New Keynesian Economics

A school of thought in modern macroeconomics that is derived from Keynesian Economics

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What is New Keynesian Economics?

New Keynesian Economics is a school of thought in modern macroeconomics that is derived from Keynesian Economics. The original Keynesian economic theory was published in the 1930s; however, classical economists in the 1970s and 1980s critiqued and adjusted Keynesian Economics to create New Keynesian Economics.

New Keynesian Economics

New Keynesian Assumptions

New Keynesian Economics comes with two main assumptions. First, that people and companies behave rationally and with rational expectations. Second, New Keynesian Economics assumes a variety of market inefficiencies – including sticky wages and imperfect competition.

Sticky wages refer to when employee wages don’t necessarily reflect their company’s or the economy’s performance; moreover, wages are said to be stickier downwards than upwards due to the unwillingness of employees to receive lower nominal pay. Also, the employees’ unwillingness to receive lower wages can result in involuntary unemployment.

In addition to sticky wages, the New Keynesian Economics assumption of imperfect competition refers to market situations that can include monopolies, duopolies, cartels, and collusion. It can help explain the varying effects of fiscal policy on different companies in the same industry.

New Keynesian Menu Costs

New Keynesian economics also supports the idea of sticky prices through a concept called menu costs and that menu costs contribute to market inefficiencies. For a company to change the price of a good or service, costs must be incurred, i.e., changing the price in catalogs or a menu. Some argue that menu costs are small and negligible to macroeconomics.

However, others argue that though menu costs are typically low for companies, it is not negligible. Also, those who argue the importance of menu costs push the idea that changing the prices of a good or service serves as an externality. By decreasing the cost of a good, the consumers’ real income increases, considering the good isn’t an inferior good, and the demand for the good in the entire industry will increase, as the average cost of the good in the industry slightly decreases.

Thus, one company decreasing its prices slightly stimulates the economy. However, companies typically do not account for such externality when deciding whether the costs to change the price are larger than the cost to not change it. Consequently, companies may not change their prices quickly to meet the changes in demand.

Imperfect Competition

Imperfect competition is another cause of market inefficiency that New Keynesian Economics explains. A study by Huw Dixon and Gregory Mankiw in the 1980s found that a fiscal multiplier could increase inefficiencies brought on by fiscal policy changes. In imperfect competition, i.e., a monopoly, fiscal policy doesn’t affect every company equally, resulting in the idea of a fiscal multiplier.

New Keynesian supporters argue that the reason a fiscal multiplier could increase inefficiencies is that real wages tend to decrease in imperfect competition and that households tend to choose leisure over consumption in imperfect competition.

Supporters further argue that when governments impose fiscal policy to increase spending, leisure and consumption both decrease, so households are working more but consuming less. Consequently, the greater imperfection in competition, the greater the fiscal multiplier.

Efficiency Wages

New Keynesian Economics argues that unemployment is caused by the efficiency in wages. Other macroeconomic theories argue that unemployment is a self-correcting mechanism where large labor supplies would put downward pressure on wages; consequently, as companies offer a lower wage, their demand for labor would increase, thus reducing the labor supply and unemployment.

However, New Keynesian Economics argues that wages drive worker productivity and efficiency. The effect of wages on productivity is what causes companies to not decrease their wages, which would reduce the labor supply and unemployment. Additionally, though decreasing wages may lead to lower wage costs for the company, decreasing the wages may also lower productivity, thus decreasing corporate profits.

In addition to higher wages increasing productivity, New Keynesian supporters also argue that higher wages decrease employee turnover. If wages are decreased, skilled employees of the company may leave to find a better wage elsewhere. Also, turnover is costly for companies due to the rehiring and retraining costs of new employees.

Additional Resources

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