Answer to Question #39750 in Macroeconomics for Leo

Question

Explain in three well-structured paragraphs the basic principles of the New Keynesian Economics.

Answer 1

New Keynesian economics as a philosophy took root in the 1980s in response to the criticisms of many of Keynes' original precepts as espoused by classical economists in the previous decade. The new Keynesian theory attempts to address, among other things, the sluggish behavior of prices and its cause. The theory explains how market failures could be caused by inefficiencies and might justify government intervention. Like the New Classical approach, NewKeynesian economic 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.