Neo-Keynesian economics

Last updated

Neo-Keynesian economics is a school of macroeconomic thought that was developed in the post-war period from the writings of John Maynard Keynes. A group of economists (notably John Hicks, Franco Modigliani and Paul Samuelson), attempted to interpret and formalize Keynes' writings and to synthesize it with the neoclassical models of economics. Their work has become known as the neoclassical synthesis and created the models that formed the core ideas of neo-Keynesian economics. These ideas dominated mainstream economics in the post-war period and formed the mainstream of macroeconomic thought in the 1950s, 1960s and 1970s. [1]

Macroeconomics branch of economics that studies aggregated indicators

Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of an economy as a whole. This includes regional, national, and global economies.

John Maynard Keynes English economist

John Maynard Keynes, 1st Baron Keynes, was a British economist, trained mathematician, whose ideas fundamentally changed the theory and practice of macroeconomics and the economic policies of governments. He built on and greatly refined earlier work on the causes of business cycles, and was one of the most influential economists of the 20th century. Widely considered the founder of modern macroeconomics, his ideas are the basis for the school of thought known as Keynesian economics, and its various offshoots.

John Hicks British economist

Sir John Richard Hicks was a British economist. He was considered one of the most important and influential economists of the twentieth century. The most familiar of his many contributions in the field of economics were his statement of consumer demand theory in microeconomics, and the IS/LM model (1937), which summarised a Keynesian view of macroeconomics. His book Value and Capital (1939) significantly extended general-equilibrium and value theory. The compensated demand function is named the Hicksian demand function in memory of him.

Contents

A series of developments occurred that shook neo-Keynesian theory in the 1970s as the advent of stagflation and the work of monetarists like Milton Friedman cast doubt on neo-Keynesian theories. The result would be a series of new ideas to bring tools to Keynesian analysis that would be capable of explaining the economic events of the 1970s. The next great wave of Keynesian thinking began with the attempt to give Keynesian macroeconomic reasoning a microeconomic basis. The new Keynesians helped create a "new neoclassical synthesis" that currently forms the mainstream of macroeconomic theory. [2] [3] [4]

In economics, stagflation, or recession-inflation, is a situation in which the inflation rate is high, the economic growth rate slows, and unemployment remains steadily high. It presents a dilemma for economic policy, since actions intended to lower inflation may exacerbate unemployment

Monetarism is a school of thought in monetary economics that emphasizes the role of governments in controlling the amount of money in circulation. Monetarist theory asserts that variations in the money supply have major influences on national output in the short run and on price levels over longer periods. Monetarists assert that the objectives of monetary policy are best met by targeting the growth rate of the money supply rather than by engaging in discretionary monetary policy.

Milton Friedman American economist, statistician, and writer

Milton Friedman was an American economist who received the 1976 Nobel Memorial Prize in Economic Sciences for his research on consumption analysis, monetary history and theory and the complexity of stabilization policy. With George Stigler and others, Friedman was among the intellectual leaders of the second generation of Chicago school of economics, a methodological movement at the University of Chicago's Department of Economics, Law School and Graduate School of Business from the 1940s onward. Several students and young professors who were recruited or mentored by Friedman at Chicago went on to become leading economists, including Gary Becker, Robert Fogel, Thomas Sowell and Robert Lucas Jr.

Following the emergence of the new Keynesian school, neo-Keynesians have sometimes been referred to as "Old-Keynesians". [5]

Origins

John Maynard Keynes provided the framework for synthesizing a host of economic ideas present between 1900 and 1940 and that synthesis bears his name, as is generally known as Keynesian economics. The first generation of Keynesians were focused on unifying the ideas into workable paradigms, combining them with ideas from classical economics and the writings of Alfred Marshall.

Keynesian economics is a group of various macroeconomic theories about how in the short run – and especially during recessions – economic output is strongly influenced by aggregate demand. In the Keynesian view, named for British economist John Maynard Keynes, aggregate demand does not necessarily equal the productive capacity of the economy; instead, it is influenced by a host of factors and sometimes behaves erratically, affecting production, employment, and inflation.

Classical economics or classical political economy is a school of thought in economics that flourished, primarily in Britain, in the late 18th and early-to-mid 19th century. Its main thinkers are held to be Adam Smith, Jean-Baptiste Say, David Ricardo, Thomas Robert Malthus, and John Stuart Mill. These economists produced a theory of market economies as largely self-regulating systems, governed by natural laws of production and exchange.

Alfred Marshall British economist

Alfred Marshall, FBA was one of the most influential economists of his time. His book, Principles of Economics (1890), was the dominant economic textbook in England for many years. It brings the ideas of supply and demand, marginal utility, and costs of production into a coherent whole. He is known as one of the founders of neoclassical economics. Although Marshall took economics to a more mathematically rigorous level, he did not want mathematics to overshadow economics and thus make economics irrelevant to the layman.

These neo-Keynesians generally looked at labor contracts as sources of wage stickiness to generate equilibrium models of unemployment. Their efforts (known as the neo-classical synthesis) resulted in the development of the IS–LM model and other formalizations of Keynes' ideas. This intellectual program would produce eventually monetarism and other versions of Keynesian macroeconomics in the 1960s.

IS–LM model Keynesian macroeconomic model about interest rates and assets markets that places general equilibrium (simultaneous equilibria in goods/asset markets) at the intersection of “investment–saving” (IS) and “liquidity preference–money supply” (LM)

The IS–LM model, or Hicks–Hansen model, is a two-dimensional macroeconomic tool that shows the relationship between interest rates and assets market. The intersection of the "investment–saving" (IS) and "liquidity preference–money supply" (LM) curves models "general equilibrium" where supposed simultaneous equilibria occur in both the goods and the asset markets. Yet two equivalent interpretations are possible: first, the IS–LM model explains changes in national income when price level is fixed short-run; second, the IS–LM model shows why an aggregate demand curve can shift. Hence, this tool is sometimes used not only to analyse economic fluctuations but also to suggest potential levels for appropriate stabilisation policies.

Neoclassical synthesis

The IS-LM model is used to analyze the effect of demand shocks on the economy Islm.svg
The IS–LM model is used to analyze the effect of demand shocks on the economy

After Keynes, Keynesian analysis was combined with neoclassical economics to produce what is generally termed "the neoclassical synthesis", which dominates mainstream macroeconomic thought. Though it was widely held that there was no strong automatic tendency to full employment, many believed that if government policy were used to ensure it, the economy would behave as classical or neoclassical theory predicted.

The neoclassical synthesis, or the neoclassical–Keynesian synthesis was a post-World War II academic movement in economics that worked towards absorbing the macroeconomic thought of John Maynard Keynes into neoclassical economics. The resultant macroeconomic theories and models are termed neo-Keynesian economics. Mainstream economics is largely dominated by the synthesis, being largely Keynesian in macroeconomics and neoclassical in microeconomics.

In the post-World War II years, Keynes's policy ideas were widely accepted. For the first time, governments prepared good quality economic statistics on an ongoing basis and a theory that told them what to do. In this era of New Deal liberalism and social democracy, most western capitalist countries enjoyed low, stable unemployment and modest inflation.

IS–LM model (investment saving–liquidity preference money supply)

It was with John Hicks that Keynesian economics produced a clear model which policy-makers could use to attempt to understand and control economic activity. This model, the IS–LM model, is nearly as influential as Keynes' original analysis in determining actual policy and economics education.

It relates aggregate demand and employment to three exogenous quantities, i.e. the amount of money in circulation, the government budget and the state of business expectations. This model was very popular with economists after World War II because it could be understood in terms of general equilibrium theory. This encouraged a much more static vision of macroeconomics than that described above.

Phillips curve

The Phillips curve in the U.S in the 1960s Philipsus60.png
The Phillips curve in the U.S in the 1960s

The second main part of a Keynesian policy-maker's theoretical apparatus was the Phillips curve. This curve, which was more of an empirical observation than a theory, indicated that increased employment and decreased unemployment implied increased inflation. Keynes had only predicted that falling unemployment would cause a higher price, not a higher inflation rate. Thus the economist could use the IS–LM model to predict, for example, that an increase in the money supply would raise output and employment—and then use the Phillips curve to predict an increase in inflation.

The strength of Keynesianism's influence can be seen by the wave of economists which began in the late 1940s with Milton Friedman- Milton Friedman rejected Keynesian teaching this is misleading. Instead of rejecting macro-measurements and macro-models of the economy, they embraced the techniques of treating the entire economy as having a supply and demand equilibrium, but unlike the Keynesians—they argued that "crowding out" effects would hobble or deprive fiscal policy of its positive effect. Instead, the focus should be on monetary policy, which was largely ignored by early Keynesians. The monetarist critique pushed Keynesians toward a more balanced view of monetary policy and inspired a wave of revisions to Keynesian theory.

Through the 1950s, moderate degrees of government demand leading industrial development and use of fiscal and monetary counter-cyclical policies continued and reached a peak in the "go go" 1960s, where it seemed to many Keynesians that prosperity was now permanent. However, with the oil shock of 1973 and the economic problems of the 1970s, modern liberal economics began to fall out of favor. During this time, many economies experienced high and rising unemployment, coupled with high and rising inflation, contradicting the Phillips curve's prediction.

This stagflation meant that both expansionary (anti-recession) and contractionary (anti-inflation) policies had to be applied simultaneously, a clear impossibility. This dilemma led to the rise of ideas based upon more classical analysis, including monetarism, supply-side economics and new classical economics. This produced a "policy bind" and the collapse of the Keynesian consensus on the economy.

New Keynesian economics

Through the 1980s, Keynesian macroeconomics fell out of fashion as a policy tool and as a field of study. Instead, it was felt that combining economics with behavioral science, game theory and monetary theory were more important areas of study. On the policy level, it was the era of Margaret Thatcher and Ronald Reagan, who advocated slashing the size of the government sector. However, beginning in the late 1980s economics began shifting back to a study of macro-economics and policy makers began to look for means of managing the global financial network, which was increasingly interlinked.[ citation needed ]

In the 1990s, the "uncoupling" of money supply and inflation caused an increasing questioning of the original form of monetarism.[ citation needed ] The repeated failures of "big bang" marketization in the former Soviet Bloc have encouraged the recent revival in Keynesian ideas, with particular emphasis on giving the Keynesian macroeconomic analysis theoretically sound foundations in microeconomics.[ citation needed ] These theories have been called new Keynesian economics. The heart of the new Keynesian view rests on microeconomic models that indicate that nominal wages and prices are "sticky", i.e. do not change easily or quickly with changes in supply and demand, so that quantity adjustment prevails. According to economist Paul Krugman, this "works beautifully in practice but very badly in theory". [6] This integration is further spurred by work of other economists which questions rational decision-making in a perfect information environment as a necessity for micro-economic theory. Imperfect decision making such as that investigated[ citation needed ] by Joseph Stiglitz underlines the importance of management of risk in the economy.

New classical economics relied on the theory of rational expectations to reject Keynesian economics. Most well-known is the critique by Robert Lucas, who argues[ citation needed ] that rational expectations will defeat any monetary or fiscal policy. However, new Keynesians argue that this critique only works if the economy has a unique equilibrium at full employment. Price stickiness means that there are a variety of possible equilibria in the short run, so that rational expectations models do not produce any simple result.

Some macroeconomists have returned to the IS–LM model and the Phillips curve as a first approximation of how an economy works. New versions of the Phillips curve, such as the triangle model, allow for stagflation since the curve can shift due to supply shocks or changes in built-in inflation. In the 1990s, the original ideas of "full employment" had been replaced by the NAIRU theory,[ citation needed ] sometimes called the "natural rate of unemployment". This theory pointed to the dangers of getting unemployment too low because accelerating inflation can result, but it is unclear exactly what the value of the NAIRU is—or whether it really exists or not.

See also

Notes and references

  1. "The Neoclassical-Keynesian Synthesis". The History of Economic Thought Website. The New School. Archived from the original on June 5, 2002. Retrieved April 23, 2009.
  2. Woodford, Michael. Convergence in Macroeconomics: Elements of the New Synthesis. January 2008. http://www.columbia.edu/~mw2230/Convergence_AEJ.pdf.
  3. Mankiw, N. Greg. The Macroeconomist as Scientist and Engineer. May 2006. p. 14–15. http://scholar.harvard.edu/files/mankiw/files/macroeconomist_as_scientist.pdf?m=1360042085.
  4. Goodfriend, Marvin and King, Robert G. The New Neoclassical Synthesis and The Role of Monetary Policy. Federal Reserve Bank of Richmond. Working papers. June 1997. No. 98–5. http://www.richmondfed.org/publications/research/working_papers/1998/pdf/wp98-5.pdf.
  5. Hayes, M.G. (2008). The Economics of Keynes: A new guide to the General Theory. Edward Elgar Publishing. pp. 2–3, 31. ISBN   978-1-84844-056-2.
  6. Krugman, Paul. "There's something about macro" . Retrieved January 2, 2008.

Related Research Articles

Post-Keynesian economics is a school of economic thought with its origins in The General Theory of John Maynard Keynes, with subsequent development influenced to a large degree by Michał Kalecki, Joan Robinson, Nicholas Kaldor, Sidney Weintraub, Paul Davidson, Piero Sraffa and Jan Kregel. Historian Robert Skidelsky argues that the post-Keynesian school has remained closest to the spirit of Keynes' original work. It is a heterodox approach to economics.

Full employment is a situation in which everyone who wants a job can have work hours they need on fair wages. Because people switch jobs, full employment involves a positive stable rate of unemployment. An economy with full employment might still have underemployment where part-time workers cannot find jobs appropriate to their skill level. In macroeconomics, full employment is sometimes defined as the level of employment at which there is no cyclical or deficient-demand unemployment.

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.

Nicholas Kaldor British/Hungarian economist

Nicholas Kaldor, Baron Kaldor, born Káldor Miklós, was a Cambridge economist in the post-war period. He developed the "compensation" criteria called Kaldor–Hicks efficiency for welfare comparisons (1939), derived the cobweb model, and argued for certain regularities observable in economic growth, which are called Kaldor's growth laws. Kaldor worked alongside Gunnar Myrdal to develop the key concept Circular Cumulative Causation, a multicausal approach where the core variables and their linkages are delineated. Both Myrdal and Kaldor examine circular relationships, where the interdependencies between factors are relatively strong, and where variables interlink in the determination of major processes. Gunnar Myrdal got the concept from Knut Wicksell and developed it alongside Nicholas Kaldor when they worked together at the United Nations Economic Commission for Europe. Myrdal concentrated on the social provisioning aspect of development, while Kaldor concentrated on demand-supply relationships to the manufacturing sector. Kaldor also coined the term "convenience yield" related to commodity markets and the so-called theory of storage, which was initially developed by Holbrook Working.

A macroeconomic model is an analytical tool designed to describe the operation of the problems of economy

of a country or a region. These models are usually designed to examine the comparative statics and dynamics of aggregate quantities such as the total amount of goods and services produced, total income earned, the level of employment of productive resources, and the level of prices.

Neutrality of money is the idea that a change in the stock of money affects only nominal variables in the economy such as prices, wages, and exchange rates, with no effect on real variables, like employment, real GDP, and real consumption. Neutrality of money is an important idea in classical economics and is related to the classical dichotomy. It implies that the central bank does not affect the real economy by creating money. Instead, any increase in the supply of money would be offset by a proportional rise in prices and wages. This assumption underlies some mainstream macroeconomic models. Others like monetarism view money as being neutral only in the long-run.

Edmund Phelps American economist

Edmund Strother Phelps is an American economist and the recipient of the 2006 Nobel Memorial Prize in Economic Sciences.

New classical macroeconomics, sometimes simply called new classical economics, is a school of thought in macroeconomics that builds its analysis entirely on a neoclassical framework. Specifically, it emphasizes the importance of rigorous foundations based on microeconomics, especially rational expectations.

Paul Davidson is an American macroeconomist who has been one of the leading spokesmen of the American branch of the post-Keynesian school in economics. He is a prolific writer and has actively intervened in important debates on economic policy from a position that is very critical of mainstream economics.

Outline of economics Overview of and topical guide to economics

The following outline is provided as an overview of and topical guide to economics:

Keynesian Revolution economic theory

The Keynesian Revolution was a fundamental reworking of economic theory concerning the factors determining employment levels in the overall economy. The revolution was set against the then orthodox economic framework, namely neoclassical economics.

History of macroeconomic thought

Macroeconomic theory has its origins in the study of business cycles and monetary theory. In general, early theorists believed monetary factors could not affect real factors such as real output. John Maynard Keynes attacked some of these "classical" theories and produced a general theory that described the whole economy in terms of aggregates rather than individual, microeconomic parts. Attempting to explain unemployment and recessions, he noticed the tendency for people and businesses to hoard cash and avoid investment during a recession. He argued that this invalidated the assumptions of classical economists who thought that markets always clear, leaving no surplus of goods and no willing labor left idle.

Post-war displacement of Keynesianism

The post-war displacement of Keynesianism was a series of events which from mostly unobserved beginnings in the late 1940s, had by the early 1980s led to the replacement of Keynesian economics as the leading theoretical influence on economic life in the developed world. Similarly, the allied discipline known as Development economics was largely displaced as the guiding influence on economic policies adopted by developing nations.

Inflationism is a heterodox economic, fiscal, or monetary policy, that predicts that a substantial level of inflation is harmless, desirable or even advantageous. Similarly, inflationist economists advocate for an inflationist policy.

The new neoclassical synthesis (NNS) or new synthesis is the fusion of the major, modern macroeconomic schools of thought, new classical and New-Keynesianism, into a consensus on the best way to explain short-run fluctuations in the economy. This new synthesis is analogous to the neoclassical synthesis that combined neoclassical economics with Keynesian macroeconomics. The new synthesis provides the theoretical foundation for much of contemporary mainstream economics. It is an important part of the theoretical foundation for the work done by the Federal Reserve and many other central banks.