New Keynesian economics emerged in the 1980s as a response to the Lucas critique and the rational expectations revolution led by New Classical economists such as Robert Lucas, Thomas Sargent, and Edward Prescott. Earlier Keynesian models had been criticized for lacking microfoundations — that is, for assuming aggregate relationships (like the original Phillips curve) without deriving them from the optimizing behavior of households and firms. New Keynesians accepted the methodological demand for microfoundations but rejected the New Classical conclusion that markets clear continuously and that monetary policy is neutral.
The defining feature of the school is nominal rigidity: prices and wages do not adjust instantly to shocks. This is typically modeled through staggered price-setting, most famously the Calvo (1983) pricing mechanism, in which a fraction of firms can reset prices each period, or via menu-cost models associated with N. Gregory Mankiw and others. Because some prices are sticky, changes in nominal aggregate demand — including monetary policy — have real effects on output and employment in the short run.
Core building blocks of the standard New Keynesian model include:
- A dynamic IS curve derived from intertemporal household optimization (the Euler equation).
- A New Keynesian Phillips Curve linking current inflation to expected future inflation and the output gap.
- A monetary policy rule, often a Taylor-type interest rate rule.
Key contributors include Mankiw, David Romer, Olivier Blanchard, Stanley Fischer, John Taylor, Michael Woodford, and Jordi Galí. Woodford's Interest and Prices (2003) and Galí's Monetary Policy, Inflation, and the Business Cycle (2008) are standard references.
The framework underpins most modern DSGE models used at central banks including the Federal Reserve, ECB, and Bank of England. It justifies inflation targeting, forward guidance, and countercyclical policy, and it has been extended to incorporate financial frictions and heterogeneous agents (HANK models) following the 2008 global financial crisis.
Example
When the European Central Bank used forward guidance during the 2010s to anchor inflation expectations, it relied on New Keynesian models in which sticky prices give monetary policy real short-run traction.
Frequently asked questions
Old Keynesian models assumed sticky prices and wages without deriving them from optimizing behavior. New Keynesians retain stickiness but build it on explicit microfoundations with rational expectations.
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