New Keynesian Economics
Definition
New Keynesian economics is a modern macroeconomic school that builds on classical Keynesian ideas by adding microeconomic foundations. It explains short-run fluctuations and involuntary unemployment through price and wage “stickiness”—the tendency of prices and wages to adjust slowly to changes in demand or supply—and highlights the powerful role of monetary policy.
Historical background
Keynesian economics dominated much of 20th-century macroeconomic thinking after the Great Depression. In the late 1970s, however, the experience of stagflation and critiques by new classical economists (notably Robert Lucas and Thomas Sargent) exposed weaknesses in traditional Keynesian models. New Keynesian economics emerged as a response, incorporating microeconomic behavior to explain why markets sometimes fail to clear and why public policy can matter.
Core ideas and mechanisms
- Price and wage rigidity: Firms and workers do not instantly adjust prices and wages. Sticky nominal variables can produce real effects—output and employment deviate from their long-run levels.
- Microfoundations: New Keynesian models derive macro behavior from individual optimization (households and firms), but include market frictions such as imperfect competition and information problems.
- Imperfect competition: Firms are often modeled as monopolistic competitors that set prices and take sales as given, so they do not behave like pure price takers.
- Rational expectations with frictions: Agents form forward-looking (rational) expectations, but those expectations can be distorted by asymmetric information, limited information, and strategic behavior, reinforcing price rigidity.
- Channels generating stickiness: Explanations include menu costs, staggered price and wage setting, adjustment costs, and coordination failures. These frictions justify why aggregate prices do not instantly mirror nominal shocks.
Policy implications
- Monetary policy is powerful: Because of nominal rigidities, central banks can influence real activity and employment in the short run. New Keynesian models provide modern theoretical support for active monetary stabilization.
- Fiscal policy debate: New Keynesians generally acknowledge situations where government intervention can improve outcomes (e.g., demand shortfalls), but they also consider limits and possible private-sector responses (such as increased saving) that can blunt fiscal stimulus.
Criticisms and limitations
- Predictive failures: Critics highlight that mainstream New Keynesian models did not foresee the severity of the 2008–2009 financial crisis and struggled to account for the prolonged weak recovery and episodes of secular stagnation.
- Explaining stickiness: While the framework offers mechanisms for price and wage rigidity, there is ongoing debate about which frictions are most important in practice and how well models capture real-world adjustment dynamics.
- Financial sector and instability: Early New Keynesian models focused on nominal rigidities and often underweighted financial sector linkages and balance-sheet effects; subsequent work has sought to incorporate these elements.
Key takeaways
- New Keynesian economics marries Keynesian insights about demand shortfalls with microeconomic foundations to explain why markets sometimes fail to clear.
- Sticky prices and wages are central: they create scope for monetary policy to affect real output and employment in the short run.
- The approach dominated academic macroeconomics from the 1990s through the run-up to the 2008 crisis, but its limitations revealed by the crisis spurred further model improvements—especially the incorporation of financial frictions.
Further reading
- Lucas, R. E., Jr., & Sargent, T. J., “After Keynesian Macroeconomics.”
- Federal Reserve Bank of New York, “Inflation in the Great Recession and New Keynesian Models.”