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New Keynesian economics is a school of contemporary macroeconomics that strives to provide microeconomic foundations for Keynesian economics. It developed partly as a response to criticisms of Keynesian macroeconomics by adherents of New Classical macroeconomics.
Two main assumptions define the New Keynesian approach to macroeconomics. Like the New Classical approach, New Keynesian macroeconomic analysis usually assumes that households and firms have rational expectations. But the two schools differ in that New Keynesian analysis usually assumes a variety of market failures. In particular, New Keynesians assume that there is Imperfect competition in price and wage setting to help explain why prices and wages can become "sticky", which means they do not adjust instantaneously to changes in economic conditions.
Wage and price stickiness, and the other market failures present in New Keynesian models, imply that the economy may fail to attain full employment. Therefore, New Keynesians argue that macroeconomic stabilization by the government (using fiscal policy) or by the central bank (using monetary policy) can lead to a more efficient macroeconomic outcome than a laissez faire policy would.
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Significant early contributions to New Keynesian theory were compiled in 1991 by editors N. Gregory Mankiw and David Romer in New Keynesian Economics, volumes 1 and 2.[1] The papers in these volumes focused mostly on microfoundations, that is, microeconomic ingredients that could produce Keynesian macroeconomic effects, and did not yet attempt to construct complete macroeconomic models.
More recently, macroeconomists have begun to build dynamic stochastic general equilibrium (DSGE) models with Keynesian features. The New Keynesian DSGE modeling methodology is explained in Michael Woodford's textbook Interest and Prices: Foundations of a Theory of Monetary Policy.[2] Economists are now actively estimating quantitative models of this type,[3][4] and using them to analyze optimal monetary and fiscal policy.
'Nominal rigidities', that is, sticky prices and wages, are a central aspect of all New Keynesian models. Why should prices adjust slowly? One common explanation given by New Keynesians is the presence of 'menu costs', meaning small costs that must be paid in order to adjust nominal prices. For example, the costs of making a new catalog, price list, or menu would be considered menu costs. Even though these costs seem small, New Keynesians explain how they could amplify short-run fluctuations. Not only do the firms have to pay to change the price, but also, according to N. Gregory Mankiw, there are also externalities that go along with changing prices.[5] As Mankiw describes, a firm that lowers its prices because of a decrease in the money supply will be raising the real income of the customers of that product. This will allow the buyers to purchase more, which will not necessarily be from the firm that lowered their prices. As firms do not receive the full benefit from reducing their prices their incentive to adjust prices in response to macroeconomic events is reduced.
Recent studies (e.g. Golosov and Lucas)[6] find that the size of the menu cost needed to match the micro-data of price adjustment inside an otherwise standard business cycle model is implausibily large to justify the menu-cost argument. The reason is that such models lack "real rigidity" (see Ball and Romer). This is a property that markups do not get squeezed by large adjustment in factor prices (such as wages) that could occur in response to the monetary shock. Modern New Keynesian models address this issue by assuming that the labor market is segmented, so that the expansion in employment by a given firm does not lead to lower profits for the other firms (see Woodford 2003).
Other sources of price stickiness include
Besides sticky prices, another market imperfection built into most New Keynesian models is the assumption that firms are monopolistic competitors.[7] In fact, without some monopoly power it would make no sense to assume sticky prices, because under perfect competition, any firm with a price slightly higher than the others would be unable to sell anything, and any firm with a price slightly lower than the others would be obliged to sell much more than they can profitably produce. Therefore, New Keynesian models assume instead that firms use their market power to maintain their prices above marginal cost, so that even if they fail to set prices optimally they will remain profitable. Many macroeconomic studies have estimated typical firms' degree of market power, so this information can be used in parameterizing New Keynesian models.
Other microeconomic elements that appear in some New Keynesian models (though not so commonly as sticky prices and imperfect competition) include the following.
After the pioneering work, surveyed in the Mankiw and Romer volumes, on what types of microeconomic ingredients might produce Keynesian macroeconomic effects, economists began putting these pieces together to construct macroeconomic models. These models describe the decisions of households, monopolistically competitive firms, the government or central bank, and sometimes other economic agents. The monopolistic firms are assumed to face some type of price stickiness, so each time firms adjust their prices, they must bear in mind that those prices are likely to remain fixed longer than they would like. Many models assume wages are rigid too. Total output is determined by households' purchases, which depend on the prices of the firms. Since macroeconomic behavior is derived from the interaction of the decisions of all these players, acting over time, in the face of uncertainty about future conditions, these models are classified as dynamic stochastic general equilibrium (DSGE) models. The parameters of the model are usually estimated or chosen to make the model's dynamics resemble the actual macroeconomic data from the country or region under study. This modeling methodology is surveyed in Woodford (2003), op. cit.
New Keynesian economists fully agree with New Classical economists that in the long run, the classical dichotomy holds: changes in the money supply are neutral. However, because prices are sticky in the New Keynesian model, an increase in the money supply (or equivalently, a decrease in the interest rate) does increase output and lower unemployment in the short run.
Nonetheless, New Keynesian economists do not advocate using expansive monetary policy for short run gains in output and employment, as it would raise inflationary expectations and thus store up problems for the future. Instead, they advocate using monetary policy for stabilization. That is, suddenly increasing the money supply just to produce a temporary economic boom is not recommended as eliminating the increased inflationary expectations will be impossible without producing a recession. However when the economy is hit by some unexpected external shock, it may be a good idea to offset the macroeconomic effects of the shock with monetary policy. This is especially true if the unexpected shock is one (like a fall in consumer confidence) which tends to lower both output and inflation; in that case, expanding the money supply (lowering interest rates) helps by increasing output while stabilizing inflation and inflationary expectations.
Studies of optimal monetary policy in New Keynesian DSGE models have focused on interest rate rules (especially 'Taylor rules'), specifying how the central bank should adjust the nominal interest rate in response to changes in inflation and output. (More precisely, optimal rules usually react to changes in the output gap, rather than changes in output per se.) In some simple New Keynesian DSGE models, it turns out that stabilizing inflation suffices, because maintaining perfectly stable inflation also stabilizes output and employment to the maximum degree desirable. Blanchard and Galí have called this property the 'divine coincidence'.[13] However, they also show that in models with more than one market imperfection (for example, frictions in adjusting the employment level, as well as sticky prices), there is no longer a 'divine coincidence', and instead there is a tradeoff between stabilizing inflation and stabilizing employment.[12]
Over the years, a sequence of 'new' macroeconomic theories related to or opposed to Keynesianism have been influential.[14] After World War II, Paul Samuelson used the term neoclassical synthesis to refer to the integration of Keynesian economics with neoclassical economics. The idea was that the government and the central bank would maintain rough full employment, so that neoclassical notions—centered on the axiom of the universality of scarcity—would apply. John Hicks' IS/LM model was central to the neoclassical synthesis.
Later work by economists such as James Tobin and Franco Modigliani involving more emphasis on the microfoundations of consumption and investment was sometimes called neo-Keynesianism. It is often contrasted with the post-Keynesianism of Paul Davidson, which emphasizes the role of fundamental uncertainty in economic life, especially concerning issues of private fixed investment.
New Keynesianism, associated with John B. Taylor, Stanley Fischer, Gregory Mankiw, David Romer, Olivier Blanchard, Nobuhiro Kiyotaki, Jordi Galí, and Michael Woodford, is a response to Robert Lucas and the new classical school. That school criticized the inconsistencies of Keynesianism in the light of the concept of "rational expectations". The new classicals combined a unique market-clearing equilibrium (at full employment) with rational expectations. The New Keynesians use "microfoundations" to demonstrate that price stickiness hinders markets from clearing. Thus, the rational expectations-based equilibrium need not be unique.
Whereas the neoclassical synthesis hoped that fiscal and monetary policy would maintain full employment, the new classicals assumed that price and wage adjustment would automatically attain this situation in the short run. The new Keynesians, on the other hand, see full employment as being automatically achieved only in the long run, since prices are "sticky" in the short run. Government and central-bank policies are needed because the "long run" may be very long.
Emphasis has also been placed during the 2008 global financial and economic crisis on Keynes' stress on the importance of coordination of macroeconomic policies (e.g., monetary and fiscal stimulus) and of international economic institutions such as the World Bank and International Monetary Fund (IMF), and of the maintenance of an open trading system. This has been reflected in the work of IMF economists[15] and of Donald Markwell.[16]
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