New Keynesian economics
In the late 1970s, Stanley Fischer published an article titled Long-Term Contracts, Rational Expectations, and the Optimal Money Supply Rule. This work introduced a staggered contract model where two unions take turns setting wages for the next two periods. The Federal Reserve Bank of Richmond later noted that this approach contrasted sharply with John B. Taylor's earlier models from 1979 and 1980. Taylor argued that nominal wages remained constant over the entire contract life. Both Fischer and Taylor agreed that only current wage setters used the latest information while half the economy relied on old data. These early theories established that fixed nominal wages allowed monetary authorities to control employment rates by adjusting money supply. Critics like Robert Lucas had previously challenged Keynesian economics using rational expectations. New Keynesians responded by building microeconomic foundations into their models to explain why markets might fail to clear instantly.
George Akerlof and Janet Yellen proposed in 1985 that bounded rationality caused firms to avoid changing prices unless benefits exceeded small thresholds. Gregory Mankiw expanded this concept through menu costs, which represent lump-sum expenses incurred when altering price tags. Olivier Blanchard and Nobuhiro Kiyotaki extended these ideas to include both wages and prices in their influential article Monopolistic Competition and the Effects of Aggregate Demand. Laurence Ball and David Romer demonstrated in 1990 how real rigidities interacted with nominal ones to create significant disequilibrium. Real rigidities occur whenever a firm remains slow to adjust its actual prices despite changing economic conditions. Huw Dixon showed that even if menu costs applied to just one sector, they influenced the rest of the economy. This interaction made prices less responsive to demand changes across the entire market. The fiscal multiplier increased with the degree of imperfect competition found in output markets. When government spending rose, higher taxes reduced leisure and consumption simultaneously. Households substituted away from work toward leisure as real wages fell under imperfect competition.
Guillermo Calvo published Staggered Prices in a Utility-Maximizing Framework in 1983 using continuous time mathematics. Modern versions now rely on discrete time calculations where firms face a probability called the hazard rate for resetting prices. This survival rate determines whether a price stays unchanged during any given period. Tack Yun became one of the first economists to combine Calvo pricing with Real Business Cycle Theory in 1996. Goodfriend and King outlined four central elements for this new synthesis: intertemporal optimization, rational expectations, imperfect competition, and costly price adjustment. Richard Clarida, Jordi Galí, and Mark Gertler consolidated these ideas into a three-equation model published in the Journal of Economic Literature in 2000. Frank Smets and Rafael Wouters developed complex Dynamic Stochastic General Equilibrium models in 2007 featuring habit persistence and capital adjustment costs. Lawrence Christiano, Martin Eichenbaum, and Charles Evans contributed similar frameworks emphasizing monetary policy representation through Taylor rules. These sophisticated models incorporated sticky information alongside traditional sticky prices to better match empirical evidence from countries like the United States and the Eurozone.
Greg Kaplan, Benjamin Moll, and Gianluca Violante coined the term HANK model in their 2018 paper describing households accumulating two distinct asset types. One asset remained liquid while another stayed illiquid, creating rich heterogeneity in portfolio composition across different families. About two-thirds of hand-to-mouth households held non-trivial amounts of illiquid wealth despite possessing little cash on hand. Oh and Reis introduced uninsurable idiosyncratic labor income risk in 2012, giving rise to non-degenerate wealth distributions. McKay and Reis followed with similar approaches in 2016, while Guerrieri and Lorenzoni added further complexity in 2017. Monetary policy transmission worked primarily through household labor income rather than intertemporal substitution for these wealthy hand-to-mouth groups. Changes in interest rates shifted government budget constraints, affecting disposable income directly. Aggregate monetary shocks proved distributional neutral since they impacted returns on capital differently depending on existing wealth levels. This failure of Ricardian Equivalence meant monetary policy interacted strongly with fiscal decisions during economic fluctuations.
John B Taylor formulated his eponymous rule in 1993 as a reduced form approximation of central bank responsiveness to inflation and output changes. The Taylor principle describes how nominal interest rates rise by more than one percentage point for each percent increase in inflation. Goodfriend and King found that consensus models produced specific policy implications regarding short-run versus long-run neutrality. Blanchard and Galí identified what they called the divine coincidence where stabilizing inflation also maximized employment stability. However, models containing multiple market imperfections revealed tradeoffs between stabilizing prices and jobs instead of perfect alignment. Alves demonstrated in 2014 that this property failed to hold in non-linear forms unless inflation targets remained exactly zero. Federal Reserve Bank of Minneapolis published warnings in July 2008 stating New Keynesian models were not yet useful for quarter-to-quarter quantitative advice. Studies focused on optimal rules reacting to output gaps rather than raw output figures themselves. Central banks maintained credibility through rules-based policies like inflation targeting while avoiding expansive measures designed solely for temporary booms.
Paul Samuelson originally used the term neoclassical synthesis after World War II to describe integrating Keynesian economics with neoclassical principles. John Hicks developed the IS/LM model which became central to early versions of this synthesis. James Tobin and Franco Modigliani later emphasized microfoundations of consumption and investment in neo-Keynesianism. Robert Lucas criticized these approaches using rational expectations concepts during the new classical school era. The new neoclassical synthesis emerged in the 1990s combining dynamic aspects of Real Business Cycle Theory with imperfect competition features from New Keynesian frameworks. This merger formed the theoretical basis of mainstream macroeconomics today. IMF economists Antonio Spilimbergo, Steve Symansky, Olivier Blanchard, and Carlo Cottarelli highlighted centralized coordination importance during the 2008 global financial crisis. Donald Markwell contributed further analysis showing how international institutions like the World Bank supported controlled trading systems. The resolution between new classical and New Keynesian schools occurred when both accepted that long-run neutrality held true despite short-run price stickiness.
Common questions
What is New Keynesian economics and when did it emerge?
New Keynesian economics emerged in the 1970s as a response to rational expectations challenges from Robert Lucas. It builds microeconomic foundations into models to explain why markets fail to clear instantly due to price stickiness.
Who developed the Taylor rule and what does it describe about interest rates?
John B Taylor formulated his eponymous rule in 1993 as a reduced form approximation of central bank responsiveness to inflation and output changes. The Taylor principle describes how nominal interest rates rise by more than one percentage point for each percent increase in inflation.
How do menu costs affect economic behavior according to Gregory Mankiw and others?
Gregory Mankiw expanded the concept through menu costs which represent lump-sum expenses incurred when altering price tags. These costs cause firms to avoid changing prices unless benefits exceed small thresholds creating significant disequilibrium across the market.
What is the HANK model and who coined the term in 2018?
Greg Kaplan Benjamin Moll and Gianluca Violante coined the term HANK model in their 2018 paper describing households accumulating two distinct asset types. One asset remained liquid while another stayed illiquid creating rich heterogeneity in portfolio composition across different families.
When did New Keynesian economics become part of mainstream macroeconomics?
The new neoclassical synthesis emerged in the 1990s combining dynamic aspects of Real Business Cycle Theory with imperfect competition features from New Keynesian frameworks. This merger formed the theoretical basis of mainstream macroeconomics today after resolving differences between schools regarding long-run neutrality.
All sources
51 references cited across the entry
- 1bookSurfing EconomicsHuw Dixon
- 5journalThe State of New Keynesian Economics: A Partial AssessmentJordi Galí — 2018
- 6journalLong-Term Contracts, Rational Expectations, and the Optimal Money Supply RuleS. Fischer — 1977
- 7journalStaggered wage setting in a macro modelJohn B Taylor — 1979
- 8journalAggregate Dynamics and Staggered ContractsJohn B Taylor — 1980
- 9journalA Quick Refresher Course in MacroeconomicsN. Gregory Mankiw — 1990
- 10bookSurfing Economics: Essays for the Inquiring EconomistHuw Dixon — Palgrave — 2001
- 11journalInflation and Costs of Price AdjustmentEytan Sheshinski et al. — 1977
- 12journalCan Small Deviations from Rationality Make Significant Differences to Economic Equilibria?George A. Akerlof et al. — 1985
- 13journalA Near-rational Model of the Business Cycle, with Wage and Price InertiaGeorge A. Akerlof et al. — 1985
- 14journalSmall Menu Costs and Large Business Cycles: A Macroeconomic Model of MonopolyN. Gregory Mankiw — 1985
- 15journalThe Output-Inflation Trade-off When Prices Are Costly to ChangeMichael Parkin — 1986
- 16journalMonopolistic Competition and the Effects of Aggregate DemandO. Blanchard et al. — 1987
- 17journalA Mixed Industrial Structure Magnifies the Importance of Menu CostsHuw Dixon et al. — 1999
- 18journalFiscal Policy Under Imperfect Competition with Flexible Prices: An Overview and SurveyL. Costa et al. — 2011
- 19journalStaggered Prices in a Utility-Maximizing FrameworkGuillermo A Calvo — 1983
- 20journalCoordinating Coordination Failures in Keynesian ModelsRussel Cooper et al. — 1988
- 21journalAggregate Demand Management in Search EquilibriumPeter A. Diamond — 1982
- 22journalEquilibrium Unemployment as a Worker Discipline DeviceC. Shapiro et al. — 1984
- 23journalDiscretion versus Policy Rules in PracticeJohn B. Taylor — 1993
- 24journalNew Keynesian Economics and the Phillips CurveJohn M. Roberts — 1995
- 25bookAdvanced MacroeconomicsDavid Romer — McGraw-Hill Irwin — 2012
- 26journalMonetary Policy Rules and Macroeconomic Stability: Evidence and Some TheoryRichard Clarida et al. — 2000
- 27journalAn Estimated Dynamic Stochastic General Equilibrium Model of the Euro AreaFrank Smets et al. — 2003
- 28journalNominal rigidities and the dynamic effects of a shock to monetary policyLawrence Christiano et al. — 2005
- 29journalSticky Information Versus Sticky Prices: A Proposal To Replace The New Keynesian Phillips CurveN. G. Mankiw et al. — 2002
- 30journalNew Keynesian Models: Not Yet Useful for Policy AnalysisV. V. Chari et al. — 2008
- 31journalA Tale of Two Rigidities: Sticky Prices in a Sticky-Information EnvironmentEdward S. II Knotec — 2010
- 32journalState-Dependent or Time-Dependent Pricing: Does It Matter For Recent U.S. Inflation?Peter J. Klenow et al. — 2008
- 33journalSticky Prices in the Euro Area: A Summary of New Micro-EvidenceLuis J. Álvarez et al. — 2006
- 34journalExamining The Behaviour Of Individual UK Consumer PricesPhilip Bunn et al. — 2012
- 35journalIntegrating Sticky Prices and Sticky InformationBill Dupor et al. — 2010
- 36journalTargeted Transfers and the Fiscal Response to the Great RecessionHyunseung Oh et al. — February 2011
- 37journalOptimal Automatic StabilizersAlisdair McKay et al. — June 2016
- 38journalCredit Crises, Precautionary Savings, and the Liquidity TrapVeronica Guerrieri et al. — 1 August 2017
- 39journalMonetary Policy According to HANKGreg Kaplan et al. — March 2018
- 41journalA Model of the Consumption Response to Fiscal Stimulus PaymentsGreg Kaplan et al. — 2014
- 42journalMoney and risk in a DSGE framework: A Bayesian application to the EurozoneJ. Benchimol et al. — 2012
- 43journalMoney in the production function: a new Keynesian DSGE perspectiveJ. Benchimol — 2015
- 44journalReal wage rigidities and the New Keynesian modelOlivier Blanchard et al. — 2007
- 45journalA New Keynesian model with unemploymentOlivier Blanchard et al. — Center for Financial Studies, Goethe University, Frankfurt — 2007
- 47journalLack of Divine Coincidence in New-Keynesian ModelsS. A. L. Alves — 2014
- 48journalRevolution and evolution in 20th century macroeconomicsMichael Woodford — Columbia University — 1999
- 49bookMonetary Policy, Inflation and the Business Cycle: An Introduction to the New Keynesian Framework and Its ApplicationsJordi Gali — Princeton University Press — 2015
- 51bookJohn Maynard Keynes and International Relations: Economic Paths to War and PeaceDonald Markwell — Oxford University Press — 2006