New Keynesian Economics

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21 Aug, 2024

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The New Keynesian economics is a theoretical economic model in modern macroeconomics based on the original Keynesian Economics. This school of thought was developed in the late 20th century. It aimed to adjust and rectify the criticisms in the original Keynesian economics and explain economic fluctuation with greater accuracy.

This economic theory addressed the limitations of the original Keynesian economics. The features of New Keynesian economics are a combination of the elements of Neoclassical economics and original Keynesian economics. It stresses the impact of aggregate demand and the influence of supply and individual consumer behavior on economic outcomes.

What Is New Keynesian Economics?

The New Keynesian economics is a macroeconomic theory derived from the original Keynesian economics in the late 20th century. It addresses all the shortcomings of the Keynesian economics theory.
This concept emphasizes the role of aggregate demand and supply and individual consumer behavior and decision-making process on economic outcomes.
It acknowledges that several market imperfections, like sticky prices and wages, exist, impacting the market's ability to adjust smoothly to the changing demand and supply.

New Keynesian Economics Explained

The New Keynesian economics is a macroeconomics theory derived from the original Keynesian economics theory. Formulated in the late 20th century, this theory addresses all the limitations of the Keynesian theory. It is a combination of neoclassical economics, which emphasizes the impact of individual consumer behavior and supply, and Keynesian economics, which places great importance on the influence of aggregate demand on economic outcomes.

The features of New Keynesian economics are as follows:

It acknowledges that the market conditions are prone to fluctuations in the short run. These fluctuations significantly impact several aspects of the economy, like inflation, output, and employment.
It suggests that market imperfections like sticky prices and wages exist, which impede the market's ability to adjust seamlessly to the changing demand and supply.
Furthermore, these imperfections can result in prolonged periods of recession and unemployment, where economic activities get reduced considerably.

Assumptions

The assumptions of New Keynesian economics are as follows:

This economic theory assumes that markets have the features of imperfect competition, which implies that the companies have some power over the market. Imperfect competitions include monopolies, duopolies, collusions, and cartels. This assumption differs from the idea of perfect competition, which results in rigidities like sticky prices and wages.
This theory assumes that prices and wages cannot adjust instantly to aggregate demand and supply changes. It assumes that these factors take time to adjust due to several factors, including imperfect information and long-term contracts.
One of the assumptions of New Keynesian economics is that economic factors like firms and consumers always have rational expectations about future economic conditions. They form their expectations based on the information available, and their expectations are unbiased.
This school of economics assumes that an economy's monetary policies substantially impact actual economic variables in the short run. The central banks or regulatory bodies can alter the interest rates or use various financial tools to monitor the aggregate demand, which will help stabilize the economy.

Policy Implications

The policy implications of New Keynesian economics are as follows:

This economic theory emphasizes that the central banks in an economy should actively control the monetary policy to help stabilize the economy. These institutions can impact economic factors like investment and consumption by adjusting interest rates or taking other financial measures. It will help with employment and keep the inflation rates within the desired range.
This economic model suggests that government taxation and spending help in counterbalancing the fluctuations in the business cycle. An expansionary fiscal policy during the recession and a contractionary fiscal policy during inflation can aid in bringing stability to the economy.
This theory acknowledges that nominal rigidities, including sticky prices and wages, can impede and hold back the market from adjusting to fluctuating economic conditions. Formulating policies that would help increase price and wage flexibility can reduce such rigidities and enhance market operations.

Criticisms

The criticisms of New Keynesian economics are as follows:

This economic model assumes that all economic agents have pragmatic expectations and can accurately forecast future economic conditions based on all the information they receive. This assumption may not apply in the real world as companies and consumers may have biased opinions that impact their rationale. Any deviation from the logical expectations can adversely affect the effectiveness of the policies formulated based on these assumptions.
Although this school of economics acknowledges the existence of market imperfections, it treats them very simply. It fails to capture the complexity of the pricing behaviors in different industries and firms.
This theory acknowledges the importance of fiscal policy for assisting in economic stability. However, it does not recognize these policies' possible restrictions and drawbacks. Factors like the time taken to implement the fiscal measures, political restraints, and the potential for inefficient resource allocation are not considered.
One of the criticisms of New Keynesian economics suggests that this model places too much importance on the role of monetary policy in monitoring aggregate demand and stabilizing the economy. It may not be enough to resolve deeper issues hindering economic stability and long-term growth.

New Keynesian Economics vs Keynesian Economics

The differences are as follows:

New Keynesian Economics: This economic model emphasizes more on microeconomic principles by including individual behavior and decisions in its analysis. It assumes that economic agents have rational expectations and can predict future economic conditions precisely without bias depending on all the available information. This model suggests a monetary and fiscal policy combination is necessary for financial stability. It places importance on monetary tools like interest rate adjustments for controlling aggregate demand.
Keynesian Economics: This economic model primarily emphasizes aggregate relationships instead of considering individual decision-making processes and behaviors. It does not strongly assume the possibility of rational expectations and places more importance on fiscal policy alone as a measure for maintaining economic stability.

New Keynesian Economics vs New Classical Economics

The differences are as follows:

New Keynesian Economics: This economic model acknowledges market imperfections like sticky prices and wages as a cause for economic fluctuations. It recognizes that these imperfections can result in market conditions like involuntary unemployment and prolonged recessions. It acknowledges the possibility of some imperfect or biased expectations that may impact economic outcomes. Furthermore, it believes active government intervention may be necessary to bring financial stability and minimize market fluctuations.
New Classical Economics: This economic model assumes that markets are perfectly competitive and efficient, and the deviations are self-correcting. It assumes that consumer and firm expectations are always rational and can accurately predict future economic conditions without prejudice. Furthermore, it believes the government's role in bringing financial stability is limited. It relies on the market mechanism's efficiency and suggests that government intervention may result in negative consequences and distortions.

Frequently Asked Questions (FAQs)

1. What is coordination failure in New Keynesian economics?

Coordination failure in this economy is a scenario where several economic factors, like consumers and companies, cannot coordinate their economic activities in such a manner that results in the most efficient and ideal outcomes. This failure occurs due to a lack of proper information and nominal rigidities. It can result in the underutilization of resources and increased unemployment. Therefore, an economy cannot reach its maximum potential due to coordination failure among its various agents.

2. Does New Keynesian economics support market intervention?

Yes, this economics supports market intervention from the government as a means to combat market failures. It acknowledges that the market can display inefficiencies arising from several factors and that government intervention may be necessary to curb these irregularities in the market. Government policies such as taxation, standards and regulations, and social safety nets may help correct these efficiencies and boost economic growth and stability.

3. How does New Keynesian economics address inflation?

This school of economics acknowledges that a change in the total demand may result in inflation. In addition, it recognizes the possible disparity in the expected and actual variables in the economy. In this economics, the central banks and other regulatory frameworks use various economic tools, such as monetary policies and interest rate adjustments, to manage the aggregate demand. As a result, the economy can keep the inflation rate within the desired range.