14.1 New classical and new Keynesian economics
4 min read•august 9, 2024
New classical and new Keynesian economics emerged as competing theories in the late 20th century. They offered different explanations for economic fluctuations and policy effectiveness, shaping modern macroeconomic thought.
These schools of thought introduced key concepts like , real , and . Their debates and eventual synthesis led to more sophisticated economic models, influencing how we understand and approach economic policy today.
New Classical Economics
Rational Expectations and Real Business Cycle Theory
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- Rational expectations hypothesis assumes economic agents make decisions based on all available information
- Individuals use past experiences and current conditions to form expectations about future economic variables
- attributes economic fluctuations to real shocks rather than monetary factors
- serve as primary drivers of business cycles in this model
- Emphasizes the role of productivity changes in causing economic expansions and contractions
- Argues that government intervention is largely ineffective in stabilizing the economy
Supply-Side Economics and Policy Implications
- Supply-side economics focuses on increasing to stimulate economic growth
- Advocates for lower tax rates to incentivize work, savings, and investment ()
- Promotes deregulation to reduce business costs and increase productivity
- Encourages policies aimed at improving human capital through education and training
- Critiques demand-side policies for potentially crowding out private investment
- Suggests that reducing government intervention can lead to more efficient resource allocation
Lucas Critique and Macroeconomic Modeling
- challenges the use of historical data to predict effects of economic policies
- Argues that changes in policy regimes alter the underlying structure of economic relationships
- Emphasizes the importance of incorporating expectations into economic models
- Calls for in macroeconomic models to account for individual behavior
- Influences the development of more sophisticated econometric techniques
- Leads to the creation of new approaches in policy analysis and forecasting
New Keynesian Economics
Price Stickiness and Menu Costs
- Price stickiness refers to the slow adjustment of prices in response to changes in economic conditions
- explain why prices and wages do not immediately adjust to market-clearing levels
- represent the expenses associated with changing prices (updating price lists, menus, catalogs)
- Small menu costs can lead to significant macroeconomic effects due to price stickiness
- Firms may choose to maintain current prices if adjustment costs outweigh potential benefits
- Price stickiness contributes to and
Efficiency Wages and Labor Market Dynamics
- Efficiency wage theory suggests firms may pay workers above market-clearing wages
- Higher wages can increase productivity, reduce turnover, and attract higher-quality workers
- Leads to as wages remain above the market-clearing level
- Explains wage rigidity and persistent unemployment in labor markets
- Challenges the classical view of flexible wages and full employment equilibrium
- Provides a rationale for why wages may not adjust downward during economic downturns
New Keynesian Phillips Curve and Inflation Dynamics
- relates inflation to real economic activity and expected future inflation
- Incorporates into the traditional Phillips curve framework
- Assumes firms set prices based on expected future marginal costs
- Explains the persistence of inflation and the role of expectations in price-setting behavior
- Helps policymakers understand the trade-offs between inflation and output stabilization
- Provides a theoretical foundation for in monetary policy
Macroeconomic Modeling
Dynamic Stochastic General Equilibrium (DSGE) Models
- DSGE models integrate elements from both new classical and new Keynesian economics
- Incorporate microeconomic foundations to analyze aggregate economic phenomena
- Account for the dynamic nature of economic decisions and random shocks
- Allow for the analysis of policy effects on different economic agents and sectors
- Widely used by central banks and policymakers for forecasting and policy analysis
- Criticized for their complexity and reliance on strong assumptions about rational behavior
Rational Expectations in Modern Macroeconomic Models
- Rational expectations hypothesis assumes agents use all available information to form expectations
- Incorporated into both new classical and new Keynesian models
- Challenges the effectiveness of systematic monetary policy in influencing real economic variables
- Leads to the development of more sophisticated econometric techniques (vector autoregression)
- Influences the design of policy rules and the analysis of policy credibility
- Contributes to the debate on rules versus discretion in monetary policy
Synthesis of New Classical and New Keynesian Approaches
- Modern macroeconomic models often combine elements from both schools of thought
- Incorporates price stickiness and imperfect competition from new Keynesian economics
- Retains rational expectations and intertemporal optimization from new classical economics
- Allows for both short-run non-neutrality of money and
- Provides a framework for analyzing both supply and demand shocks
- Facilitates the study of optimal monetary and fiscal policies in a unified framework
Key Terms to Review (25)
Adaptive expectations: Adaptive expectations is a theory in economics suggesting that individuals form their expectations about the future based on past experiences and gradually adjust those expectations as new information becomes available. This approach emphasizes the role of historical data in shaping future predictions, making it a key concept in understanding how people respond to economic changes over time, especially concerning inflation and monetary policy.
Aggregate demand shocks: Aggregate demand shocks refer to sudden and unexpected changes in the total demand for goods and services in an economy, which can significantly impact economic output and prices. These shocks can be caused by various factors, including changes in consumer confidence, fiscal policy adjustments, or fluctuations in investment levels. Understanding aggregate demand shocks is crucial for analyzing both new classical and new Keynesian economic theories, as they influence how economies respond to disturbances and the effectiveness of policy measures.
Aggregate Supply: Aggregate supply refers to the total quantity of goods and services that producers in an economy are willing and able to supply at a given overall price level in a specific period. This concept plays a crucial role in determining overall economic output and is essential for understanding how economies react to different fiscal and monetary policies.
Business cycles: Business cycles refer to the fluctuations in economic activity that an economy experiences over a period, typically characterized by periods of expansion and contraction. These cycles can significantly impact employment, production, and overall economic growth, making them essential to understand for effective economic policy and forecasting.
Countercyclical policy: Countercyclical policy refers to economic measures taken by the government or central bank to counteract fluctuations in the business cycle, aiming to stabilize the economy during periods of expansion and contraction. These policies typically involve increasing government spending and lowering taxes during economic downturns to stimulate growth, while reducing spending and increasing taxes during periods of economic expansion to cool off overheating economies. This approach contrasts with the perspectives of new classical and new Keynesian economics, which have different views on the effectiveness and implementation of such policies.
Dynamic stochastic general equilibrium: Dynamic stochastic general equilibrium (DSGE) is a framework used in macroeconomic modeling that incorporates random shocks and time-varying dynamics to understand the behavior of an economy over time. This approach emphasizes the role of expectations and the interconnections among various sectors in the economy, enabling economists to analyze how different variables interact under uncertainty. DSGE models are crucial for studying the effects of monetary and fiscal policy, particularly within the contexts of new classical and new Keynesian theories.
Efficiency wages: Efficiency wages are wages that employers set above the market equilibrium level to enhance worker productivity, reduce turnover, and improve morale. By paying higher wages, employers aim to attract better talent, motivate employees to work harder, and decrease the likelihood of shirking. This concept plays a crucial role in understanding labor markets and the overall economic dynamics in both new classical and new Keynesian frameworks.
Forward-looking expectations: Forward-looking expectations refer to the anticipations that individuals and firms have about future economic conditions, which can influence their current decisions. These expectations are critical in both new classical and new Keynesian economics, as they help to determine behaviors regarding consumption, investment, and price-setting. The way people form these expectations can have significant implications for economic stability and the effectiveness of policy measures.
Inflation targeting: Inflation targeting is a monetary policy framework that aims to maintain price stability by setting a specific inflation rate as the goal for monetary authorities. This approach helps guide economic decisions by clearly communicating the targets to the public, which can influence expectations and behaviors in the economy. It connects closely with economic theories about how central banks should operate to achieve stability and growth, reflecting underlying principles of monetarism and modern economic thought.
Involuntary unemployment: Involuntary unemployment occurs when individuals are willing and able to work at the prevailing wage rate but cannot find employment due to external factors, such as economic downturns or structural changes in the labor market. This type of unemployment is a key concept in understanding economic fluctuations and the effectiveness of government intervention in stabilizing the economy.
Laffer Curve: The Laffer Curve illustrates the relationship between tax rates and tax revenue, suggesting that there is an optimal tax rate that maximizes revenue. Beyond this optimal point, increasing tax rates can lead to decreased revenue due to reduced economic activity, tax evasion, or avoidance. This concept is essential in understanding how both new classical and new Keynesian economists approach taxation, government revenue, and economic growth.
Long-run classical results: Long-run classical results refer to the economic theories and predictions that emerge when markets are allowed to adjust fully to changes over time, leading to a return to full employment and equilibrium. These results emphasize that in the long run, real variables such as output and employment are determined by factors like technology and resources rather than nominal variables like money supply. This idea is central to both new classical and new Keynesian frameworks, where it suggests that despite short-term fluctuations, the economy ultimately self-corrects through market forces.
Lucas Critique: The Lucas Critique is an economic theory formulated by Robert Lucas that argues traditional macroeconomic models fail to account for changes in policy because they do not incorporate how people's expectations about the future influence their behavior. This critique emphasizes the importance of microfoundations in macroeconomic analysis, suggesting that economic agents adjust their expectations based on policy changes, thus making historical data insufficient for predicting the effects of new policies.
Menu costs: Menu costs refer to the costs incurred by businesses when they change their prices, such as printing new menus or labels. These costs can lead to price stickiness, as companies may avoid changing prices frequently due to the expenses and administrative burdens involved. This phenomenon is particularly relevant in the context of economic theories that explore how prices adjust in response to changes in supply and demand.
Microfoundations: Microfoundations refer to the underlying individual behavior and decision-making processes that explain macroeconomic phenomena. This approach seeks to connect macroeconomic theories and models with the actions of individuals and firms, emphasizing how these smaller units contribute to larger economic outcomes. By focusing on individual-level choices, microfoundations provide insights into issues like aggregate demand, price formation, and market dynamics, which are critical in understanding broader economic concepts.
Monetary non-neutrality: Monetary non-neutrality refers to the idea that changes in the money supply can have real effects on the economy, particularly in the short run. This concept suggests that an increase or decrease in the money supply can influence variables such as output, employment, and investment, rather than only affecting price levels. This challenges the classical view that money is neutral in the long run, and highlights the significance of monetary policy in managing economic fluctuations.
Natural rate of unemployment: The natural rate of unemployment is the level of unemployment that exists when the economy is at full employment, excluding cyclical unemployment caused by economic downturns. It represents the equilibrium where the labor market is balanced, factoring in frictional and structural unemployment due to normal labor market dynamics. Understanding this concept helps economists analyze how various economic theories approach employment and inflation dynamics.
New Keynesian Phillips Curve: The New Keynesian Phillips Curve is a modern adaptation of the traditional Phillips Curve that captures the relationship between inflation and economic activity, particularly focusing on how expectations of future inflation influence current price-setting behavior. This model emphasizes the role of nominal rigidities, such as sticky prices and wages, which can lead to short-term trade-offs between inflation and unemployment. By incorporating rational expectations, this curve illustrates how forward-looking agents adjust their behavior based on anticipated future economic conditions.
Nominal rigidities: Nominal rigidities refer to the inflexibility of prices and wages to adjust in response to changes in economic conditions. This phenomenon often results from contracts, social norms, or institutional factors that prevent immediate price adjustments, impacting how economies respond to shocks. In the context of economic theory, nominal rigidities are central to understanding how fluctuations in aggregate demand can affect output and employment.
Output gap: The output gap is the difference between the actual output of an economy and its potential output, expressed as a percentage of potential output. When the economy operates below its potential, a negative output gap exists, indicating unused capacity, while a positive output gap signals an economy producing above its potential, potentially leading to inflationary pressures.
Price stickiness: Price stickiness refers to the resistance of prices to change, even when supply and demand conditions shift significantly. This phenomenon often leads to short-term market inefficiencies, as businesses may be slow to adjust prices in response to changing economic conditions. Price stickiness is a key feature in understanding how economic fluctuations occur and why some markets may not clear immediately.
Rational expectations: Rational expectations is an economic theory suggesting that individuals make forecasts about the future based on all available information and past experiences, leading to decisions that reflect their best estimates of future events. This concept implies that people will not be systematically wrong in their predictions, as they utilize data to form a well-informed understanding of the economic environment. This theory plays a crucial role in shaping economic policies and debates about market efficiency and the effectiveness of government interventions.
Real business cycle theory: Real business cycle theory is an economic theory that explains fluctuations in economic activity as the result of real (i.e., non-monetary) shocks, such as changes in technology or productivity, rather than fluctuations in demand. It suggests that these real shocks cause variations in output and employment, which are seen as natural responses to changes in the economy's fundamental conditions. This perspective connects with broader macroeconomic theories that seek to explain how economies react to various stimuli.
Short-run economic fluctuations: Short-run economic fluctuations refer to the temporary variations in economic activity, output, and employment levels that occur due to shifts in demand and supply conditions in the economy. These fluctuations can manifest as business cycles, characterized by periods of expansion and contraction that impact overall economic performance. Understanding these fluctuations is crucial for analyzing how different economic theories interpret market dynamics and policy responses during varying economic conditions.
Technology shocks: Technology shocks refer to sudden and unexpected changes in the technological landscape that significantly affect productivity, economic output, and overall growth. These shocks can lead to immediate shifts in supply or demand within an economy, influencing business cycles, employment, and inflationary pressures. In various economic theories, understanding how these shocks impact markets and policies is crucial for predicting future economic conditions.