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7.4 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 nonThe

new Keynesian school 365

market-clearing models. In this matter Post Keynesians were first off the

mark (see Chapter 8, and Dixon and Rankin, 1994).

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.