Belief: Agents are rational but markets are imperfect due to such phenomena as ‘sticky prices’, and these imperfections can cause market failure and recessions.
Policy recommendation: The government should use monetary policy to stabilise the economy.
New Keynesian economics was developed in response to the New Classical school and attempts to provide micro foundations for Keynesian economics. New Keynesians assume that agents have rational expectations but also that there exits many market failures, such as imperfect competition, which cause price and wage rigidities. In New Keynesian models, these rigidities, or stickiness, lead to failures in the market adjustment mechanism and prevent the economy from reaching full employment. This school of thought recommends the government use fiscal and monetary policy to stabilise the economy.
Perhaps the most famous New Keynesian models are the efficiency wage models in which firms pay their workers a wage that maximises productivity rather than clears the market. In the Shapiro-Stiglitz efficiency wage mode, firms pay workers a higher than market-clearing wage in order to dissuade them from shirking (putting in less effort at work). If all firms pay above market-clearing wages then the labour market will fail to clear and there will be a pool of unemployed workers. Consequently, unemployment becomes a serious threat to workers in a job and they are discouraged from shirking at work.
In the early 1990s, the ideas of the New Keynesian school were fused with Real Business Cycle Theory to create the New Neoclassical synthesis. Real Business Cycle models were dynamic, but their assumptions of perfect competition were thought to be unrealistic; whereas New Keynesian models were static but built on real-world operations of sticky wages. The New Neoclassical synthesis paints a picture of an economy that is a dynamic general equilibrium system which deviates from an optimum allocation of resources in the short-run due to market imperfections and sticky prices. This synthesis uses price rigidities to explain how monetary policy affects employment in the short-run and, subsequently, many central banks use this model to form their analysis of monetary policy.
– Sticky wages/prices
– Asymmetric information
– Efficiency wages
– Coordination failure
– Sticky information