New Keynesian Economics
Although the term ‘new Keynesian’ was first used by Parkin and Bade in
1982 in their textbook on modern macroeconomics (1982b), it is clear that
this line of thought had been conceived in the 1970s during the first phase of
the new classical revolution. The burgeoning new Keynesian literature since
then has been primarily concerned with the ‘search for rigorous and convincing
models of wage and/or price stickiness based on maximising behaviour
and rational expectations’ (Gordon, 1990). New Keynesian economics developed
in response to the perceived theoretical crisis within Keynesian economics
which had been exposed by Lucas during the 1970s. The paramount task
facing Keynesian theorists is to remedy the theoretical flaws and inconsistencies
in the old Keynesian model. Therefore, new Keynesian theorists aim to
construct a coherent theory of aggregate supply where wage and price rigidities
can be rationalized.
Both the old and new versions of classical economics assume continuous
market clearing and in such a world the economy can never be constrained by a
lack of effective demand. To many economists the hallmark of Keynesian
economics is the absence of continuous market clearing. In both the old (neoclassical
synthesis) and new versions of Keynesian models the failure of prices
to change quickly enough to clear markets implies that demand and supply
shocks will lead to substantial real effects on an economy’s output and employment.
In a Keynesian world, deviations of output and employment from their
equilibrium values can be substantial and prolonged, and are certainly interpreted
as damaging to economic welfare. As Gordon (1993) points out, ‘the
appeal of Keynesian economics stems from the evident unhappiness of workers
and firms during recessions and depressions. Workers and firms do not act as if
they were making a voluntary choice to cut production and hours worked.’ New
Keynesians argue that a theory of the business cycle based on the failure of
markets to clear is more realistic than the new classical or real business cycle
alternatives. The essential difference between the old and new versions of
Keynesian economics is that the models associated with the neoclassical synthesis
tended to assume nominal rigidities, while the attraction of the new
Keynesian approach is that it attempts to provide acceptable microfoundations
to explain the phenomena of wage and price stickiness.
The reader should be aware that new Keynesian economists are an extremely
heterogeneous group, so much so that the use of the term ‘school’ is
more convenient than appropriate. Nevertheless, economists who have made
significant contributions to the new Keynesian literature, even if some of
them may object to the label ‘new Keynesian’, include Gregory Mankiw and
Lawrence Summers (Harvard); Olivier Blanchard (MIT), Stanley Fischer
(Citigroup, and formerly at MIT); Bruce Greenwald, Edmund Phelps and
Joseph Stiglitz (Columbia); Ben Bernanke (Princeton); Laurence Ball (Johns
Hopkins); George Akerlof, Janet Yellen and David Romer (Berkeley); Robert
Hall and John Taylor (Stanford); Dennis Snower (Birkbeck, London) and
Assar Lindbeck (Stockholm). The proximity of US new Keynesians to the
east and west coasts inspired Robert Hall to classify these economists under
the general heading of ‘Saltwater’ economists. By a strange coincidence new
classical economists tend to be associated with ‘Freshwater’ academic institutions:
Chicago, Rochester, Minnesota and Carnegie-Mellon (see Blanchard,
1990b; Snowdon and Vane, 1999b; Snowdon, 2002a).
At this point it should be noted that some writers have also identified a
‘European’ brand of macroeconomic analysis which has also been called
‘new Keynesian’. The European variant emphasizes imperfect competition in
the labour market as well as the product market, reflecting the higher unionization
rates which characterize European economies (Hargreaves-Heap, 1992).
The appropriateness of a bargaining approach to wage determination, as a
microfoundation to Keynesian macroeconomics, is much more contentious in
the USA, where a minority of workers belong to a union. The use of the
imperfect competition macro model to examine the problem of unemployment
is best represented in the work of Richard Layard, Stephen Nickell and
Richard Jackman (LSE), Wendy Carlin (University College, London) and
David Soskice (Duke). These economists provide the most comprehensive
introduction to the European brand of new Keynesianism (see Layard et al.,
1991, 1994; Carlin and Soskice, 1990). There is of course considerable
overlap between the two brands of new Keynesianism, especially when it
comes to the issue of real wage rigidity (see section 7.7.3). Economists such
as Bénassy, Drèze, Grandmont and Malinvaud have also developed general
equilibrium models where non-market-clearing and price-making agents give
such models Keynesian features. In a survey of this literature Bénassy (1993)
suggests that ‘it would certainly be worthwhile to integrate the most relevant
new Keynesian insights’ into this general equilibrium approach.
At the beginning of the 1980s, three alternative explanations of the business
cycle were on offer within mainstream economics (there were others
outside the mainstream such as Austrian, Post Keynesian and Marxian; see
Chapters 8 and 9, and Snowdon and Vane, 2002b). The mainstream alternatives
were (i) flexible price, monetary misperception equilibrium business
cycle theories developed and advocated by Lucas (see Chapter 5); (ii) sticky
price expectational models emphasizing some element of wage and price
rigidity (for example, Fischer, 1977; Phelps and Taylor, 1977; Taylor, 1980);
and (iii) real business cycle models which increasingly became the main
flagship of the new classical equilibrium theorists during the 1980s (see
Chapter 6). By the mid-1980s the ‘Saltwater–Freshwater’ debate was essentially
between the sticky price and real business cycle varieties, given the
demise of the new classical monetary models. However, a major concern of
new Keynesian theorists has been to explain how nominal rigidities arise
from optimizing behaviour. Ball et al. (1988) consider the decline of Keynesian
economics during the 1970s to have been mainly due to the failure to solve
this theoretical problem.
In the remainder of this chapter we will examine the main elements of the
very diverse new Keynesian literature. First we identify the essential characteristics
of what is commonly understood to be the new Keynesian approach.
Although the term ‘new Keynesian’ was first used by Parkin and Bade in
1982 in their textbook on modern macroeconomics (1982b), it is clear that
this line of thought had been conceived in the 1970s during the first phase of
the new classical revolution. The burgeoning new Keynesian literature since
then has been primarily concerned with the ‘search for rigorous and convincing
models of wage and/or price stickiness based on maximising behaviour
and rational expectations’ (Gordon, 1990). New Keynesian economics developed
in response to the perceived theoretical crisis within Keynesian economics
which had been exposed by Lucas during the 1970s. The paramount task
facing Keynesian theorists is to remedy the theoretical flaws and inconsistencies
in the old Keynesian model. Therefore, new Keynesian theorists aim to
construct a coherent theory of aggregate supply where wage and price rigidities
can be rationalized.
Both the old and new versions of classical economics assume continuous
market clearing and in such a world the economy can never be constrained by a
lack of effective demand. To many economists the hallmark of Keynesian
economics is the absence of continuous market clearing. In both the old (neoclassical
synthesis) and new versions of Keynesian models the failure of prices
to change quickly enough to clear markets implies that demand and supply
shocks will lead to substantial real effects on an economy’s output and employment.
In a Keynesian world, deviations of output and employment from their
equilibrium values can be substantial and prolonged, and are certainly interpreted
as damaging to economic welfare. As Gordon (1993) points out, ‘the
appeal of Keynesian economics stems from the evident unhappiness of workers
and firms during recessions and depressions. Workers and firms do not act as if
they were making a voluntary choice to cut production and hours worked.’ New
Keynesians argue that a theory of the business cycle based on the failure of
markets to clear is more realistic than the new classical or real business cycle
alternatives. The essential difference between the old and new versions of
Keynesian economics is that the models associated with the neoclassical synthesis
tended to assume nominal rigidities, while the attraction of the new
Keynesian approach is that it attempts to provide acceptable microfoundations
to explain the phenomena of wage and price stickiness.
The reader should be aware that new Keynesian economists are an extremely
heterogeneous group, so much so that the use of the term ‘school’ is
more convenient than appropriate. Nevertheless, economists who have made
significant contributions to the new Keynesian literature, even if some of
them may object to the label ‘new Keynesian’, include Gregory Mankiw and
Lawrence Summers (Harvard); Olivier Blanchard (MIT), Stanley Fischer
(Citigroup, and formerly at MIT); Bruce Greenwald, Edmund Phelps and
Joseph Stiglitz (Columbia); Ben Bernanke (Princeton); Laurence Ball (Johns
Hopkins); George Akerlof, Janet Yellen and David Romer (Berkeley); Robert
Hall and John Taylor (Stanford); Dennis Snower (Birkbeck, London) and
Assar Lindbeck (Stockholm). The proximity of US new Keynesians to the
east and west coasts inspired Robert Hall to classify these economists under
the general heading of ‘Saltwater’ economists. By a strange coincidence new
classical economists tend to be associated with ‘Freshwater’ academic institutions:
Chicago, Rochester, Minnesota and Carnegie-Mellon (see Blanchard,
1990b; Snowdon and Vane, 1999b; Snowdon, 2002a).
At this point it should be noted that some writers have also identified a
‘European’ brand of macroeconomic analysis which has also been called
‘new Keynesian’. The European variant emphasizes imperfect competition in
the labour market as well as the product market, reflecting the higher unionization
rates which characterize European economies (Hargreaves-Heap, 1992).
The appropriateness of a bargaining approach to wage determination, as a
microfoundation to Keynesian macroeconomics, is much more contentious in
the USA, where a minority of workers belong to a union. The use of the
imperfect competition macro model to examine the problem of unemployment
is best represented in the work of Richard Layard, Stephen Nickell and
Richard Jackman (LSE), Wendy Carlin (University College, London) and
David Soskice (Duke). These economists provide the most comprehensive
introduction to the European brand of new Keynesianism (see Layard et al.,
1991, 1994; Carlin and Soskice, 1990). There is of course considerable
overlap between the two brands of new Keynesianism, especially when it
comes to the issue of real wage rigidity (see section 7.7.3). Economists such
as Bénassy, Drèze, Grandmont and Malinvaud have also developed general
equilibrium models where non-market-clearing and price-making agents give
such models Keynesian features. In a survey of this literature Bénassy (1993)
suggests that ‘it would certainly be worthwhile to integrate the most relevant
new Keynesian insights’ into this general equilibrium approach.
At the beginning of the 1980s, three alternative explanations of the business
cycle were on offer within mainstream economics (there were others
outside the mainstream such as Austrian, Post Keynesian and Marxian; see
Chapters 8 and 9, and Snowdon and Vane, 2002b). The mainstream alternatives
were (i) flexible price, monetary misperception equilibrium business
cycle theories developed and advocated by Lucas (see Chapter 5); (ii) sticky
price expectational models emphasizing some element of wage and price
rigidity (for example, Fischer, 1977; Phelps and Taylor, 1977; Taylor, 1980);
and (iii) real business cycle models which increasingly became the main
flagship of the new classical equilibrium theorists during the 1980s (see
Chapter 6). By the mid-1980s the ‘Saltwater–Freshwater’ debate was essentially
between the sticky price and real business cycle varieties, given the
demise of the new classical monetary models. However, a major concern of
new Keynesian theorists has been to explain how nominal rigidities arise
from optimizing behaviour. Ball et al. (1988) consider the decline of Keynesian
economics during the 1970s to have been mainly due to the failure to solve
this theoretical problem.
In the remainder of this chapter we will examine the main elements of the
very diverse new Keynesian literature. First we identify the essential characteristics
of what is commonly understood to be the new Keynesian approach.
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