What it means
The original Keynesian approach, from the 1930s, argued that total spending in an economy can fall short and leave people out of work. Later critics said it lacked firm foundations in individual behaviour.
New Keynesians responded by building models where households and firms make rational decisions, yet the economy still behaves in ways that call for policy action. The central idea is stickiness.
Prices and wages do not change instantly, because firms face costs of changing price lists, contracts last for months or years, and workers resist pay cuts. Because of this, a fall in demand leads to lower output and jobs for a time, rather than an instant drop in prices that clears the market.
A second idea is imperfect competition. Firms in the real world have some power to set their own prices, which means they respond to changes in costs and demand gradually.
Together, these ideas create a role for central banks, which can influence spending by moving interest rates and so help the economy adjust more smoothly. The best-known tool from this school is the New Keynesian Phillips curve, which links inflation to expected future inflation and the output gap.
The output gap is the difference between what the economy produces and what it could produce at full capacity. Central banks use models of this type to decide how much to raise or lower rates.
For managers, it is a useful way to understand why interest rate decisions affect sales and hiring, and why inflation expectations matter. If customers and workers expect prices to rise, they bake that into contracts and wage demands, which can keep inflation going.
Critics argue that the models can be too simple and failed to predict some crises, so they are best treated as a guide and not a forecast.
In practice
Real-world examples.
Example
A central bank sees demand weakening and cuts interest rates by 1 percentage point. Mortgage rates fall and a homebuilder sees enquiries rise by 12%. The economists at the bank rely on a New Keynesian model to estimate how long the effect will take.
Example
A restaurant chain prints menus every six months and negotiates supplier contracts a year ahead. When food costs jump, it cannot change prices straight away and its margin falls from 14% to 9% for a time. This is a real-world example of sticky prices.
Example
A government planning a $30,000,000,000 stimulus package asks advisers how much it will lift output. They use a New Keynesian model to show that the impact depends on how quickly firms adjust prices and how central banks respond. The model suggests a larger effect when interest rates are already very low.
Formula
Calculation
New Keynesian Phillips curve: Inflation (this period) = beta x Expected inflation (next period) + kappa x Output gap
Suppose expected inflation is 2.0%, the discount factor beta is 0.95, the slope kappa is 0.1 and the economy is running 2% above its potential, so the output gap is 2. Inflation = (0.95 x 2.0%) + (0.1 x 2) = 1.90% + 0.20% = 2.10%. A basket of goods costing $100 today would cost $102.10 a year later. If the output gap were 0, inflation would be 1.90%, so the extra 0.20% is due to the hot economy.Case study
Seen in the real world.
Hartland is a fictional economy used in this illustrative story. A sudden drop in export demand left factories with unsold goods, but wages and contracts stayed fixed for the year, so firms cut jobs and unemployment rose from 5% to 8%. A policy adviser using New Keynesian reasoning argued that prices would take too long to fall on their own.
The central bank reduced its policy rate from 4% to 1%, and the government temporarily expanded unemployment benefits. Spending recovered, and within eighteen months unemployment was back to 5.5%. The adviser noted that the rate cut worked because wages and prices were sticky and so the economy needed the extra spending to bridge the gap.
Watch out
Common mistakes.
- Treating New Keynesian economics as identical to the original Keynesian theory. It adds explicit models of individual decision-making and sticky prices.
- Believing it says government spending always helps. The effect depends on conditions such as spare capacity and interest rates.
- Assuming it is only theory. Central banks use models built on these ideas in setting interest rates.
Questions
People also ask.
What does sticky mean?
It means prices and wages adjust slowly, so shocks to demand have real effects on output and jobs before prices fully adjust.
How is it different from monetarism?
Monetarism focuses on money supply and favours rules, while New Keynesians emphasise price rigidity and active stabilisation policy.
What are the main criticisms?
Critics say the models rely on strong assumptions and did not foresee major financial crises.
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