Neo-Keynesian Economics

Neo-Keynesian Economics

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Neo-Keynesian economics is a school of macroeconomic
Macroeconomics
Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of the whole economy. This includes a national, regional, or global economy...

 thought that was developed in the post-war period from the writings of John Maynard Keynes
John Maynard Keynes
John Maynard Keynes, Baron Keynes of Tilton, CB FBA , was a British economist whose ideas have profoundly affected the theory and practice of modern macroeconomics, as well as the economic policies of governments...

. A group of economists (notably John Hicks
John Hicks
Sir John Richard Hicks was a British economist and one of the most important and influential economists of the twentieth century. The most familiar of his many contributions in the field of economics were his statement of consumer demand theory in microeconomics, and the IS/LM model , which...

, Franco Modigliani
Franco Modigliani
Franco Modigliani was an Italian economist at the MIT Sloan School of Management and MIT Department of Economics, and winner of the Nobel Memorial Prize in Economics in 1985.-Life and career:...

, and Paul Samuelson
Paul Samuelson
Paul Anthony Samuelson was an American economist, and the first American to win the Nobel Memorial Prize in Economic Sciences. The Swedish Royal Academies stated, when awarding the prize, that he "has done more than any other contemporary economist to raise the level of scientific analysis in...

), attempted to interpret and formalize Keynes' writings, and to synthesize it with the neo-classical models of economics. Their work has become known as the neo-classical synthesis, and created the models that formed the core ideas of neo-Keynesian economics. These ideas dominated mainstream economics in the post-war period, and formed the mainstream of macroeconomic thought in the 1950s, 60s and 70s.

In the 1970s a series of developments occurred that shook neo-Keynesian theory. The advent of stagflation
Stagflation
In economics, stagflation is a situation in which the inflation rate is high and the economic growth rate slows down and unemployment remains steadily high...

, and the work of monetarists
Monetarism
Monetarism is a tendency in economic thought that emphasizes the role of governments in controlling the amount of money in circulation. It is the view within monetary economics that variation in the money supply has major influences on national output in the short run and the price level over...

 like Milton Friedman
Milton Friedman
Milton Friedman was an American economist, statistician, academic, and author who taught at the University of Chicago for more than three decades...

, cast doubt on neo-Keynesian theories. The result would be a series of new ideas to bring tools to Keynesian analysis that would be capable of explaining the economic events of the 1970s. The next great wave of Keynesian thinking began with the attempt to give Keynesian macroeconomic reasoning a microeconomic basis. The new Keynesian
New Keynesian economics
New Keynesian economics is a school of contemporary macroeconomics that strives to provide microeconomic foundations for Keynesian economics. It developed partly as a response to criticisms of Keynesian macroeconomics by adherents of New Classical macroeconomics.Two main assumptions define the New...

s helped create a "new neo-classical synthesis" that currently forms the mainstream of macroeconomic theory. Following the emergence of the new Keynesian school, neo-Keynesians have sometimes been referred to as Old-Keynesians.

Origins


John Maynard Keynes
John Maynard Keynes
John Maynard Keynes, Baron Keynes of Tilton, CB FBA , was a British economist whose ideas have profoundly affected the theory and practice of modern macroeconomics, as well as the economic policies of governments...

 provided the framework for synthesizing a host of economic ideas present between 1900 and 1940, and that synthesis bears his name, as is generally known as Keynesian economics
Keynesian economics
Keynesian economics is a school of macroeconomic thought based on the ideas of 20th-century English economist John Maynard Keynes.Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses by the...

. The first generation of Keynesians were focused on unifying the ideas into workable paradigms, combining them with ideas from classical economics
Classical economics
Classical economics is widely regarded as the first modern school of economic thought. Its major developers include Adam Smith, Jean-Baptiste Say, David Ricardo, Thomas Malthus and John Stuart Mill....

 and the writings of Alfred Marshall
Alfred Marshall
Alfred Marshall was an Englishman and one of the most influential economists of his time. His book, Principles of Economics , was the dominant economic textbook in England for many years...

. These neo-Keynesians generally looked at labor contracts and as a source of price and wage stickiness to generate equilibrium models of unemployment. Their efforts (known as the neo-classical synthesis) resulted in the development of the IS/LM model
IS/LM model
The IS/LM model is a macroeconomic tool that demonstrates the relationship between interest rates and real output in the goods and services market and the money market...

, and other formalizations of Keynes' ideas. This intellectual program would produce eventually monetarism
Monetarism
Monetarism is a tendency in economic thought that emphasizes the role of governments in controlling the amount of money in circulation. It is the view within monetary economics that variation in the money supply has major influences on national output in the short run and the price level over...

 and other versions of Keynesian macroeconomics in the 1960s.

Neoclassical synthesis



After Keynes, Keynesian analysis was combined with classical economics to produce what is generally termed "the neoclassical synthesis
Neoclassical synthesis
Neoclassical synthesis is a postwar academic movement in economics that attempts to absorb the macroeconomic thought of John Maynard Keynes into the thought of neoclassical economics...

" which dominates mainstream macroeconomic thought. Though it was widely held that there was no strong automatic tendency to full employment, many believed that if government policy were used to ensure it, the economy would behave as classical or neoclassical theory predicted.

In the post-World War II
World War II
World War II, or the Second World War , was a global conflict lasting from 1939 to 1945, involving most of the world's nations—including all of the great powers—eventually forming two opposing military alliances: the Allies and the Axis...

 years, Keynes's policy ideas were widely accepted. For the first time, governments prepared good quality economic statistics on an ongoing basis and a theory that told them what to do. In this era of New Deal liberalism
New liberalism
New Liberalism is a book by Matthew Kalkman that examines the evolution of Liberalism from its early beginnings to its potential future incarnations. The author argues that New Liberalism is the next step in this evolution: the notion that, in order for a society to be maintained and to evolve, it...

 and social democracy
Social democracy
Social democracy is a political ideology of the center-left on the political spectrum. Social democracy is officially a form of evolutionary reformist socialism. It supports class collaboration as the course to achieve socialism...

, most western capitalist
Capitalism
Capitalism is an economic system that became dominant in the Western world following the demise of feudalism. There is no consensus on the precise definition nor on how the term should be used as a historical category...

 countries enjoyed low, stable unemployment and modest inflation.

It was with John Hicks
John Hicks
Sir John Richard Hicks was a British economist and one of the most important and influential economists of the twentieth century. The most familiar of his many contributions in the field of economics were his statement of consumer demand theory in microeconomics, and the IS/LM model , which...

 that Keynesian economics produced a clear model
Model (economics)
In economics, a model is a theoretical construct that represents economic processes by a set of variables and a set of logical and/or quantitative relationships between them. The economic model is a simplified framework designed to illustrate complex processes, often but not always using...

 which policy-makers could use to attempt to understand and control economic activity. This model, the IS/LM model
IS/LM model
The IS/LM model is a macroeconomic tool that demonstrates the relationship between interest rates and real output in the goods and services market and the money market...

, is nearly as influential as Keynes' original analysis in determining actual policy and economics education. It relates aggregate demand and employment to three exogenous
Exogenous
Exogenous refers to an action or object coming from outside a system. It is the opposite of endogenous, something generated from within the system....

 quantities, i.e., the amount of money
Money
Money is any object or record that is generally accepted as payment for goods and services and repayment of debts in a given country or socio-economic context. The main functions of money are distinguished as: a medium of exchange; a unit of account; a store of value; and, occasionally in the past,...

 in circulation, the government budget, and the state of business expectations. This model was very popular with economists after World War II because it could be understood in terms of general equilibrium theory. This encouraged a much more static vision of macroeconomics than that described above.
The second main part of a Keynesian policy-maker's theoretical apparatus was the Phillips curve
Phillips curve
In economics, the Phillips curve is a historical inverse relationship between the rate of unemployment and the rate of inflation in an economy. Stated simply, the lower the unemployment in an economy, the higher the rate of inflation...

. This curve, which was more of an empirical observation than a theory, indicated that increased employment, and decreased unemployment
Unemployment
Unemployment , as defined by the International Labour Organization, occurs when people are without jobs and they have actively sought work within the past four weeks...

, implied increased inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...

. Keynes had only predicted that falling unemployment would cause a higher price, not a higher inflation rate
Inflation rate
In economics, the inflation rate is a measure of inflation, the rate of increase of a price index . It is the percentage rate of change in price level over time. The rate of decrease in the purchasing power of money is approximately equal.The inflation rate is used to calculate the real interest...

. Thus, the economist could use the IS/LM model to predict, for example, that an increase in the money supply would raise output and employment—and then use the Phillips curve to predict an increase in inflation.

The strength of Keynesianism's influence can be seen by the wave of economists which began in the late 1940s with Milton Friedman
Milton Friedman
Milton Friedman was an American economist, statistician, academic, and author who taught at the University of Chicago for more than three decades...

. Instead of rejecting macro-measurements and macro-models of the economy, they embraced the techniques of treating the entire economy as having a supply and demand equilibrium. But unlike the Keynesians, they argued that "crowding out" effects would hobble or deprive fiscal policy of its positive effect. Instead, the focus should be on monetary policy, which was largely ignored by early Keynesians. The monetarist critique pushed Keynesians toward a more balanced view of monetary policy, and inspired a wave of revisions to Keynesian theory.

Through the 1950s, moderate degrees of government demand leading industrial development, and use of fiscal and monetary counter-cyclical policies continued, and reached a peak in the "go go" 1960s, where it seemed to many Keynesians that prosperity was now permanent. However, with the oil shock of 1973, and the economic problems of the 1970s, modern liberal economics began to fall out of favor. During this time, many economies experienced high and rising unemployment, coupled with high and rising inflation, contradicting the Phillips curve's prediction. This stagflation
Stagflation
In economics, stagflation is a situation in which the inflation rate is high and the economic growth rate slows down and unemployment remains steadily high...

 meant that both expansionary (anti-recession) and contractionary (anti-inflation) policies had to be applied simultaneously, a clear impossibility. This dilemma led to the rise of ideas based upon more classical analysis, including monetarism
Monetarism
Monetarism is a tendency in economic thought that emphasizes the role of governments in controlling the amount of money in circulation. It is the view within monetary economics that variation in the money supply has major influences on national output in the short run and the price level over...

, supply-side economics
Supply-side economics
Supply-side economics is a school of macroeconomic thought that argues that economic growth can be most effectively created by lowering barriers for people to produce goods and services, such as lowering income tax and capital gains tax rates, and by allowing greater flexibility by reducing...

 and new classical economics. This produced a "policy bind" and the collapse of the Keynesian consensus on the economy.

New Keynesian economics


Through the 1980s Keynesian macro-economics fell out of fashion as a policy tool, and as a field of study. Instead it was felt that combining economics with behavioral science, game theory and monetary theory were more important areas of study. On the policy level it was the era of Margaret Thatcher
Margaret Thatcher
Margaret Hilda Thatcher, Baroness Thatcher, was Prime Minister of the United Kingdom from 1979 to 1990...

 and Ronald Reagan
Ronald Reagan
Ronald Wilson Reagan was the 40th President of the United States , the 33rd Governor of California and, prior to that, a radio, film and television actor....

, who advocated slashing the size of the non-military government sector. However, beginning in the late 1980s economics began shifting back to a study of macro-economics, and policy makers began to look for means of managing the global financial network, which was increasingly interlinked.

In the 1990s the "uncoupling" of money supply and inflation caused an increasing questioning of the original form of monetarism. The repeated failures of "big bang" marketization in the former Soviet Bloc have encouraged the recent revival in Keynesian ideas, with particular emphasis on giving the Keynesian macroeconomic analysis theoretically sound foundations in microeconomics. These theories have been called new Keynesian economics
New Keynesian economics
New Keynesian economics is a school of contemporary macroeconomics that strives to provide microeconomic foundations for Keynesian economics. It developed partly as a response to criticisms of Keynesian macroeconomics by adherents of New Classical macroeconomics.Two main assumptions define the New...

. The heart of the new Keynesian view rests on microeconomic models that indicate that nominal wages and prices are "sticky," i.e., do not change easily or quickly with changes in supply and demand, so that quantity adjustment
Quantity adjustment
In economics, the concept of quantity adjustment refers to one possible result of supply and demand disequilibrium in a market, either due to or in the absence of external constraints on the market...

 prevails. This, according to economist Paul Krugman
Paul Krugman
Paul Robin Krugman is an American economist, professor of Economics and International Affairs at the Woodrow Wilson School of Public and International Affairs at Princeton University, Centenary Professor at the London School of Economics, and an op-ed columnist for The New York Times...

, "works beautifully in practice but very badly in theory." This integration is further spurred by work of other economists which questions rational decision-making in a perfect information environment as a necessity for micro-economic theory. Imperfect decision making such as that investigated by Joseph Stiglitz underlines the importance of management of risk in the economy.

New classical economics relied on the theory of rational expectations
Rational expectations
Rational expectations is a hypothesis in economics which states that agents' predictions of the future value of economically relevant variables are not systematically wrong in that all errors are random. An alternative formulation is that rational expectations are model-consistent expectations, in...

 to reject Keynesian economics. Most well-known is the critique by Robert Lucas
Robert Lucas, Jr.
Robert Emerson Lucas, Jr. is an American economist at the University of Chicago. He received the Nobel Prize in Economics in 1995 and is consistently indexed among the top 10 economists in the Research Papers in Economics rankings. He is married to economist Nancy Stokey.He received his B.A. in...

, who argues that rational expectations will defeat any monetary or fiscal policy. But new Keynesians argue that this critique only works if the economy has a unique equilibrium
Underemployment equilibrium
In Keynesian economics, underemployment equilibrium refers to a situation with a persistent shortfall relative to full employment and potential output so that unemployment is higher than at the NAIRU or the "natural" rate of unemployment. This situation is not seen as solvable via laissez-faire...

 at full employment
Full employment
In macroeconomics, full employment is a condition of the national economy, where all or nearly all persons willing and able to work at the prevailing wages and working conditions are able to do so....

. Price stickiness means that there are a variety of possible equilibria in the short run, so that rational expectations models do not produce any simple result.

In the end, many macroeconomists have returned to the IS/LM model
IS/LM model
The IS/LM model is a macroeconomic tool that demonstrates the relationship between interest rates and real output in the goods and services market and the money market...

 and the Phillips curve
Phillips curve
In economics, the Phillips curve is a historical inverse relationship between the rate of unemployment and the rate of inflation in an economy. Stated simply, the lower the unemployment in an economy, the higher the rate of inflation...

 as a first approximation of how an economy works. New versions of the Phillips curve, such as the "Triangle Model
Triangle model
In macroeconomics, the triangle model employed by new Keynesian economics is a model of inflation derived from the Phillips Curve and given its name by Robert J. Gordon. The model views inflation as having three root causes: built-in inflation, demand-pull inflation, and cost-push inflation...

", allow for stagflation, since the curve can shift due to supply shocks or changes in built-in inflation
Built-in inflation
Built-in inflation is a type of inflation that results from past events and persists in the present.Built-in inflation is one of three major determinants of the current inflation rate. In Robert J. Gordon's triangle model of inflation, the current inflation rate equals the sum of demand-pull...

. In the 1990s, the original ideas of "full employment" had been replaced by the NAIRU
NAIRU
In monetarist economics, particularly the work of Milton Friedman, on which also worked Lucas Papademos and Franco Modigliani in 1975,NAIRU is an acronym for Non-Accelerating Inflation Rate of Unemployment, and refers to a level of unemployment below which inflation rises.It is widely used in...

 theory, sometimes called the "natural rate of unemployment." This theory pointed to the dangers of getting unemployment too low, because accelerating inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...

 can result. However, it is unclear exactly what the value of the NAIRU is – or whether it really exists or not. While the Keynesian triumphalism of the 1960s is certainly not due for a revival, Keynesian ideas persist, often used to attain very conservative goals .

For a relatively open economy this simple Keynesianism must be complemented by considerations of foreign exchange market
Foreign exchange market
The foreign exchange market is a global, worldwide decentralized financial market for trading currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends...

s, exchange rate
Exchange rate
In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...

s, and the balance of payments
Balance of payments
Balance of payments accounts are an accounting record of all monetary transactions between a country and the rest of the world.These transactions include payments for the country's exports and imports of goods, services, financial capital, and financial transfers...

. Also needed is an understanding of issues of long-term growth of potential
Economic growth
In economics, economic growth is defined as the increasing capacity of the economy to satisfy the wants of goods and services of the members of society. Economic growth is enabled by increases in productivity, which lowers the inputs for a given amount of output. Lowered costs increase demand...

. The open economy considerations which were the basis of the conservative or neo-liberal revival of policy, were then codified by Keynesian economists.