Neo-Keynesian Economics - New Keynesian Economics

New Keynesian Economics

Through the 1980s Keynesian macro-economics fell out of fashion as a policy tool, and as a field of study. Instead it was felt that combining economics with behavioral science, game theory and monetary theory were more important areas of study. On the policy level it was the era of Margaret Thatcher and Ronald Reagan, who advocated slashing the size of the non-military government sector. However, beginning in the late 1980s economics began shifting back to a study of macro-economics, and policy makers began to look for means of managing the global financial network, which was increasingly interlinked.

In the 1990s the "uncoupling" of money supply and inflation caused an increasing questioning of the original form of monetarism. The repeated failures of "big bang" marketization in the former Soviet Bloc have encouraged the recent revival in Keynesian ideas, with particular emphasis on giving the Keynesian macroeconomic analysis theoretically sound foundations in microeconomics. These theories have been called new Keynesian economics. The heart of the new Keynesian view rests on microeconomic models that indicate that nominal wages and prices are "sticky," i.e., do not change easily or quickly with changes in supply and demand, so that quantity adjustment prevails. This, according to economist Paul Krugman, "works beautifully in practice but very badly in theory." This integration is further spurred by work of other economists which questions rational decision-making in a perfect information environment as a necessity for micro-economic theory. Imperfect decision making such as that investigated by Joseph Stiglitz underlines the importance of management of risk in the economy.

New classical economics relied on the theory of rational expectations to reject Keynesian economics. Most well-known is the critique by Robert Lucas, who argues that rational expectations will defeat any monetary or fiscal policy. But new Keynesians argue that this critique only works if the economy has a unique equilibrium at full employment. Price stickiness means that there are a variety of possible equilibria in the short run, so that rational expectations models do not produce any simple result.

In the end, many macroeconomists have returned to the IS/LM model and the Phillips curve as a first approximation of how an economy works. New versions of the Phillips curve, such as the "Triangle Model", allow for stagflation, since the curve can shift due to supply shocks or changes in built-in inflation. In the 1990s, the original ideas of "full employment" had been replaced by the NAIRU theory, sometimes called the "natural rate of unemployment." This theory pointed to the dangers of getting unemployment too low, because accelerating inflation can result. However, it is unclear exactly what the value of the NAIRU is – or whether it really exists or not. While the Keynesian triumphalism of the 1960s is certainly not due for a revival, Keynesian ideas persist, often used to attain very conservative goals.

For a relatively open economy this simple Keynesianism must be complemented by considerations of foreign exchange markets, exchange rates, and the balance of payments. Also needed is an understanding of issues of long-term growth of potential. The open economy considerations which were the basis of the conservative or neo-liberal revival of policy, were then codified by Keynesian economists.