What Is New Keynesian Economics?
Key takeaways
– New Keynesian economics is a modern macroeconomic framework that adds microeconomic foundations to Keynesian ideas, explaining why prices and wages may adjust slowly (are “sticky”) and how that can produce output and employment fluctuations.
– Its core mechanisms include monopolistic competition, nominal rigidities (staggered/Calvo pricing, menu costs, wage contracts), and rational expectations with imperfect information.
– Policy implications emphasize the role of monetary policy (inflation targeting, forward guidance, unconventional tools at the zero lower bound) and a conditional role for fiscal policy, especially when monetary policy is constrained.
– Strengths: provides tractable, microfounded models (DSGE) used in central banks and academic research. Criticisms: limited handling of financial frictions, representative‑agent assumptions, and an imperfect record predicting major crises (e.g., 2008).
1. What the school tries to explain
New Keynesian economics seeks to explain why the economy sometimes deviates from full employment and why changes in nominal aggregates (like the money supply) can affect real output in the short run. Unlike early Keynesianism, it grounds macro relationships in microeconomic behavior (firms and households optimizing under constraints) while allowing for frictions that prevent immediate price and wage adjustment.
2. Historical background (brief)
– Keynesian policy approaches dominated mid–20th century thinking but struggled to account for 1970s stagflation.
– The “New Classical” critique (rational expectations and microfoundations) prompted a revision of Keynesian theory. Robert Lucas and Thomas Sargent were key figures pointing out limitations of older models (see Lucas & Sargent, “After Keynesian Macroeconomics”).
– New Keynesian economists incorporated microfoundations while keeping price/wage rigidities to explain observed short-run nonneutralities of money. By the 1990s these models became central to academic macroeconomics and policy analysis.
3. Core assumptions and mechanisms
– Rational expectations: agents form expectations about future variables in a forward‑looking, model‑consistent way, but their information may be incomplete.
– Monopolistic competition: firms have some price-setting power (not perfect price takers). This leads firms to choose prices rather than take them as given.
– Nominal rigidities (stickiness) — the crucial ingredient that makes monetary and fiscal policy matter in the short run:
– Calvo (staggered) pricing: firms can only reset prices infrequently and randomly, producing gradual price adjustment.
– Menu costs and contractual wages: small costs of changing prices or sticky wage contracts can make price/wage changes infrequent.
– Imperfect information and adjustment costs can likewise slow downward adjustment of wages and prices.
– New Keynesian Phillips Curve: links current inflation to expected future inflation and real marginal costs (or output gap), capturing forward‑looking inflation dynamics associated with nominal rigidities.
4. Typical modeling tools
– DSGE (dynamic stochastic general equilibrium) models with microfoundations and nominal rigidities are the primary analytic vehicle. They are used for policy simulation, scenario analysis, and academic research.
– The Taylor rule and optimal policy analyses are often embedded in these frameworks to study central bank behavior.
5. Policy implications
– Monetary policy: Central banks can stabilize inflation and output by managing expectations and short‑term interest rates. Credible commitment to an inflation target helps anchor expectations.
– At the zero lower bound (ZLB) or effective lower bound, conventional policy may be constrained; New Keynesian models motivate unconventional tools: forward guidance, quantitative easing, negative rates (where feasible).
– Fiscal policy: In normal times, monetary policy is often seen as the primary stabilizer. When rates hit the ZLB or when monetary policy is less effective, temporary fiscal stimulus can be powerful because it changes real demand and expectations; the size of fiscal multipliers depends on model details (degree of rigidity, openness, liquidity constraints).
– Structural policy: Reducing frictions (labor market reforms, improving information, reducing menu costs) can reduce the depth and duration of recessions.
6. Important strengths
– Provides internally consistent microfounded explanations for nominal rigidity and short‑run nonneutralities.
– Produces testable policy prescriptions and is widely used by central banks and researchers for forecasting and policy evaluation.
– Makes explicit the role of expectations — allowing analysis of forward guidance and credibility.
7. Criticisms and limitations
– Financial sector and crisis dynamics: Standard New Keynesian models originally underweighted financial frictions and complexity of banking/credit markets; that contributed to criticisms about their failure to forecast or explain the 2008 financial crisis fully.
– Representative‑agent and equilibrium focus: Many models use a representative household and equilibrium reasoning, which can miss distributional, heterogeneity, and out‑of‑equilibrium dynamics.
– Parameter sensitivity and empirical fit: Results (e.g., size of multipliers) depend on model specification and calibration; some critics argue they understate the role of fiscal policy or real rigidities in certain contexts.
– Expectation formation: While models assume rational expectations, real‑world expectation formation can be more complex (bounded rationality, information frictions).
8. Practical steps (by audience)
For central bankers and policymakers
1. Anchor inflation expectations with a clear, credible inflation‑targeting framework.
2. Use forward guidance and policy commitments to influence expectations, especially when short‑term rates are near the lower bound.
3. Be prepared to deploy unconventional monetary tools (QE, credit easing) when conventional policy is constrained.
4. Coordinate monetary and fiscal policy during severe downturns: when the ZLB binds, temporary, well‑targeted fiscal stimulus can be effective.
5. Invest in data, model diversity, and stress testing — incorporate financial frictions and heterogeneous agents into policy models to improve crisis resilience.
For fiscal authorities
1. Design countercyclical fiscal policies that are timely, targeted, and temporary in recessions; consider automatic stabilizers (unemployment insurance, progressive taxation).
2. When employing stimulus at the ZLB, prioritize projects and transfers with high short‑term multipliers and effective delivery mechanisms.
For businesses and households
1. In environments of sticky wages/prices, consider contract structures (indexation, inflation clauses) and price‑setting practices that manage adjustment costs.
2. Monitor central bank communication — expectations matter: credible communication can reduce uncertainty about inflation and rates.
For students and researchers
1. Study foundational papers: Lucas & Sargent (1979), Calvo (1983) on staggered pricing, and modern expositions (texts on DSGE/New Keynesian methods).
2. Learn computational methods for solving and estimating DSGE models and explore extensions with financial frictions and heterogeneous agents.
3. Compare model predictions to empirical evidence and explore robustness to different assumptions about expectations and market structure.
Conclusion
New Keynesian economics fused Keynesian insights about short‑run nonneutralities with microeconomic rigor. Its emphasis on nominal rigidities and expectations has shaped modern macro policy and central‑bank practice. However, real‑world complexity — financial markets, heterogeneity, and institutional details — means models must keep evolving. Policymakers benefit from the framework while also complementing it with models that better capture financial frictions and distributional effects.
Selected sources and further reading
– Investopedia. “New Keynesian Economics.” https://www.investopedia.com/terms/n/new-keynesian-economics.asp
– Lucas, R. E., Jr., & Sargent, T. J. (1979). “After Keynesian Macroeconomics.” Federal Reserve Bank of Minneapolis Quarterly Review, 3(2). https://www.minneapolisfed.org
– Calvo, G. A. (1983). “Staggered Prices in a Utility‑Maximizing Framework.” Journal of Monetary Economics.
– Federal Reserve Bank of New York. “Inflation in the Great Recession and New Keynesian Models.” https://www.newyorkfed.org
– International Monetary Fund. “What Is Keynesian Economics?” https://www.imf.org
If you’d like, I can:
– Summarize the key mathematical equations used in New Keynesian models (e.g., NK Phillips Curve, IS equation, monetary policy rule).
– Provide a short reading list (textbooks and papers) tailored to your level (beginner, advanced).
– Show how a simple DSGE New Keynesian model is solved and simulated in software (e.g., MATLAB, Dynare, Python).