The New Keynesian School
The term ‘new Keynesian’ was first used by Michael Parkin and R. Bade in 1982 in their textbook on
modern macroeconomics. But it is clear that this line of thought had been conceived in the 1970s
during the first phase of the new classical revolution. The 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 behavior and rational expectations’. 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.
The new Keynesian economists are an extremely heterogeneous group. The 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).
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 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?
New Keynesians answer both questions in the affirmative. Non-neutralities arise from sticky
prices, and market imperfections explain this behaviour of prices. In contrast, the early real
business cycle models gave a negative response to both questions.
Those younger-generation economists seeking to strengthen the Keynesian model did so
primarily by developing and improving the micro foundations of ‘Fort Keynes’ which had
come under theoretical attack . This is recognized by Mankiw and Romer, who note that the
reconstruction of Keynesian economics has ‘been part of a revolution in micro economics’.
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 price making monopolistic, rather than perfectly competitive,
firms.
, 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, as well as some
economists within the orthodox monetarist school 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.
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’ 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.
Rigidities
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
Nominal Rigidities
Both orthodox and new Keynesian approaches assume that prices adjust slowly following a
disturbance. But, unlike the Keynesian cross or IS–LM approaches, which arbitrarily assume
fixed nominal wages and prices, the new Keynesian approach seeks to provide a
microeconomic underpinning for the slow adjustment of both wages and prices. The new
Keynesian approach assumes that workers and firms are rational utility and profit maximizers,
respectively.
New classicists adopt the flexible price auction model and apply this to the analysis of
transactions conducted in all markets, including the labour market. But the new Keynesians
argue that it is important to utilize the Hicksian distinction between markets which are
essentially fix-price, predominantly the labour market and a large section of the goods
market, and markets which are flex-price, predominantly financial and commodity markets. In
fix-price markets price setting is the norm, with price and wage inertia a reality. In order to
generate monetary non-neutrality (real effects) Keynesian models rely on the failure of
nominal wages and prices to adjust promptly to their new market-clearing levels following an
aggregate demand disturbance. Keynesians have traditionally concentrated their attention on
the labour market and nominal wage stickiness in order to explain the tendency of market
economies to depart from full employment equilibrium. However, it is important to note that
for any given path of nominal aggregate demand it is price, not wage, stickiness which is
The term ‘new Keynesian’ was first used by Michael Parkin and R. Bade in 1982 in their textbook on
modern macroeconomics. But it is clear that this line of thought had been conceived in the 1970s
during the first phase of the new classical revolution. The 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 behavior and rational expectations’. 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.
The new Keynesian economists are an extremely heterogeneous group. The 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).
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 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?
New Keynesians answer both questions in the affirmative. Non-neutralities arise from sticky
prices, and market imperfections explain this behaviour of prices. In contrast, the early real
business cycle models gave a negative response to both questions.
Those younger-generation economists seeking to strengthen the Keynesian model did so
primarily by developing and improving the micro foundations of ‘Fort Keynes’ which had
come under theoretical attack . This is recognized by Mankiw and Romer, who note that the
reconstruction of Keynesian economics has ‘been part of a revolution in micro economics’.
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 price making monopolistic, rather than perfectly competitive,
firms.
, 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, as well as some
economists within the orthodox monetarist school 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.
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’ 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.
Rigidities
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
Nominal Rigidities
Both orthodox and new Keynesian approaches assume that prices adjust slowly following a
disturbance. But, unlike the Keynesian cross or IS–LM approaches, which arbitrarily assume
fixed nominal wages and prices, the new Keynesian approach seeks to provide a
microeconomic underpinning for the slow adjustment of both wages and prices. The new
Keynesian approach assumes that workers and firms are rational utility and profit maximizers,
respectively.
New classicists adopt the flexible price auction model and apply this to the analysis of
transactions conducted in all markets, including the labour market. But the new Keynesians
argue that it is important to utilize the Hicksian distinction between markets which are
essentially fix-price, predominantly the labour market and a large section of the goods
market, and markets which are flex-price, predominantly financial and commodity markets. In
fix-price markets price setting is the norm, with price and wage inertia a reality. In order to
generate monetary non-neutrality (real effects) Keynesian models rely on the failure of
nominal wages and prices to adjust promptly to their new market-clearing levels following an
aggregate demand disturbance. Keynesians have traditionally concentrated their attention on
the labour market and nominal wage stickiness in order to explain the tendency of market
economies to depart from full employment equilibrium. However, it is important to note that
for any given path of nominal aggregate demand it is price, not wage, stickiness which is
