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JA5. The New Keynesian Economics

Statement

Although not explicitly mentioned in Chapter 20, John Maynard Keynes is considered a foundational source in the understanding of macroeconomics. After performing research outside the textbook, please explain in three well-structured paragraphs the basic principles of the New Keynesian Economics and how it addresses perceived limitations to classic Keynesian theory.

Answer

Introduction

Keynesian economics is a macroeconomic theory that focuses on the role of aggregate demand in the economy. The New Keynesian Economics is based on the original theory and was developed in the 1980s. This text will start by reviewing some of the literature on the topic, then discuss the principles of New Keynesian Economics, and finally explain how it addresses perceived limitations of the classic Keynesian theory.

Literature Review

The original Keynesian economics was developed by John Maynard Keynes during the Great Depression in the 1930s; however, the theory has evolved over time and in the 1980s a new version emerged as a response to criticisms of the original theory. The New Keynesian Economics builds on the original Keynesian theory but introduces several modifications (Mankiw, 2018). The keynesian model agrees with the classical model on the long run, but it differs in the short run (Khan Academy, 2012) in that classical models can not explain short-run economic fluctuations.

“New Keynesian models suggest that business cycles occur because nominal wages and prices are slow to adjust to changes in aggregate demand” (Cameron & Hall, 2004). Hic (2019) lists interesting conditions that led to the raise of New Keynesian Economics, such as 1970’s Opec oil crises, the 80’s high unemployment despite strict monetary policy, and other economic situations that proved new Keynesian models to be more accurate and realistic than the other models. “Sticky wages refer to when employee wages don’t necessarily reflect their company’s or the economy’s performance” (CFI Team, 2023), that is, wages are slow to adjust to changes in the economy.

Principles of New Keynesian Economics

New Keynesian Economics are based on the assumptions of rational expectations and the existence of market inefficiencies including sticky wages and imperfect competitions. While prices move up and down easily, wages tend to be sticky, that is slow change either upward or downward, and wages going down is very hard due to employee unwillingness to accept a pay cut. It also assumes that markets are far from perfect competition and acknowledges the existence of monopoly and other practices such as collusion and price discrimination (CFI Team, 2023).

Menu costs is another principle behind slow response, which indicates that changing prices comes at a costs such as changing printings, advertising, and other places where prices are shown. Aggregate-demand externality is another principle refers to the increase/decrease in demand due to price changes, that is, every little price decrease leaves customers with more purchasing power that is reflected on the demand, and vice versa. Staggering prices is another principle, that is, not all prices change at the same time. Another principle explains recession due to coordination failure between different actors in the economy.

How New Keynesian Economics Addresses Limitations of Classic Keynesian Theory

The main difference between classical and old keynesian economics and the new keynesian economics is about the speed at which process and wages adjust. The classic economists assume that wages and prices are flexible, thus they can clear aby supply-demand imbalance quickly; while the new keynesian economists thinks differently as we saw in the previous chapter (Mankiw, 2018).

The new keynesian economists explained involuntary unemployment in the short run despite the strong influence of monetary policies which was not clearly explained with classical methods, as classical economists believe that high unemployment would press down on wages, but that is not usually what happens as wages rarely go down.

Conclusion

To conclude, we tried to collect some information about the New Keynesian Economics, its principles, and how it addresses the limitations of the classic Keynesian theory. The New Keynesian Economics more realistically explains the short-run economic fluctuations and the involuntary unemployment that occurs in the economy. It is based on the assumption that wages and prices are sticky and markets are far from perfect competition.

Word count: 636.

References