New Keynesian economics

Wage and price stickiness, and the other present descriptions of market failures in New Keynesian models, imply that the economy may fail to attain full employment.

The first model of Sticky information was developed by Stanley Fischer in his 1977 article, Long-Term Contracts, Rational Expectations, and the Optimal Money Supply Rule.

These early new Keynesian theories were based on the basic idea that, given fixed nominal wages, a monetary authority (central bank) can control the employment rate.

George Akerlof and Janet Yellen put forward the idea that due to bounded rationality firms will not want to change their price unless the benefit is more than a small amount.

Gregory Mankiw took the menu-cost idea and focused on the welfare effects of changes in output resulting from sticky prices.

For example, a firm can face real rigidities if it has market power or if its costs for inputs and wages are locked-in by a contract.

[20] Even if prices are perfectly flexible, imperfect competition can affect the influence of fiscal policy in terms of the multiplier.

Huw Dixon and Gregory Mankiw developed independently simple general equilibrium models showing that the fiscal multiplier could be increasing with the degree of imperfect competition in the output market.

[21][22] The reason for this is that imperfect competition in the output market tends to reduce the real wage, leading to the household substituting away from consumption towards leisure.

The greater the degree of imperfect competition in the output market, the lower the real wage and hence the more the reduction falls on leisure (i.e. households work more) and less on consumption.

As in other cases of coordination failure, Diamond's model has multiple equilibria, and the welfare of one agent is dependent on the decisions of others.

[36] For example, in developing countries, firms might pay more than a market rate to ensure their workers can afford enough nutrition to be productive.

[43] In the early 1990s, economists began to combine the elements of new Keynesian economics developed in the 1980s and earlier with Real Business Cycle Theory.

The new neoclassical synthesis essentially combined the dynamic aspects of RBC with imperfect competition and nominal rigidities of new Keynesian models.

In particular, the rule describes how, for each one-percent increase in inflation, the central bank tends to raise the nominal interest rate by more than one percentage point.

This culminated in the three-equation new Keynesian model found in the survey by Richard Clarida, Jordi Gali, and Mark Gertler in the Journal of Economic Literature.

Seminal papers were published by Frank Smets and Rafael Wouters[53][54] and also Lawrence J. Christiano, Martin Eichenbaum and Charles Evans[55] The common features of these models included: The idea of sticky information found in Fischer's model was later developed by Gregory Mankiw and Ricardo Reis.

[56] This added a new feature to Fischer's model: there is a fixed probability that a worker can replan their wages or prices each period.

Mankiw and Reis found that the model of sticky information provided a good way of explaining inflation persistence.

Sticky information models do not have nominal rigidity: firms or unions are free to choose different prices or wages for each period.

In addition to sticky prices, a typical HANK model features uninsurable idiosyncratic labor income risk which gives rise to a non-degenerate wealth distribution.

The direct corollary is that monetary policy is mostly transmitted via general equilibrium effects that work through the household labor income, rather than through intertemporal substitution, which is the main transmission channel in Representative Agent New Keynesian (RANK) models.

[69][70] Nonetheless, New Keynesian economists do not advocate using expansive monetary policy for short run gains in output and employment, as it would raise inflationary expectations and thus store up problems for the future.

[72] Further, while some macroeconomists believe that New Keynesian models are on the verge of being useful for quarter-to-quarter quantitative policy advice, disagreement exists.

[73] Alves (2014)[74] showed that the divine coincidence does not necessarily hold in the non-linear form of the standard New-Keynesian model.

At any other desired target for the inflation rate, there is an endogenous trade-off, even under the absence real imperfections such as sticky wages, and the divine coincidence no longer holds.

The idea was that the government and the central bank would maintain rough full employment, so that neoclassical notions—centered on the axiom of the universality of scarcity—would apply.

Later work by economists such as James Tobin and Franco Modigliani involving more emphasis on the microfoundations of consumption and investment was sometimes called neo-Keynesianism.

It is often contrasted with the post-Keynesianism of Paul Davidson, which emphasizes the role of fundamental uncertainty in economic life, especially concerning issues of private fixed investment.

Whereas the neoclassical synthesis hoped that fiscal and monetary policy would maintain full employment, the new classicals assumed that price and wage adjustment would automatically attain this situation in the short run.