DEFINITION of 'New Keynesian Economics'

New Keynesian Economics is a modern macroeconomic school of thought that evolved from classical Keynesian economics. This revised theory differs from classical Keynesian thinking in terms of how quickly prices and wages adjust. New Keynesian advocates maintain that prices and wages are "sticky," meaning they adjust more slowly to short-term economic fluctuations. This, in turn, explains such economic factors as involuntary unemployment and the impact of federal monetary policies.

BREAKING DOWN 'New Keynesian Economics'

New Keynesian economics as a philosophy took root in the 1980s in response to the criticisms of many of Keynes' original precepts as espoused by classical economists in the previous decade.

The new Keynesian theory attempts to address, among other things, the sluggish behavior of prices and its cause. The theory explains how market failures could be caused by inefficiencies and might justify government intervention. The benefits of government intervention remains a flashpoint for debate.

Issues with New Keynesian Economics

The main issue of this economic doctrine is explaining why changes in aggregate price levels are “sticky.” While under New Classical Macroeconomics competitive price-taking firms make choices on how much output to produce, and not at what price, in New Keynesian Economics, monopolistically competitive firms set their prices and accept the level of sales as a constraint.

From a New Keynesian Economics point of view, two main arguments try to answer why aggregate prices fail to imitate the nominal GNP evolution. Principally, under both approaches to macroeconomics, it is assumed economic agents, households and firms have rational expectations. However, New Keynesian Economics maintains that rational expectations become distorted as market failure arises from asymmetric information and imperfect competition. As economic agents can’t have a full scope of the economic reality, their information will be limited, and there will be little reason to believe that other agents will change their prices, and therefore keep their expectations unchanged. As such, expectations are a crucial element of price determination; as they remain unaltered, so will price, which leads to price rigidity.

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