Core Propositions and Features of New Keynesian Economics
New Keynesian economics emerged mainly as a response to the theoretical
crisis facing Keynesian economics that emerged during the 1970s. In their
brief survey of new Keynesian economics Mankiw and Romer (1991) define
new Keynesian economics with reference to the answer a particular theory
gives to the following pair of questions:
Question 1 Does the theory violate the classical dichotomy? That is, is
money non-neutral?
Question 2 Does the theory assume that real market imperfections in the
economy are crucial for understanding economic fluctuations?
Of the mainstream schools only new Keynesians answer both questions in the
affirmative. Non-neutralities arise from sticky prices, and market imperfections
explain this behaviour of prices. Thus, according to Mankiw and Romer,
it is the ‘interaction of nominal and real imperfections’ that distinguishes new
Keynesian economics from the other research programmes in macroeconomics.
In contrast, the early real business cycle models gave a negative response
to both questions.
The disequilibrium Keynesian models of the 1970s (for example, Barro
and Grossman, 1976) imposed wage and price rigidities on a Walrasian
system, whereas more traditional Keynesian and monetarist models did not
regard the explanation of nominal rigidities as a priority. The latter two
groups tend to regard empirical evidence as being far more important than
theoretical purity; for example, speaking from a monetarist perspective, Laidler
(1992b) has argued emphatically that ‘better and more explicit microfoundations
do not guarantee more accurate empirical predictions about the
outcome of any macropolicy experiment’. However, as Mankiw and Romer
(1991) highlight, new Keynesians are not protagonists in the old 1960s-style
monetarist–Keynesian debate. This is for two reasons. First, there is no unified
new Keynesian view of the role of fiscal policy although new Keynesians do
give much greater weight to the stabilizing role of monetary policy compared
to the old Keynesian view (see Mankiw, 2002, and Chapters 3 and 4). For this
reason Mankiw and Romer argue that much of new Keynesian economics
could just as easily be renamed ‘new monetarist economics’ (see also DeLong,
2000). Second, new Keynesians do not hold a unified view on the desirability
and feasibility of activist (discretionary) stabilization policy. While most new
Keynesians accept the thrust of Friedman’s critique relating to the problems
that arise from uncertainty, time lags and the potential for political distortions
of policy, they also reject the ‘hard core’ monetarist argument relating to the
need for a strict monetary growth rate rule. Their views relating to Friedman’s
natural rate hypothesis also vary from extreme scepticism to modified
acceptance in terms of a ‘time-varying NAIRU’ (see Gordon, 1997, 1998;
Galbraith, 1997; Stiglitz, 1997; Phelps and Zoega, 1998; Mankiw, 2001;
Akerlof, 2002; Ball and Mankiw, 2002; Mankiw and Reis, 2002).
During the 1980s new Keynesian developments had a distinctly non-empirical
flavour. Those younger-generation economists seeking to strengthen
the Keynesian model did so primarily by developing and improving the
microfoundations of ‘Fort Keynes’ which had come under theoretical attack
(see Blinder, 1992a). This is recognized by Mankiw and Romer (1991), who
note that the reconstruction of Keynesian economics has ‘been part of a
revolution in microeconomics’. Those Keynesian commanders who allocated
scarce research resources to the theoretical, rather than empirical, front in
defence of ‘Fort Keynes’ did so because they felt that the modified Keynesian
model incorporating both the Phelps–Friedman expectations-augmented
Phillips curve and the impact of supply shocks was sufficiently resilient to
hold its own on the empirical front. Once the theoretical defences had been
reinforced, resources could gradually be reallocated to the empirical front in
order to test the new Keynesian models.
A crucial difference between new classical and new Keynesian models
arises with regard to price-setting behaviour. In contrast to the price takers
who inhabit new classical models, new Keynesian models assume pricemaking
monopolistic, rather than perfectly competitive, firms (Dixon, 1997).
Although the theory of monopolistic competition had been developed independently
by Robinson (1933) and Chamberlin (1933) before the publication
of Keynes’s General Theory, it is only recently that mainstream Keynesian
theorists have begun seriously to incorporate imperfect competition into non
market-clearing models. In this matter Post Keynesians were first off the
mark
Most new Keynesian models assume that expectations are formed rationally.
This is clearly one area where the new classical revolution of the 1970s
has had a profound effect on macroeconomists in general. However, some
prominent Keynesians (Blinder, 1987b; Phelps, 1992), as well as some economists
within the orthodox monetarist school (Laidler, 1992b) remain critical
of the theoretical foundations and question the empirical support for the
rational expectations hypothesis. Hence, although the incorporation of rational
expectations in new Keynesian models is the norm, this need not
always be the case.
Although new Keynesian economists share an interest in improving the
supply side of Keynesian models, they hold a wide diversity of views relating
to policy issues such as the debate over the importance of discretion, rather
than rules, in the conduct of fiscal and monetary policy. New Keynesians
regard both supply and demand shocks as potential sources of instability (see
Blanchard and Quah, 1989) but part company with real business cycle theorists
particularly when it comes to an assessment of a market economy’s
capacity to absorb such shocks so that equilibrium (full employment) is
maintained. Many new Keynesians (but not all) also share Keynes’s view that
involuntary unemployment is both possible and likely.
New Keynesian economists inhabit a brave new theoretical world characterized
by imperfect competition, incomplete markets, heterogeneous labour
and asymmetric information, and where agents are frequently concerned with
fairness. As a result the ‘real’ macro world, as seen through new Keynesian
eyes, is characterized by the possibility of coordination failures and macroeconomic
externalities. One problem with new Keynesian developments is
that the research programme has proved to be so ‘article-laden’ (Colander,
1988) that there is no single unified new Keynesian model; rather there is a
multiplicity of explanations of wage and price rigidities and their macroeconomic
consequences. Different elements within the new Keynesian school
emphasize various aspects and causes of market imperfections and their
macroeconomic effects. However, the numerous explanations are not mutually
exclusive and often complement each other. In short, as Leslie’s (1993)
comment captures so well, ‘New Keynesianism throws bucketfuls of grit into
the smooth-running neoclassical paradigms.’
Because the literature reviewed here is so wide-ranging, it is convenient to
divide the explanations of rigidities between those that focus on nominal
rigidities and those that focus on real rigidities. A nominal rigidity occurs if
something prevents the nominal price level from adjusting so as exactly to
mimic nominal demand disturbances. A real rigidity occurs if some factor
prevents real wages from adjusting or there is stickiness of one wage relative
to another, or of one price relative to another (see Gordon, 1990). First we
shall examine the impact of nominal rigidities.
New Keynesian economics emerged mainly as a response to the theoretical
crisis facing Keynesian economics that emerged during the 1970s. In their
brief survey of new Keynesian economics Mankiw and Romer (1991) define
new Keynesian economics with reference to the answer a particular theory
gives to the following pair of questions:
Question 1 Does the theory violate the classical dichotomy? That is, is
money non-neutral?
Question 2 Does the theory assume that real market imperfections in the
economy are crucial for understanding economic fluctuations?
Of the mainstream schools only new Keynesians answer both questions in the
affirmative. Non-neutralities arise from sticky prices, and market imperfections
explain this behaviour of prices. Thus, according to Mankiw and Romer,
it is the ‘interaction of nominal and real imperfections’ that distinguishes new
Keynesian economics from the other research programmes in macroeconomics.
In contrast, the early real business cycle models gave a negative response
to both questions.
The disequilibrium Keynesian models of the 1970s (for example, Barro
and Grossman, 1976) imposed wage and price rigidities on a Walrasian
system, whereas more traditional Keynesian and monetarist models did not
regard the explanation of nominal rigidities as a priority. The latter two
groups tend to regard empirical evidence as being far more important than
theoretical purity; for example, speaking from a monetarist perspective, Laidler
(1992b) has argued emphatically that ‘better and more explicit microfoundations
do not guarantee more accurate empirical predictions about the
outcome of any macropolicy experiment’. However, as Mankiw and Romer
(1991) highlight, new Keynesians are not protagonists in the old 1960s-style
monetarist–Keynesian debate. This is for two reasons. First, there is no unified
new Keynesian view of the role of fiscal policy although new Keynesians do
give much greater weight to the stabilizing role of monetary policy compared
to the old Keynesian view (see Mankiw, 2002, and Chapters 3 and 4). For this
reason Mankiw and Romer argue that much of new Keynesian economics
could just as easily be renamed ‘new monetarist economics’ (see also DeLong,
2000). Second, new Keynesians do not hold a unified view on the desirability
and feasibility of activist (discretionary) stabilization policy. While most new
Keynesians accept the thrust of Friedman’s critique relating to the problems
that arise from uncertainty, time lags and the potential for political distortions
of policy, they also reject the ‘hard core’ monetarist argument relating to the
need for a strict monetary growth rate rule. Their views relating to Friedman’s
natural rate hypothesis also vary from extreme scepticism to modified
acceptance in terms of a ‘time-varying NAIRU’ (see Gordon, 1997, 1998;
Galbraith, 1997; Stiglitz, 1997; Phelps and Zoega, 1998; Mankiw, 2001;
Akerlof, 2002; Ball and Mankiw, 2002; Mankiw and Reis, 2002).
During the 1980s new Keynesian developments had a distinctly non-empirical
flavour. Those younger-generation economists seeking to strengthen
the Keynesian model did so primarily by developing and improving the
microfoundations of ‘Fort Keynes’ which had come under theoretical attack
(see Blinder, 1992a). This is recognized by Mankiw and Romer (1991), who
note that the reconstruction of Keynesian economics has ‘been part of a
revolution in microeconomics’. Those Keynesian commanders who allocated
scarce research resources to the theoretical, rather than empirical, front in
defence of ‘Fort Keynes’ did so because they felt that the modified Keynesian
model incorporating both the Phelps–Friedman expectations-augmented
Phillips curve and the impact of supply shocks was sufficiently resilient to
hold its own on the empirical front. Once the theoretical defences had been
reinforced, resources could gradually be reallocated to the empirical front in
order to test the new Keynesian models.
A crucial difference between new classical and new Keynesian models
arises with regard to price-setting behaviour. In contrast to the price takers
who inhabit new classical models, new Keynesian models assume pricemaking
monopolistic, rather than perfectly competitive, firms (Dixon, 1997).
Although the theory of monopolistic competition had been developed independently
by Robinson (1933) and Chamberlin (1933) before the publication
of Keynes’s General Theory, it is only recently that mainstream Keynesian
theorists have begun seriously to incorporate imperfect competition into non
market-clearing models. In this matter Post Keynesians were first off the
mark
Most new Keynesian models assume that expectations are formed rationally.
This is clearly one area where the new classical revolution of the 1970s
has had a profound effect on macroeconomists in general. However, some
prominent Keynesians (Blinder, 1987b; Phelps, 1992), as well as some economists
within the orthodox monetarist school (Laidler, 1992b) remain critical
of the theoretical foundations and question the empirical support for the
rational expectations hypothesis. Hence, although the incorporation of rational
expectations in new Keynesian models is the norm, this need not
always be the case.
Although new Keynesian economists share an interest in improving the
supply side of Keynesian models, they hold a wide diversity of views relating
to policy issues such as the debate over the importance of discretion, rather
than rules, in the conduct of fiscal and monetary policy. New Keynesians
regard both supply and demand shocks as potential sources of instability (see
Blanchard and Quah, 1989) but part company with real business cycle theorists
particularly when it comes to an assessment of a market economy’s
capacity to absorb such shocks so that equilibrium (full employment) is
maintained. Many new Keynesians (but not all) also share Keynes’s view that
involuntary unemployment is both possible and likely.
New Keynesian economists inhabit a brave new theoretical world characterized
by imperfect competition, incomplete markets, heterogeneous labour
and asymmetric information, and where agents are frequently concerned with
fairness. As a result the ‘real’ macro world, as seen through new Keynesian
eyes, is characterized by the possibility of coordination failures and macroeconomic
externalities. One problem with new Keynesian developments is
that the research programme has proved to be so ‘article-laden’ (Colander,
1988) that there is no single unified new Keynesian model; rather there is a
multiplicity of explanations of wage and price rigidities and their macroeconomic
consequences. Different elements within the new Keynesian school
emphasize various aspects and causes of market imperfections and their
macroeconomic effects. However, the numerous explanations are not mutually
exclusive and often complement each other. In short, as Leslie’s (1993)
comment captures so well, ‘New Keynesianism throws bucketfuls of grit into
the smooth-running neoclassical paradigms.’
Because the literature reviewed here is so wide-ranging, it is convenient to
divide the explanations of rigidities between those that focus on nominal
rigidities and those that focus on real rigidities. A nominal rigidity occurs if
something prevents the nominal price level from adjusting so as exactly to
mimic nominal demand disturbances. A real rigidity occurs if some factor
prevents real wages from adjusting or there is stickiness of one wage relative
to another, or of one price relative to another (see Gordon, 1990). First we
shall examine the impact of nominal rigidities.
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