New Keynesian economics, which was developed during the 1980's, is different from Keynesian economics in that it incorporates some New Classical precepts into the old Keynesian model.
The primary difference between New Keynesian and New Classical thought is the degree of wage and price flexibility. According to N. Gregory Mankiw in Fortune, New Classical economists "believe that prices "clear" markets--balance supply and demand--by adjusting quickly. New Keynesian economists, however, believe that market-clearing models cannot explain short-run economic fluctuations, and so they advocate models with "sticky" wages and prices. New Keynesian theories rely on this stickiness of wages and prices to explains why involuntary unemployment exists and why monetary policy has such a strong influence on economic activity." Among the reasons for sticky prices is the "aggregate-demand" externalities due to menu costs, which is the cost for a business to change prices. The instance given by Mankiw is the benefits bestowed on other firms when one firm lowers its prices. "When a firm lowers the price it charges, it lowers the average price level slightly and thereby raises real income. (Nominal income is determined by the money supply.) The stimulus from higher income, in turn, raises the demand for the products of all firms....it is the presence of this externality that causes price stickiness. Another critical element of New Keynesian thought, according to Mankiw, "has been the development of new theories of unemployment...Normally, economists presume that an excess supply of labor would exert a downward pressure on wages. A reduction in wages would, in turn, reduce unemployment by raising the quantity of labor demanded....New Keynesian economists often turn to theories of what they call efficiency wages to explain why this market-clearing mechanism may fail. These theories hold that high wages make employees more productive. The influence of wages on worker efficiency may explain the failure of firms to cut wages despite an excess supply of labor."
Because recessions are due to market failures, New Keynesian economists are proponents of governmental intervention into the economy when circumstances dictate it.
Click on the icon to return to the
list of economic theories.
