New Keynesian Economics
Learning Objectives
- Define New Keynesian economics and explain how it differs from both New Classical theory and old Keynesian economics.
- Explain why menu costs and price-setting frictions cause prices to be "sticky" rather than instantly market-clearing.
- Describe how wage rigidities keep labor markets from clearing quickly after a shock.
- Explain how asymmetric information and moral hazard distort economic decisions, using the 2008 financial crisis as a case.
- Connect sticky prices and wages to the case for active monetary and fiscal policy.
- Evaluate the main critiques of New Keynesian economics.
Quick Answer
New Keynesian economics is a school of macroeconomic thought, developed mainly from the 1980s onward, that explains Keynesian ideas — like recessions and unemployment lasting longer than they "should" — using rigorous microeconomic foundations. Its central claim is that prices and wages are "sticky": firms and workers don't adjust them instantly in response to demand or supply shocks, because doing so is costly (menu costs) or constrained by contracts and information problems. This stickiness means markets don't clear immediately, so a demand shock can show up as lost output and unemployment rather than just lower prices. It matters because it gives modern central banks and governments a theoretically grounded justification for intervening with tools like interest rate changes, forward guidance, and quantitative easing.
Overview
New Keynesian economics emerged in the 1980s and 1990s as a direct response to the New Classical critique of old Keynesian models. New Classical economists, led by ideas like the Lucas critique, had argued that Keynesian models were unreliable because they didn't derive aggregate relationships (like the consumption function or the Phillips curve) from the rational, optimizing behavior of individual households and firms. If people form rational expectations and markets clear continuously, New Classical models suggested, policy could do little to fight recessions except by surprise.
New Keynesians accepted the demand for rigorous microfoundations and rational expectations, but rejected the assumption that prices and wages adjust instantly. Instead, they built models showing that even small frictions — menu costs, staggered wage contracts, imperfect information — can have large macroeconomic consequences, because they prevent markets from clearing in the short run. This let New Keynesians keep the classical toolkit of optimizing, forward-looking agents while still arriving at the Keynesian conclusion that output and employment can deviate from their full-employment levels for extended periods, and that monetary and fiscal policy can help close that gap.
The importance of New Keynesian economics is that it became the intellectual backbone of most modern central banking. The dynamic stochastic general equilibrium (DSGE) models that the Federal Reserve, the European Central Bank, and other institutions use to guide interest rate decisions are largely New Keynesian in structure.
Core Concepts
Sticky Prices and Menu Costs
Definition
Sticky prices refer to the tendency of firms to change prices infrequently, even when demand or cost conditions change. Menu costs are the real costs — administrative, physical, or reputational — that firms incur when they change prices, which give them a rational reason not to adjust prices immediately.
Explanation
In a purely neoclassical (market-clearing) model, prices move instantly to balance supply and demand, so markets never stay out of equilibrium. New Keynesian economists point out that changing prices isn't free: firms must reprint menus and catalogs, renegotiate with customers, update software and shelf tags, and risk annoying customers with frequent price changes. Even small costs like these can make it individually rational for a firm to leave its price unchanged after a shock, even though the "right" price has moved. When many firms behave this way at once, the aggregate price level adjusts slowly, and the burden of adjusting to a demand shock falls on output and employment instead of prices.
Example
Suppose aggregate demand falls unexpectedly. In a flexible-price world, all prices would fall immediately, real balances would rise, and output would stay near full employment. In a sticky-price world, many firms keep prices where they were because repricing is costly, so with prices too high relative to the new lower demand, firms sell less and cut production and hours instead.
Real-World Example
During the COVID-19 pandemic, many restaurants and retailers were slow to reprice items even as their input costs and demand patterns shifted rapidly, partly because menu costs — literally reprinting menus, updating point-of-sale systems, and communicating price changes to customers — made frequent adjustment impractical. This lag in repricing was a visible, everyday illustration of price stickiness.
Why It Matters
If prices adjusted instantly, demand shocks would mostly show up as price-level changes with little effect on real output or jobs. Because prices are sticky, the same shocks show up as recessions, unemployment, and lost output — which is exactly the kind of outcome that justifies policy intervention to stabilize demand.
Common Misunderstanding
Students often think "menu costs" is a cute metaphor with no real economic weight. In New Keynesian models, even tiny per-firm costs of repricing can generate large aggregate stickiness and significant real effects, because the coordination failure among many firms amplifies a small individual cost into a large collective one.
Wage Rigidities
Definition
Wage rigidity is the tendency of nominal (and sometimes real) wages to adjust slowly to changes in labor supply and demand, preventing the labor market from clearing quickly.
Explanation
Wages are often set through contracts, implicit agreements, or social norms that aren't renegotiated every time economic conditions change. Long-term labor contracts, minimum wage laws, staggered union bargaining rounds, and firms' reluctance to cut pay (for fear of hurting morale and productivity, sometimes called "efficiency wage" concerns) all slow wage adjustment. Because wages don't fall quickly during a downturn, firms respond to weaker demand by cutting hours and laying off workers rather than lowering pay, so involuntary unemployment can persist.
Example
If a recession hits and labor demand falls, a flexible-wage market would see wages drop enough to keep everyone employed at a lower pay rate. With rigid wages, firms instead reduce headcount because they cannot (or will not) cut pay far enough, producing unemployment that a wage cut alone might have avoided.
Real-World Example
Staggered multi-year union contracts are a classic example: wages are locked in for the contract's duration regardless of what happens to the economy in the meantime, so a large share of the workforce's pay doesn't respond to a shock until contracts come up for renewal.
Why It Matters
Wage rigidity, alongside price rigidity, is one of the two central frictions New Keynesians use to explain why recessions involve real job losses rather than a quick, painless drop in pay rates. It's a key reason unemployment can be sticky and persistent rather than self-correcting.
Common Misunderstanding
Some assume wage rigidity means wages "never" change. In reality, New Keynesian models usually assume staggered adjustment — different firms and contracts reset at different times — which is enough to slow the aggregate response without requiring wages to be permanently frozen.
Incomplete and Asymmetric Information
Definition
Incomplete information means economic agents don't have full knowledge of relevant conditions when making decisions. Asymmetric information is a specific case where one party in a transaction knows more than the other, which can lead to moral hazard (a party takes on more risk because someone else bears the consequences) and adverse selection (the party with less information ends up systematically dealing with the riskiest counterparts).
Explanation
Neoclassical models often assume everyone has the information they need to make efficient decisions. New Keynesians argue this is unrealistic in labor, credit, and product markets. Firms may not know true demand conditions when setting prices; lenders may not know a borrower's true risk; insured parties may take on risks they wouldn't take if they bore the full cost themselves. These information problems distort decisions and can amplify economic instability, especially in financial markets, where they can trigger credit crunches or excessive risk-taking.
Example
A bank that expects a government bailout if it fails may make riskier loans than it would if it alone bore the losses — this is moral hazard, and it means the bank's private incentives no longer align with what's efficient for society.
Real-World Example
In the 2008 financial crisis, many large banks and financial institutions took on excessive risk in mortgage-backed securities, partly because of moral hazard: they believed (correctly, as it turned out) that they were "too big to fail" and would be rescued by the government rather than allowed to collapse. This mispricing of risk, rooted in asymmetric information between banks, regulators, and investors, contributed to the severity of the crisis.
Why It Matters
Information problems are a distinct source of market failure from sticky prices and wages, and they help explain why financial crises can produce deep, long recessions: credit markets can seize up or misallocate capital even when prices in other markets are behaving normally. This justifies financial regulation and lender-of-last-resort policies as complements to standard demand management.
Common Misunderstanding
People sometimes conflate "incomplete information" with simple ignorance that could be fixed by more data. The New Keynesian point is subtler: even fully rational agents make privately optimal but socially costly decisions when information is asymmetrically distributed, so the problem isn't a lack of intelligence but a structural feature of the transaction.
Policy Implications: Interest Rates, Forward Guidance, and QE
Definition
Because prices and wages are sticky, New Keynesian models imply that monetary and fiscal policy can have real effects on output and employment, at least in the short to medium run, rather than only moving the price level. Key tools include interest rate targeting, forward guidance (communicating future policy intentions), and quantitative easing (large-scale asset purchases).
Explanation
If markets cleared instantly, a central bank's actions would just pass through to prices with no effect on real output. Because sticky prices and wages prevent that instant adjustment, changes in interest rates alter real borrowing costs and real demand for a meaningful period, giving policymakers genuine leverage over the business cycle. Forward guidance works because forward-looking, rational agents adjust today's spending and investment decisions based on the central bank's credible signals about future policy, so even a promise about future rates can move current behavior. Quantitative easing extends this logic to situations where short-term interest rates are already near zero, using purchases of longer-term assets to lower long-term borrowing costs and support demand.
Example
If the central bank credibly commits to keeping interest rates low "for an extended period," households and firms may bring forward spending and investment they would otherwise have delayed, boosting demand today even before rates actually change.
Real-World Example
During the 2008 financial crisis, the Federal Reserve cut short-term rates close to zero and then turned to quantitative easing, purchasing large quantities of government and mortgage-backed securities, while also using forward guidance to signal that rates would stay low for a long time. The goal was to lower long-term borrowing costs and support aggregate demand at a time when conventional rate cuts were no longer available.
Why It Matters
This is the practical payoff of New Keynesian theory: it gives central banks a rigorous justification for the tools they actually use, and it explains why communication and expectations management (not just the current interest rate) are treated as core instruments of monetary policy today.
Common Misunderstanding
Students sometimes think New Keynesian economics implies policy can permanently boost output above its natural or potential level. In these models, policy mainly helps close temporary output gaps caused by sticky-price adjustment; it doesn't change the economy's long-run potential output, which is still governed by real factors like technology, capital, and labor supply.
Visual Learning
Key Terms
| Term | Definition | Related Concept |
|---|---|---|
| Menu costs | The real costs firms incur when changing prices, such as reprinting and renegotiation costs | Sticky prices |
| Sticky prices | Prices that adjust slowly to changes in supply or demand | Menu costs, market clearing |
| Wage rigidity | Slow adjustment of nominal or real wages to labor market conditions | Involuntary unemployment |
| Efficiency wages | Above-market wages firms pay to boost morale and productivity, contributing to wage stickiness | Wage rigidity |
| Asymmetric information | A situation where one party in a transaction has more or better information than the other | Moral hazard, adverse selection |
| Moral hazard | The tendency to take on more risk when someone else bears the cost of failure | Asymmetric information, 2008 financial crisis |
| Adverse selection | A situation where the less-informed party tends to attract the riskiest counterparts | Asymmetric information |
| Microfoundations | Deriving macroeconomic relationships from the optimizing behavior of individual households and firms | Lucas critique, rational expectations |
| Lucas critique | The argument that policy-based relationships in old macro models are unreliable because agents' behavior changes with policy | Microfoundations, rational expectations |
| Rational expectations | The assumption that agents use all available information to form unbiased forecasts of the future | Forward-looking behavior |
| Forward guidance | Central bank communication about the likely future path of policy, used to shape current expectations | Monetary policy, rational expectations |
| Output gap | The difference between actual output and the economy's full-employment (potential) output | Sticky prices, business cycles |
Common Mistakes
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Misconception: New Keynesian economics is just old Keynesian economics with a new name. Why it's wrong: Old Keynesian models were built on ad hoc aggregate relationships without rigorous individual optimization; New Keynesian models explicitly derive sticky-price and sticky-wage behavior from optimizing agents facing real frictions like menu costs. Correct understanding: New Keynesian economics is a synthesis — it keeps the Keynesian conclusion that markets can fail to clear quickly, but reaches that conclusion through New Classical-style microfoundations and rational expectations.
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Misconception: Sticky prices mean prices never change. Why it's wrong: Menu costs and staggered contracts only slow the pace and timing of price and wage adjustment; they don't freeze prices permanently. Correct understanding: Prices and wages in New Keynesian models do adjust, just with a lag and often in a staggered pattern across different firms and contracts, which is enough to generate short-run non-clearing without implying permanent rigidity.
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Misconception: Because New Keynesian models justify policy intervention, they imply policymakers can boost output indefinitely. Why it's wrong: These models describe temporary deviations from potential output caused by price and wage stickiness, not a permanent expansion of the economy's productive capacity. Correct understanding: Policy can help close short-run output gaps caused by sticky adjustment, but long-run potential output is still determined by real factors such as technology, capital stock, and labor supply.
Comparison and Connections
| School | Price/Wage Flexibility Assumption | Policy Effectiveness | View of Business Cycles |
|---|---|---|---|
| Keynesian (original) | Prices and wages assumed sticky, but not derived from individual optimization | Active monetary and fiscal policy strongly effective | Driven by demand shortfalls and animal spirits; markets can fail to self-correct |
| New Keynesian | Prices and wages sticky, but stickiness is derived from microfounded frictions (menu costs, contracts, information problems) | Active policy effective in the short-to-medium run, especially via credible, expectation-shaping tools | Demand shocks cause real, persistent output and employment effects because markets clear slowly |
| New Classical | Prices and wages assumed to adjust instantly, with rational expectations and market clearing | Anticipated policy is ineffective; only unanticipated shocks have real effects | Driven mainly by real shocks (technology, productivity) or unanticipated policy surprises |
| Monetarist | Prices and wages flexible in the long run, but can be sticky enough in the short run for money supply changes to matter | Steady, rule-based control of the money supply preferred over discretionary fine-tuning | Driven largely by fluctuations in the money supply and monetary policy mistakes |
Practice Questions
Recall 1: What are menu costs, and how do they contribute to sticky prices? Answer guidance: Define menu costs as the real costs of changing prices (reprinting, renegotiation, coordination) and explain that these costs make firms reluctant to change prices immediately after a shock, producing aggregate price stickiness.
Recall 2: What is asymmetric information, and give one example of moral hazard. Answer guidance: Define asymmetric information as one party having more or better information than the other in a transaction; give an example such as insured parties or bailed-out banks taking on more risk because they don't bear the full downside.
Understanding 1: Why does New Keynesian economics combine Keynesian conclusions with New Classical-style microfoundations? Answer guidance: Explain that the Lucas critique demanded models grounded in rational, optimizing behavior; New Keynesians met that demand while still explaining sticky prices/wages through real frictions, preserving the Keynesian result that demand shocks have real effects.
Understanding 2: How does wage rigidity lead to involuntary unemployment during a recession? Answer guidance: Explain that if wages can't fall enough to clear the labor market after a fall in labor demand, firms cut jobs instead of pay, leaving workers who would accept the going wage without work.
Application 1: During COVID-19, many businesses were slow to reprice goods despite rapidly changing demand. Explain this using New Keynesian concepts. Answer guidance: Apply the concept of menu costs and price-setting frictions — repricing had real administrative and logistical costs, so firms delayed adjustment, and short-run demand/supply imbalances showed up as shortages or output changes rather than instant price shifts.
Application 2: Explain how the Federal Reserve's use of quantitative easing and forward guidance during the 2008 crisis reflects New Keynesian theory. Answer guidance: Connect near-zero interest rates and sticky prices/wages preventing quick market clearing to the rationale for QE (lowering long-term rates when short rates are constrained) and forward guidance (shaping expectations of forward-looking agents) to support aggregate demand.
Analysis 1: Compare how a demand shock would play out in a New Classical model versus a New Keynesian model. Answer guidance: In New Classical models with flexible prices and rational expectations, only unanticipated shocks matter and adjustment is nearly instant; in New Keynesian models, sticky prices/wages mean even anticipated demand shocks cause real, persistent output and employment effects because markets can't clear quickly.
Analysis 2: Evaluate the critique that New Keynesian models are overly complex and still lack fully convincing microfoundations. Is this a fatal flaw? Answer guidance: Discuss the trade-off between analytical rigor and tractability — added complexity (staggered contracts, information frictions) is meant to capture real-world frictions, but critics argue some assumptions (like specific price-adjustment rules) are still somewhat ad hoc; weigh whether the added realism justifies the added complexity given the models' practical use in central banking.
FAQ
What makes New Keynesian economics different from the original Keynesian model? The original Keynesian model, developed mainly around the mid-20th century, assumed sticky prices and wages largely as a starting premise, without deriving that stickiness from the optimizing decisions of individual firms and workers. New Keynesian economics, developed from the 1980s onward, responds to the Lucas critique's demand for microfoundations by explicitly modeling why rational, forward-looking agents would choose not to adjust prices or wages instantly — through menu costs, staggered contracts, and information frictions. The conclusion (markets can fail to clear quickly) is similar, but the reasoning is far more rigorous and compatible with rational expectations.
Why do menu costs matter if they seem like such a small expense for most firms? Even a small per-firm cost of repricing can generate large aggregate effects because of a coordination problem: if enough firms individually decide it's not worth adjusting their prices right now, the aggregate price level barely moves even though the "right" price level has shifted a lot. This is sometimes called the multiplier effect of small frictions, and it's a key reason New Keynesian economists argue menu costs deserve serious attention despite looking trivial at the level of a single firm.
How does moral hazard connect to the 2008 financial crisis? Many large financial institutions took on excessive risk in the years leading up to 2008, partly because they expected — correctly — that they were "too big to fail" and would be rescued rather than allowed to collapse. Because the downside risk was implicitly shifted onto taxpayers and the broader financial system, the banks' private incentives to manage risk carefully were weakened. This is a textbook case of moral hazard rooted in asymmetric information between banks, regulators, and the public about true risk exposure, and it's one reason New Keynesian economists pay close attention to information problems in financial markets, not just sticky prices in goods markets.
Does New Keynesian theory mean central banks can always fix recessions with the right policy? No. New Keynesian models suggest that policy can help close short-run output gaps caused by sticky-price and sticky-wage adjustment, but they don't claim policy can permanently raise the economy's potential output or eliminate all business cycle fluctuations. Effectiveness also depends on credibility (for forward guidance to work, people must believe the central bank's commitments) and on constraints like the zero lower bound on interest rates, which is why tools like quantitative easing were developed for situations where conventional rate cuts run out of room.
Is New Keynesian economics the mainstream view today? It's one of the most influential frameworks in modern macroeconomics, especially for central bank policy modeling, but it isn't universally accepted. Critics point to its complexity and to lingering questions about whether its specific microfoundations (like the exact form of price-adjustment rules) really capture how firms and workers behave. Many modern models blend New Keynesian frictions with insights from other schools, including monetarist views on the money supply and behavioral economics on decision-making, rather than treating New Keynesian theory as a closed, final answer.
Quick Revision
- New Keynesian economics combines Keynesian conclusions about sticky prices and demand shortfalls with New Classical-style microfoundations and rational expectations.
- It emerged in the 1980s-90s partly in response to the Lucas critique, which demanded models grounded in individual optimizing behavior.
- Sticky prices arise from menu costs and price-setting frictions — real costs of changing prices that make firms delay adjustment.
- Wage rigidity comes from contracts, efficiency wage concerns, and social norms, and it slows labor market clearing.
- Because prices and wages adjust slowly, demand shocks show up as changes in output and employment, not just prices.
- Asymmetric information creates moral hazard (excessive risk-taking when others bear the cost) and adverse selection (the least-informed party ends up dealing with the riskiest counterparts).
- The 2008 financial crisis illustrated moral hazard: banks took on excessive risk partly due to expectations of government bailouts.
- Sticky prices and wages justify active monetary and fiscal policy to close output gaps in the short-to-medium run.
- Forward guidance works because rational, forward-looking agents adjust today's behavior based on credible signals about future policy.
- Quantitative easing extends policy influence to long-term rates when short-term rates are near zero, as the Fed used during 2008.
- New Keynesian models don't claim policy can raise long-run potential output — only that it can help close temporary gaps.
- Critics argue the models are complex and that some of their microfoundations remain somewhat ad hoc.
Related Topics
Prerequisites: Classical, Keynesian
Related Topics: Monetarist, New Classical
Next Topics: Macroeconomic Schools Overview