SummaryInflation and unemployment can be very harmful to the economy. However, knowing how a problem originates is always helpful when trying to fix it. This is the reason why economists have created an incredible amount of economic models that try to explain how inflation and unemployment behave. In this LP we take a look at a few economic models that explain, at least to some extent or in some given context, inflation and unemployment.
The New Keynesian Economics seeks to provide Keynesianism with microeconomic foundation support. This contemporary economic doctrine comes as a response to the critiques that Keynesianism received from the New Classical Macroeconomics (NCM) advocates.
New Keynesian Economics can be traced back to late 70s when the first foundations were built by economists such as Stanley Fischer, Edmund Phelps and John Taylor. One of the best economists to characterize the New Keynesian Economics is Gregory Mankiw, as he has made many contributions to this doctrine.
The main issue of this economic doctrine is to explain why changes in the aggregate price level are “sticky”. While in NCM competitive price-taking firms make choices on how much output to produce, and not at what price, in New Keynesian Economics monopolistically competitive firms set their own individual prices and accept the level of sales as a constraint. From a New Keynesian Economics point of view, two main arguments try to answer why aggregate prices fail to imitate the nominal GNP evolution. One of them is used both by NKE and NCM approach to macroeconomics, this is the assumption that economic agents, households and firms have rational expectations. However New Keynesian Economics considers that rational expectations become distorted as market failure arises from asymmetric information and imperfect competition. As economic agents can’t have a full scope of the economic reality their information will be limited, and there will be no reasons to believe that other agents will change their prices, and therefore maintain their expectations unchanged. Expectations are a crucial part for price determination, as they remain unaltered, so will the price, what leads to price rigidity. For firms, price rigidity may also come from what’s known as menu costs, this is, costs that result from price changes.
As a result of this price stickiness, which implies a slow adjustment of the economy and can lead to undesired levels of unemployment, government intervention is justified to stabilize the economy, by using both fiscal and monetary policies. However, this intervention ought to be minimal, much lower than New Keynesian Economics’s predecessors, the Neoclassical Synthesis, would argue for.