output to produce, and not at what price, while in New Keynesian economics, monopolistically competitive companies set their prices and accept the level of sales as a constraint.

From a New Keynesian economics point of view, two main arguments try to answer why aggregate prices fail to imitate the nominal gross national product (GNP) evolution. Principally, under both approaches to macroeconomics, it is assumed economic agents, households, and companies have rational expectations.

However, New Keynesian economics maintains that rational expectations become distorted as market failure arises from asymmetric information and imperfect competition. As economic agents can’t have a full scope of the economic reality, their information will be limited. There will be little reason to believe that other agents will change their prices, and, as a result, they will keep their expectations unchanged. As such, expectations are a crucial element of price determination; as they remain unaltered, so will price, which leads to price rigidity.