New Keynesian economics

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New Keynesian economics developed partly in response to new classical economics. It strives to provide microeconomic foundations to Keynesian economics by showing how imperfect markets can justify demand management by the government or its central bank. The main assumption of New Keynesian economics that distinguishes it from the new classical economics is that wages and prices do not adjust instantly to allow the economy to attain full employment. (This price and wage stickiness is explained using microeconomic theory.) Thus, unemployed resources and non-clearing markets can exist and persist, even when rational expectations apply.

A commonly used explanation that New Keynesians use to explain why prices adjust slowly is menu costs. This is saying that the reason firms do not change their prices immediately is due to the costs that they must incur in order to do so. For instance, the cost of making a new catalog, price list, or menu is considered menu costs. Even though such a cost seems minor, New Keynesians explain how it can cause short-run fluctuations. Not only do the firms have to pay to change the price, but there are also externalities that go along with changing prices (Mankiw). 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. So firms will hesitate before doing so, because they do not want to assist other companys sales.

It is easy to over-emphasize the real-world importance of menu costs in the modern era, since desktop publishing programs make it easy to reprint menus (and because many menus are stated in electronic form, e.g., on the Internet). Further, cutting prices is especially easy to do when they are advertised as discount "sales" or done using coupons. These methods allow price-cutters to capture most of the external benefits of their actions.


Economists never get together at conventions to standardize names, but in the vernacular there is a family relationship between the "neoclassical synthesis," "neo-Keynesianism," and "new Keynesianism." The "neoclassical synthesis" arose after World War II, with Paul Samuelson: 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.

Led by economists such as James Tobin and Franco Modigliani, neo-Keynesianism is based on the synthesis but puts more emphasis on microfoundations, the use of Walrasian general equilibrium theory in macroeconomics. This developed over time. It is often contrasted with the post-Keynesianism of Paul Davidson, et al., which emphasizes the role of fundamental uncertainty in economic life, especially concerning issues of private fixed investment.

New Keynesianism, associated with Gregory Mankiw, currently chair of the Council of Economic Advisors under President George W. Bush, is a response to the Robert Lucas and the new classical school. That school criticized the inconsistencies of the neo-Keynesian school in 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 say: we have "microfoundations" that indicate that markets do not clear because of price stickiness. Thus, there is no unique equilibrium in the short run. Thus, the rational expectations-based critique doesn't apply.

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.

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Macroeconomic schools of thought

Keynesian economics | Monetarism | New classical economics
New Keynesian economics | Austrian School | Supply-side economics
Post-Keynesian economics
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