Keynesian vs. Neo-Keynesian Economics: An Overview

Classical economic theory presumed that if demand for a commodity or service was raised, then prices would rise correspondingly and companies would increase output to meet public demand. The classical theory did not differentiate between microeconomics and macroeconomics.

However, during the Great Depression of the 1930s, the macroeconomy was in evident disequilibrium. This led John Maynard Keynes to write "The General Theory of Employment, Interest, and Money" in 1936, which played a large role in distinguishing the field of macroeconomics as distinct from microeconomics. The theory centers on the total spending of an economy and the implications of this on output and inflation.

Key Takeaways

  • Keynesian theory does not see the market as being able to naturally restore itself.
  • Neo-Keynesian theory focuses on economic growth and stability rather than full employment.
  • Neo-Keynesian theory identifies the market as not self-regulating.

Keynesian

One point of departure from classical Keynesian theory was that it did not see the market as possessing the capacity to restore itself to equilibrium naturally. For this reason, state regulations were imposed on the capitalist economy. Classic Keynesian theory only proposes sporadic and indirect state intervention.

Neo-Keynesian

Just as Keynes posited his theory in response to gaps in classical economic analysis, Neo-Keynesianism derives from observed differences between Keynes's theoretical postulations and real economic phenomena. The Neo-Keynesian theory was articulated and developed mainly in the U.S. during the post-war period. Neo-Keynesians did not place as heavy an emphasis on the concept of full employment but instead focused on economic growth and stability.

The reasons the Neo-Keynesians identified that the market was not self-regulating were manifold. First, monopolies may exist, which means the market is not competitive in a pure sense. This also means that certain companies have discretionary powers to set prices and may not wish to lower or raise prices during periods of fluctuations to meet demands from the public.

Labor markets are also imperfect. Second, trade unions and other companies may act according to individual circumstances, resulting in a stagnation in wages that does not reflect the actual conditions of the economy. Third, real interest rates may depart from natural interest rates as monetary authorities adjust the rates to avoid temporary instability in the macroeconomy.

The two major areas of microeconomics by Neo-Keynesians are price rigidity and wage rigidity.

In the 1960s, Neo-Keynesianism began to examine the microeconomic foundations that the macroeconomy depended on more closely. This led to a more integrated examination of the dynamic relationship between microeconomics and macroeconomics, which are two separate but interdependent strands of analysis.

The two major areas of microeconomics, which may significantly impact the macroeconomy as identified by Neo-Keynesians, are price rigidity and wage rigidity. Both of these concepts intertwine with social theory negating the pure theoretical models of classical Keynesianism.

For instance, in the case of wage rigidity, as well as influence from trade unions (which have varying degrees of success), managers may find it difficult to convince workers to take wage cuts on the basis that it will minimize unemployment, as workers may be more concerned about their own economic circumstances than more abstract principles. Lowering wages may also reduce productivity and morale, leading to overall lower output.