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7.3 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.