Economics, New Keynesian

BIBLIOGRAPHY

The macroeconomic debates on the effectiveness of fiscal and monetary policy have raged for many decades on both sides of the Atlantic. Up to the 1970s many economists and policymakers believed in a short-run Keynesian tradeoff between inflation and unemployment (termed a Phillips Curve), so that an expansionary fiscal or monetary policy would at least boost employment and lower unemployment for some time. The accelerator hypothesis popular in the 1970s insisted that extra jobs could only be achieved at the expense of ever-increasing inflation. The critique of econometric policy evaluation put forward by Robert Lucas in 1976 insisted that people cannot be fooled all the time. The subsequent outburst of new classical economics led by Lucas and Thomas Sargent and Neil Wallace killed the popularity of Keynesian economics.

By the end of the 1970s policymakers and economists became skeptical about the possibility of expansionary demand management lowering unemployment. The new classical economists rejected Keynesian theories of aggregate demand with sluggish price and wage formation and insisted on modelling dynamic, competitive general equilibrium models with rigorous micro foundations, rational expectations, and prices and wages adjusting instantaneously to clear all goods and labor markets. Fluctuations thus arise from technology shocks rather than changes in economic policy. This generation of economists works in the spirit of classical economists like Adam Smith, David Hume, David Ricardo, John Stuart Mill, Knut Wicksell, Irving Fisher, and John Maynard Keynes of The Treatise of Money (1930) who all insisted that output is primarily determined by productive capacity.

However, in 1980 Robert Solow (1980) in his Presidential Address to the American Economic Association criticized the new classical school and its Panglossian policy prescriptions for being unrealistic and irrelevant. He missed returns to scale and oligopolistic interdependence, and was unable to accept that all unemployed households are voluntarily unemployed. Involuntary unemployment and non-clearing labor markets needed to be addressed, which, according to Solow, would require an analysis of real and nominal wage and price rigidities, which may well follow from optimizing behavior of agents in the economy during their normal activities. Solow gave a host of reasons why labor markets do not clear immediately (varying from Keynes’s idea of case-by-case resistance to wage reductions to trade unions and efficiency wages).

Soon afterward, Oliver Hart, Oliver Blanchard, and Nobu Kiyotaki, and others in Gregory Mankiw and David Romer’s New Keynesian Economics (1991) explained that aggregate demand externalities in economies with monopolistic competition produces Keynesian multipliers. With small menu costs prices can be rigid and monetary policy has real effects on the economy. In the 2000s Michael Woodford (2003) and Jordi Galí (2003) continued the New Keynesian counter-attack on the new classical orthodoxy. Their objective is to develop dynamic, noncompetitive general equilibrium models with rigorous microfoundations, but where it is costly to adjust prices instantaneously. They obtain a micro-founded, forward-looking New Keynesian Phillips Curve with a short-run trade-off between inflation and unemployment. The main advantage of this approach is that a second-order approximation to a proper micro-founded welfare loss function can be obtained. This leads to the advice that central bankers should not target the actual output gap, but should target the economy as close as possible to the level of output that would prevail under flexible wages and prices.

An important implication is that inflation is forward rather than backward looking. The reason is that prices stay fixed for a while and thus depend on expected future marginal costs and demand conditions. A big difference with the accelerator version of the Phillips Curve is that inflation leads output rather than the other way round. A monetary expansion always expands output, but only generates a lower interest rate if risk aversion is sufficiently high and money growth is not too autocorrelated. The Keynesian liquidity effect is thus not necessarily operative in the New Neoclassical Synthesis. Another insight is that policy makers should target deviations of actual output from the first-best level of output that would prevail in the absence of price and wage rigidity rather than from the de-trended level of output.

The New Keynesian approach cannot explain the quintessential Keynesian features that inflation displays inertia and monetary disinflations are contractionary. Other challenges for the New Keynesian approach are to explain pro-cyclical real wages in the face of demand shocks, allow for inventories, credit constraints, and bankruptcies in explaining the business cycle, model unemployment as a catastrophic event, and allow for psychological features such as downward rigidity of wages and not taking account of the full effects of changes in inflation at low rates of inflation.

Keynesian economics was not popular in the 1970s and 1980s. However, with the advent of New Keynesian economics, Keynes has become a source of inspiration again. Apart from giving more rigorous micro foundations, an important factor is undoubtedly that Keynesian economics is better able to explain the events of the 1970s and the 1980s as well as the recessions of the late twentieth century than the new classical economics. The New Keynesian approach must be able to explain periods of persistent, widespread involuntary unemployment, since otherwise it does not capture quintessential Keynesian features. One cannot rely on people’s misperceptions about relative prices or technology shocks alone to explain such periods. Keynes stressed the importance of animal spirits, coordination failures, and the possibility of multiple equilibrium outcomes. Coordination failures and bootstrap equilibria are important, since economies can get stuck in situations of deficient demand and widespread unemployment. Policymakers must then react by boosting confidence in the economy again. Investment by firms is financed by retained profits rather than borrowing, and this together with changes in the functional distribution of income is an important source of macroeconomic fluctuations. However, neither traditional nor New Keynesian Phillips Curves capture real world features that affect firm and bank behavior such as credit constraints, equity constraints, bankruptcies, and other market failures arising from imperfect information as discussed in Joseph Stiglitz and Bruce Greenwald’s Towards a New Paradigm in Monetary Economics (2003). If allowance is made for these features and the role of financial intermediaries, it follows that the nominal interest rate as well as the real interest rate affects the aggregate demand for goods. Monetary policy is associated with big distortions in allocation and is as much about supervision and regulation as the interest rate.

SEE ALSO Economics, Keynesian; Economics, New Classical; Economics, Post Keynesian

BIBLIOGRAPHY

Blanchard, Oliver, and Nobu Kyotaki. 1987. Monopolistic Competition and the Effects of Aggregate Demand. American Economic Review 77 (4): 647–666.

Galí, Jordi. 2003. New Perspectives on Monetary Policy, Inflation, and the Business Cycle. In Advances in Economics and Econometrics, eds. Matthias Dewatripont, Lars Hansen, and Stephen J. Turnovsky, Vol. VIII, 151–197. Cambridge, U.K.: Cambridge University Press.

Hart, Oliver D. 1982. A Model of Imperfect Competition with Keynesian Features. Quarterly Journal of Economics 97: 109–138.

Keynes, John Maynard. 1936. The General Theory of Employment, Interest, and Money. New York: Macmillan.

Lucas, Robert E., Jr. 1973. Some International Evidence on Output-Inflation Tradeoffs. American Economic Review 63: 326–335.

Lucas, Robert E., Jr. 1976. Econometric Policy Evaluation: A Critique. Carnegie-Rochester Conference Series on Public Policy 1: 19–46.

Mankiw, N. Gregory, and David Romer, eds. 1991. New Keynesian Economics. Vols. 1 and 2. Cambridge, MA: MIT Press.

Sargent, Thomas J., and Neil Wallace. 1975. “Rational” Expectations, the Optimal Monetary Instrument, and the Optimal Money Supply Rule. Journal of Political Economy 83: 241–245.

Solow, Robert M. 1980. On Theories of Unemployment. The American Economic Review 70 (1): 1–11.

Stiglitz, Joseph, and Bruce Greenwald. 2003. Towards a New Paradigm in Monetary Economics. Raffaele Mattioli Lectures. Cambridge, U.K.: Cambridge University Press.

Woodford, Michael. 2003. Interest and Prices: Foundations of a Theory of Monetary Policy. Princeton, NJ: Princeton University Press.

Frederick van der Ploeg