The Relative Successes and Shortcomings: New Keynesian Economics

Introduction

New Keynesian economics attempts to provide a microeconomic foundation for sticky wages and prices (Gartner, 2013). In macroeconomics, the 'Keynes versus Classics' debate began in the 1930s and has continued in various forms to this day. For instance, during the 'great inflation' of the 1970s, in the face of skepticism from the new classical real business cycle school, new Keynesians revised the underperforming Keynesian wage and price adjustment equations to account for the impact of inflation expectations and supply shocks on the Philips curve. In the 1980s, the debate between the neoclassical real equilibrium business cycle theorists and the New Keynesian School was the mainstream (Snowdon and Vane, 2005). Even if Lucas and Sargent et al. (no date, cited in Snowdon and Vane, 2005) argued that there are problems with the empirical basis of Keynesian models, it is undeniable that Keynesian economics is promising because it helps to explain and understand a large number of observations and experiences in the past and present, which cannot be achieved by other macroeconomic methods. Some economists even believe that Keynesian economics, which takes into account the fundamental truths contained in the neoclassical synthesis, can reassert its dominance over macroeconomics (Snowdon and Vane, 2005). This essay will critically discuss the progress and inadequacies of New Keynesian economics.

Progress of New Keynesian Economics

There is a huge difference between old and new Keynesian economics. New Keynesianism is 'new' because it has two characteristics. The first is that it starts from microeconomics, which means that the conditions are examined at the micro-level, then the aggregate output and the second is that it always employs rational expectations. But the new Keynesian economists claim to be “Keynesian”, not because they follow Keynes, but because they represent a new method to justify the old macro-statement. Essentially, new Keynesian economics recognized the importance of various defects in reality (Stiglitz, 2000, cited in Snowdon and Vane, 2005). Additionally, the difference between old and new Keynesians is that the latter tends to assume nominal rigidity, while the former tends to explain wages and price stickiness on the premise of an acceptable microscopic basis. The new Keynesian economists reconstructed Keynesian economics by taking advantage of the basis of modern microeconomic theory and aimed to perfect the theoretical flaws (due to the imperfections of the typical market economy, aggregate supply should vary with aggregate demand) in the supply side of 'old' Keynesian models. The development of New Keynesian economics was to deal with the crisis of Keynesian economic theory exposed by Lucas in the 1970s. Therefore, it can be said that the goal of the new Keynesian theorists was to correct the defects and contradictions of the old Keynesian model and construct a coherent total supply theory that can rationalize the rigidity of wages and prices (Snowdon and Vane, 2005). In Gordon's (1990, cited in Snowdon and Vane, 2005) words, it is to find a strict and convincing model of wage and/or price stickiness based on behavior maximization and rational expectations.

In some ways, new Keynesian economics may be more realistic than new classical economics. New classical economics assumes that the market continues to clear, and the economy is not constrained by the lack of effective demand. While the characteristic of Keynesian economics is that there is no continuous market clearing. In the old and new Keynesian models, the inability of prices to change in time to clear the market means that shocks to demand and supply would have a significant impact on output and employment. Keynesians believe that deviations from an equilibrium between output and employment can be severe and long-term, which can damage economic welfare (Snowdon and Vane, 2005). Gordon (1993, cited in Snowdon and Vane, 2005) argue that the attractiveness of Keynesian economics comes from the obvious dissatisfaction of workers and companies during recession and depression, that is, involuntary unemployment. New Keynesians argue that a theory of the business cycle based on the inability of markets to clear is more practical than neoclassical or real business cycle theory. New Keynesians believe that the business cycle theory on the basis of the inability of markets to clear is more practical than the new classical theory or the real business cycle theory (Snowdon and Vane, 2005).

Specifically, according to neoclassical monetary and real business cycle theory, all agents are price takers, and new classical economists believe that economic agents pursuing their own interests have rational expectations of the future and take corresponding actions. Thus, perfect, immediate price and wage flexibility ensure that any anticipated monetary shock will lead to an immediate jump in nominal wages and prices to a new equilibrium level, thereby maintaining output and employment, in which unemployment is a voluntary phenomenon. In other words, all monetary policy is basically unnecessary and ineffective in the economy. However, New Keynesian economics insists on the imperfection of the market (small menu costs, that is, the costs incurred by companies due to price changes, or micro-rigidity can lead to considerable macro stickiness.), and believes that price setters dominate the economy, and economy agents pursuing their own interests cannot see everything in the future and act accordingly. Thus, it is difficult for prices to adjust rapidly according to the changes of supply and demand, so as to achieve the purpose of market clearing. The model of real wage rigidity can generate involuntary unemployment in the long-term equilibrium. In an extremely laissez-faire market, it takes quite a long time for the economy to automatically move from non-equilibrium to equilibrium, which will cause the economy to suffer losses. Consequently, it is possible to say that government policy intervention is necessary and beneficial. As a result, the claims of new Keynesian economics may be more in line with the real world. This is because, although the new Keynesians agreed with some of the neoclassical explanations, the assumptions of neoclassical economics about the rational expectations of economic agents in economic activity were too harsh (Snowdon and Vane, 2005). According to Greenwald and Stiglitz (1993, cited in Snowdon and Vane, 2005), the new classical real business cycle theory is based on a micro-foundation, which assumes that there are no imperfect competition, incomplete markets, heterogeneous labor, and asymmetric information-related problems in the economy, but this can be said to be impossible in reality.

Finally, in explaining the stylized facts of the business cycle, it can be said that the New Keynesian model is relatively successful. Especially for economists who view involuntary unemployment as stylized facts and seek explanations, the new Keynesian theory based on imperfect competition may be superior to the new classical or real business cycle theory (Carlin and Soskice, 1990, cited in Snowdon and Vane, 2005).

Criticisms of New Keynesian Economics

The development of new Keynesian economics is because the traditional Keynesian model does not have a coherent microeconomic foundation for wages and price rigidity. But because of this, the exploration of new Keynesianism has been confined to theoretical categories, and empirical research is seriously insufficient (Snowdon and Vane, 2005). Fair (1992, cited in Snowdon and Vane, 2005) believes that the development of New Keynesian economics has made macroeconomics no longer limited to its econometric foundations. He also suggested that New Keynesians link all their views and integrate them into a verifiable macro-econometric structural model. Laidler (1992, cited in Snowdon and Vane, 2005) even urged the restoration of empirical evidence as to the focus of macroeconomic study. Nevertheless, new Keynesian economists can still refute that Blinder's (1991, 1994, cited in Snowdon and Vane, 2005) data analysis of the evidence of price stickiness, which can be viewed as stylized facts, is empirical research.

Additionally, in response to the skepticism of neoclassical economics, neo-Keynesian economics has a pathological insistence on the micro basis, which leads to the emergence of many irrelevant theories, which Blanchard (1992, cited in Snowdon and Vane, 2005) and other economists also admit to being a defect. And because there are too many explanations for wage and price inertia, New Keynesian economists cannot even reach a consensus on rigid sources and give a unified answer (Snowdon and Vane, 2005).

According to Snowdon and Vane (2005), the menu cost theory has also been questioned. It is suspected that the menu cost will lead to a substantial reduction in output and employment (Barro, 1989, cited in Snowdon and Vane, 2005). Caplin and Spulber's (1987, cited in Snowdon and Vane, 2005) research shows that menu costs may be important for individual companies, but may not cause overall macroeconomic fluctuations. In this regard, the New Keynesians believe that the development of actual rigid theory can expand the influence of nominal rigidity on output and employment (Romer, 2001, cited in Snowdon and Vane, 2005). In addition, models with menu costs (company costs due to price changes) will have multiple equilibriums. Rotemberg (1987, cited in Snowdon and Vane, 2005) pointed out that when multiple equilibriums emerge, it is difficult to know how the economy will respond to any particular government policy.

Tobin (1993, cited in Snowdon and Vane, 2005) believes that the theory of nominal and/or price rigidity in Keynesian economics is problematic. He argues that flexible wages and prices may worsen the recession, but he agrees that the nominal wage rigidity in Keynesian theory can mitigate the aggregate demand shock. However, Nominal wage rigidity is theoretically feasible, but because workers may treat nominal wages as real wage reductions (because workers cannot know the wage status of other groups of workers), this theory is resisted by rational workers (Snowdon and Vane, 2005). Summers (1988, cited in Snowdon and Vane, 2005) also proposed that the impact of relative wages will cause serious coordination problems. Greenwald and Stiglitz (1993, cited in Snowdon and Vane, 2005) even introduced a new Keynesian theory that emphasized the unstable effect of price flexibility.

Finally, Blinder (1992, cited in Snowdon and Vane, 2005) criticized the rational expectation hypothesis as unrealistic, and the relevant empirical data is also doubtful. While there is no better hypothesis than this. In addition to this, according to Davidson's (1994, cited in Snowdon and Vane, 2005) post-Keynesian view, new Keynesian economists have failed to understand the key points of Keynesian monetary theory. However, Mankiw (1992, cited in Snowdon and Vane, 2005) believes that the new Keynesian analysis does not need to be consistent with general theory.

Conclusion

According to Barro's (1989, cited in Snowdon and Vane, 2005) conclusion, even if the new Keynesian economics contains useful parts of the real business cycle, the new Keynesian economic model cannot repair the Keynesian method. However, Mankiw and Romer (1991, cited in Snowdon and Vane, 2005) come to the opposite conclusion, arguing that the new Keynesian theory has responded to the doubts raised by the new classical real business cycle theory and proves that Keynes's assumption of nominal rigidity has a theoretical basis. Keynesian economics has strong adaptability to new theories and new empirical evidence. It can continuously improve itself based on the development of microeconomics and macroeconomic theory (Shaw, 1988, cited in Snowdon and Vane, 2005). Keynesian economics has not only demonstrated its ability to absorb the nominal interest rate hypothesis of Taylor's rule and the expectations-augmented Phillips curve of the Calvo pricing model, but it has also managed to adapt to the rational expectations hypothesis and is based on the opinions and viewpoints of the real business cycle school (Ireland, 2004, cited in Snowdon and Vane, 2005). Although the opponents believe that the new Keynesian economic theory still presents new content in the old form (Snowdon and Vane, 2005), it cannot be denied that the new Keynesian economic theory has a positive impact on the development of macroeconomics.

References

• Gartner, M. (2013). Macroeconomics. Harlow, England: Pearson.
• Snowdon, B., & Vane, H. R. (2005). Modern macroeconomics: Its origins, development and current state. Cheltenham, UK: E. Elgar.