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 Keynesian approach to macroeconomics. Like the New Classical approach, New Keynesian macroeconomic analysis usually assumes that households and firms have rational expectations. But the two schools differ in that New Keynesian analysis usually assumes a variety of market failures. In particular, New Keynesians assume that there is imperfect competition in price and wage setting to help explain why prices and wages can become "sticky", which means they do not adjust instantaneously to changes in economic conditions.

Wage and price stickiness, and the other market failures present in New Keynesian models, imply that the economy may fail to attain full employment. Therefore, New Keynesians argue that macroeconomic stabilization by the government (using fiscal policy) or by the central bank (using monetary policy) can lead to a more efficient macroeconomic outcome than a laissez faire policy would.

The first wave of New Keynesian economics developed in the late 1970s. The first model of Sticky information was developed by Stanley Fischer in his 1977 article, Long-Term Contracts, Rational Expectations, and the Optimal Money Supply Rule. He adopted a "staggered" or "overlapping" contract model. Suppose that there are two unions in the economy, who take turns to choose wages. When it is a union's turn, it chooses the wages it will set for the next two periods. This contrasts with John B. Taylor's model where the nominal wage is constant over the contract life, as was subsequently developed in his two articles, one in 1979 "Staggered wage setting in a macro model'. and one in 1980 "Aggregate Dynamics and Staggered Contracts". Both Taylor and Fischer contracts share the feature that only the unions setting the wage in the current period are using the latest information: wages in half of the economy still reflect old information. The Taylor model had sticky nominal wages in addition to the sticky information: nominal wages had to be constant over the length of the contract (two periods). These early new Keynesian theories were based on the basic idea that, given fixed nominal wages, a monetary authority (central bank) can control the employment rate. Since wages are fixed at a nominal rate, the monetary authority can control the real wage (wage values adjusted for inflation) by changing the money supply and thus effect the employment rate.

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