New Keynesian economics

New Keynesian economics is a school of macroeconomic thought that emerged in the late 1970s and 1980s as a response to the challenges posed by new classical macroeconomics. It seeks to provide microeconomic foundations for the core tenets of traditional Keynesian economics, particularly the assertion that markets do not clear instantaneously and that monetary policy can have real effects on output and employment in the short run. The framework integrates rational expectations and optimizing behavior of agents with various market imperfections, such as sticky prices and wages, to explain economic fluctuations and justify active stabilization policy.

Overview

The development of New Keynesian economics was largely a reaction to the Lucas critique and the rational expectations revolution led by economists like Robert Lucas Jr. and Thomas Sargent. Pioneering contributors include Greg Mankiw, David Romer, George Akerlof, Janet Yellen, and Olivier Blanchard, who published foundational papers in journals like the American Economic Review and the Journal of Economic Perspectives. Unlike the real business cycle theory advanced by Finn Kydland and Edward Prescott, which attributes fluctuations to real shocks, New Keynesian models emphasize nominal rigidities and demand shocks as primary sources of business cycles. This school became highly influential in central banking institutions, notably the Federal Reserve and the European Central Bank, especially following the Great Moderation.

Core concepts and theoretical foundations

The theoretical edifice rests on explaining why prices and wages adjust slowly to changing economic conditions, a phenomenon known as nominal rigidity. Key microfoundational models include menu costs, as analyzed by N. Gregory Mankiw and George Akerlof, which are small costs of changing prices that can lead to significant macroeconomic inertia. The theory of efficiency wages, developed by Janet Yellen and George Akerlof, posits that firms pay above-market wages to boost productivity, leading to involuntary unemployment. Other critical concepts include staggered price-setting, famously modeled by John Taylor in his Taylor rule work on contracts, and coordination failures, where decentralized price-setters fail to coordinate on a new equilibrium. These imperfections prevent the rapid market clearing assumed by the Walrasian auctioneer of classical theory, allowing for prolonged deviations from potential output.

Policy implications

A central policy conclusion is that active monetary and fiscal policy can and should be used to stabilize the economy. New Keynesian analysis provides a rigorous rationale for inflation targeting regimes, as practiced by the Bank of England and the Federal Reserve System under chairs like Ben Bernanke. The framework supports the use of a Taylor rule to guide interest rate decisions, responding to deviations of inflation from target and of output from its natural rate. During severe downturns, such as the Great Recession or the COVID-19 pandemic, the model justifies aggressive fiscal stimulus and unconventional monetary policy like quantitative easing, as these can mitigate the negative consequences of the zero lower bound on nominal interest rates. This stands in contrast to the policy ineffectiveness proposition of new classical macroeconomics.

Criticisms and debates

The school has faced significant criticism from several quarters. Proponents of freshwater economics, such as those from the University of Chicago, argue that the assumed rigidities are either insignificant or would be eliminated by market competition. Real business cycle theorists, including Edward Prescott, contend that the models improperly minimize the role of technology shocks. From the left, Post-Keynesian economists like Paul Davidson criticize the reliance on rational expectations and equilibrium methodology as a departure from the fundamental uncertainty emphasized by John Maynard Keynes. Furthermore, the efficient-market hypothesis challenges the very possibility of systematic policy effectiveness. Debates also persist within the school regarding the relative importance of different rigidities and the optimal design of stabilization policy.

Modern developments and extensions

In the 21st century, New Keynesian economics has evolved into the dominant framework for macroeconomic policy analysis, often synthesized into New Keynesian dynamic stochastic general equilibrium (DSGE) models. These models, which incorporate elements from both New Keynesian and real business cycle traditions, are used extensively by institutions like the International Monetary Fund, the Federal Reserve Board, and the European Central Bank. Recent extensions address the zero lower bound and secular stagnation, as discussed by Lawrence Summers and Paul Krugman. The Global Financial Crisis spurred work on integrating financial frictions, as in the work of Ben Bernanke on the financial accelerator, and on modeling heterogeneous agents. Current research continues to refine price-setting mechanisms, analyze expectations formation, and assess the challenges posed by low inflation environments in the wake of events like the Great Recession. Category:Macroeconomics Category:Keynesian economics Category:Economic theories