Reviewed by Sep 30, 2020| Updated on
New Keynesian economics measures the changes in prices and wages arising due to short-term economic fluctuations. The new Keynesian economics is a modern thought process in comparison to the classical economic theory developed by the British economist, John Maynard Keynes. It belongs to the modern macroeconomic school.
The classical Keynesian economic theory was formulated after the Great Depression during the 1930s. The theory advocated an increase in government expenditure and low taxes to encourage domestic demand and revive economic growth.
However, the theory underwent a change in the latter part of the 20th century. The stagflation experienced during the 1970s made the theory non-workable. New classical economists, such as Thomas Sargent and Robert Lucas, altered the traditional theory in the light of modern microeconomic conditions.
According to them, modern microeconomic factors, such as price and wages, had a significant impact on the traditional economic model.
The new Keynesian economics studies the nature and the behaviour of the factor ‘price’. It studies the causes which result in changes in ‘price’. It also studies market inefficiencies and market failures. The new theory is in favour of deficit spending by the government arguing in favour of the expansionary economic policy.
The new Keynesian Economics had a great impact during the period from the 1990s until the financial crisis of 2008. The theory was criticised for its failure in observing the changing economic patterns and foreseeing the Great Recession that occurred during the late 2000s and from December 2007 to June 2009.
The theory is also criticised on its assumptions that economic agents, firms, and households will behave rationally. The other assumption that firms will set their price levels and accept a constraint on the sales.
However, in reality, all agents do not behave rationally due to asymmetric information. Hence, the economic agents will not have a full picture of the economic reality to change prices. This leads to price rigidity in the modern new Keynesian economics.
The theory is impractical as prices would change due to irrational choices and asymmetric information. Accordingly, prices and sales would also change.