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'''New Keynesian economics''' is a school of contemporary [[macroeconomics]] that strives to provide [[microfoundations|microeconomic foundations]] for [[Keynesian economics]]. It developed partly as a response to criticisms of Keynesian macroeconomics by adherents of [[new classical macroeconomics]].

Two main assumptions define the New Keynesian approach to macroeconomics. Like the New Classical approach, New Keynesian macroeconomic analysis usually assumes that households and firms have [[rational expectations]]. However, the two schools differ in that New Keynesian analysis usually assumes a variety of [[market failure]]s. In particular, New Keynesians assume that there is [[imperfect competition]]<ref>[http://huwdixon.org/SurfingEconomics/chapter4.pdf The role of imperfect competition in new Keynesian economics], Chapter 4 of [http://huwdixon.org/SurfingEconomics/index.html Surfing Economics] by [[Huw Dixon]]</ref> in price and wage setting to help explain why prices and wages can become "[[Sticky (economics)|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 [[Model (macroeconomics)|models]], imply that the economy may fail to attain [[full employment]]. Therefore, New Keynesians argue that macroeconomic stabilization by the government (using [[fiscal policy]]) and the [[central bank]] (using [[monetary policy]]) can lead to a more [[Pareto efficiency|efficient]] macroeconomic outcome than a ''[[laissez faire]]'' policy would.

==Development of Keynesian economics model==

===1970s===
The first wave of New Keynesian economics developed in the late 1970s. The first model of ''Sticky information'' was developed by [[Stanley Fischer]] in his 1977 article, ''Long-Term Contracts, Rational Expectations, and the Optimal Money Supply Rule''.<ref>{{cite journal |last=Fischer |first=S. |year=1977 |title=Long-Term Contracts, Rational Expectations, and the Optimal Money Supply Rule |journal=[[Journal of Political Economy]] |volume=85 |issue=1 |pages=191–205 |jstor=1828335 |doi=10.1086/260551|url=http://dspace.mit.edu/bitstream/1721.1/63894/1/longtermcontract00fisc.pdf |hdl=1721.1/63894 }}</ref>  He adopted a "staggered" or "overlapping" contract model. Suppose that there are two unions in the economy, who take turns to choose wages. When it is a union's turn, it chooses the wages it will set for the next two periods. This contrasts with [[John B. Taylor]]'s model where the nominal wage is constant over the contract life, as was subsequently developed in his two articles, one in 1979 "Staggered wage setting in a macro model'.<ref>John B Taylor (1979), 'Staggered wage setting in a macro model'. American Economic Review, Papers and Proceedings 69 (2), pp. 108–13</ref> and one in 1980 "Aggregate Dynamics and Staggered Contracts".<ref>John B Taylor (1980). "Aggregate Dynamics and Staggered Contracts," Journal of Political Economy, 88(1), pages 1-23, February.</ref>  Both Taylor and Fischer contracts share the feature that only the unions setting the wage in the current period are using the latest information: wages in half of the economy still reflect old information. The Taylor model had sticky nominal wages in addition to the sticky information: nominal wages had to be constant over the length of the contract (two periods).  These early new Keynesian theories were based on the basic idea that, given fixed nominal wages, a monetary authority (central bank) can control the employment rate. Since wages are fixed at a nominal rate, the monetary authority can control the [[real wage]] (wage values adjusted for inflation) by changing the money supply and thus affect the employment rate.<ref>Mankiw, N. Gregory (December 1990). "A Quick Refresher Course in Macroeconomics". Journal of Economic Literature, volume 28, pages 1645–1660. {{doi|10.3386/w3256}}. page 1658.</ref>

===1980s===

====Menu costs and Imperfect Competition====

In the 1980s the key concept of using menu costs in a framework of [[imperfect competition]] to explain price stickiness was developed.<ref>{{cite book |authorlink=Huw Dixon |first=Huw |last=Dixon |chapterurl=http://huwdixon.org/SurfingEconomics/chapter4.pdf |year=2001 |chapter=The Role of imperfect competition in new Keynesian economics |title=Surfing Economics: Essays for the Inquiring Economist |location=New York |publisher=Palgrave |isbn=978-0333760611 }}</ref> The concept of a lump-sum cost (menu cost) to changing the price was originally introduced by Sheshinski and Weiss (1977) in their paper looking at the effect of inflation on the frequency of price-changes.<ref>{{cite journal |last=Sheshinski |first=Eytan |last2=Weiss |first2=Yoram |year=1977 |title=Inflation and Costs of Price Adjustment |journal=[[Review of Economic Studies]] |volume=44 |issue=2 |pages=287–303 |jstor=2297067 |doi=10.2307/2297067}}</ref> The idea of applying it as a general theory of [[Nominal rigidity|Nominal Price Rigidity]] was simultaneously put forward by several economists in 1985–6. [[George Akerlof]] and [[Janet Yellen]] put forward the idea that due to [[bounded rationality]] firms will not want to change their price unless the benefit is more than a small amount.<ref>{{cite journal |last=Akerlof |first=George A. |last2=Yellen |first2=Janet L. |year=1985 |title=Can Small Deviations from Rationality Make Significant Differences to Economic Equilibria? |journal=[[American Economic Review]] |volume=75 |issue=4 |pages=708–720 |jstor=1821349 }}</ref><ref>{{cite journal |last=Akerlof |first=George A. |last2=Yellen |first2=Janet L. |year=1985 |title=A Near-rational Model of the Business Cycle, with Wage and Price Intertia |journal=[[The Quarterly Journal of Economics]] |volume=100 |issue=5 |pages=823–838 |doi=10.1093/qje/100.Supplement.823 }}</ref> This [[bounded rationality]] leads to inertia in nominal prices and wages which can lead to output fluctuating at constant nominal prices and wages. [[Gregory Mankiw]] took the menu-cost idea and focused on the [[welfare]] effects of changes in output resulting from [[sticky prices]].<ref>{{cite journal |last=Mankiw |first=N. Gregory |year=1985 |title=Small Menu Costs and Large Business Cycles: A Macroeconomic Model of Monopoly |journal=[[The Quarterly Journal of Economics]] |volume=100 |issue=2 |pages=529–538 |jstor=1885395 |doi= 10.2307/1885395}}</ref> Michael Parkin also put forward the idea.<ref>{{cite journal |first=Michael |last=Parkin |year=1986 |title=The Output-Inflation Trade-off When Prices Are Costly to Change |journal=[[Journal of Political Economy]] |volume=94 |issue=1 |pages=200–224 |doi= 10.1086/261369|jstor=1831966 |url=https://ir.lib.uwo.ca/economicsresrpt/782 }}</ref> Although the approach initially focused mainly on the rigidity of nominal prices, it was extended to wages and prices by  [[Olivier Blanchard]] and [[Nobuhiro Kiyotaki]] in their influential article ''Monopolistic Competition and the Effects of Aggregate Demand'' .<ref>{{cite journal |last=Blanchard |first=O. |last2=Kiyotaki |first2=N. |year=1987 |title=Monopolistic Competition and the Effects of Aggregate Demand |journal=[[American Economic Review]] |volume=77 |issue=4 |pages=647–666 |doi= |jstor=1814537 }}</ref> [[Huw Dixon]] and Claus Hansen showed that even if menu costs applied to a small sector of the economy, this would influence the rest of the economy and lead to prices in the rest of the economy becoming less responsive to changes in demand.<ref>{{cite journal |first=Huw |last=Dixon |first2=Claus |last2=Hansen |title=A Mixed Industrial Structure Magnifies the Importance of Menu Costs |journal=[[European Economic Review]] |year=1999 |volume=43 |issue=8 |pages=1475–1499 |jstor= |doi=10.1016/S0014-2921(98)00029-4 }}</ref>

While some studies suggested that menu costs are too small to have much of an aggregate impact, Laurence Ball and [[David Romer]] showed in 1990 that [[real rigidities]] could interact with nominal rigidities to create significant disequilibrium.<ref>Ball L. and Romer D (1990). ''Real Rigidities and the Non-neutrality of Money'', Review of Economic Studies, volume 57, pages: 183-203</ref> Real rigidities occur whenever a firm is slow to adjust its real prices in response to a changing economic environment. For example, a firm can face real rigidities if it has market power or if its costs for inputs and wages are locked-in by a contract.<ref>Romer, David (2005). Advanced Macroeconomics. New York: McGraw-Hill. {{ISBN|978-0-07-287730-4}}., pp 380–381.</ref> Ball and Romer argued that real rigidities in the labor market keep a firm's costs high, which makes firms hesitant to cut prices and lose revenue. The expense created by real rigidities combined with the menu cost of changing prices makes it less likely that firm will cut prices to a market clearing level.<ref>Mankiw, N. Gregory (1990).</ref>

Even if prices are perfectly flexible, imperfect competition can affect the influence of fiscal policy in terms of the multiplier. Huw Dixon and Gregory Mankiw developed independently simple general equilibrium models showing that the fiscal multiplier could be increasing with the degree of imperfect competition in the output market.<ref>Huw Dixon, a simple model of imperfect competition with Walrasian features, Oxford Economic Papers, (1987), 39, 134–160</ref><ref>Gregory Mankiw (1988), Imperfect competition and the Keynesian cross, Economics Letters, volume 26, pages 7-13</ref>  The reason for this is that [[imperfect competition]] in the output market tends to reduce the [[real wage]], leading to the household substituting away from [[Consumption (economics)|consumption]] towards [[leisure]]. When [[government spending]] is increased, the corresponding increase in [[Taxation|lump-sum taxation]] causes both leisure and consumption to decrease (assuming that they are both a normal good). The greater the degree of imperfect competition in the output market, the lower the [[real wage]] and hence the more the reduction falls on leisure (i.e. households work more) and less on consumption. Hence the [[fiscal multiplier]] is less than one, but increasing in the degree of imperfect competition in the output market.<ref>Costa L, Dixon H. (2011), "Fiscal Policy Under Imperfect Competition with Flexible Prices: An Overview and Survey", Economics: The Open-Access, Open-Assessment E-Journal, Vol. 5, 2011-3. {{doi|10.5018/economics-ejournal.ja.2011-3}}.</ref>

====The Calvo staggered contracts model====

In 1983 [[Guillermo Calvo]] wrote "Staggered Prices in a Utility-Maximizing Framework".<ref>Calvo, Guillermo A. (1983). "Staggered Prices in a Utility-Maximizing Framework". Journal of Monetary Economics 12 (3): 383–398. {{doi|10.1016/0304-3932(83)90060-0}}</ref>  The original article was written in a [[Discrete time and continuous time|continuous time]] mathematical framework, but nowadays is mostly used in its [[Discrete time and continuous time|discrete time]] version.  The Calvo model has become the most common way to model nominal rigidity in new Keynesian models. There is a probability that the firm can reset its price in any one period '''h''' (the [[hazard rate]]), or equivalently the probability ('''1-h''') that the price will remain unchanged in that period (the survival rate).  The probability '''h''' is sometimes called the "Calvo probability" in this context.  In the Calvo model the crucial feature is that the price-setter does not know how long the nominal price will remain in place, in contrast to the Taylor model where the length of contract is known ex ante.

==== Coordination failure ====
[[File:Coordination failure chart.svg|thumb|right|alt=Chart showing an equilibrium line at 45 degrees intersected three times by an s-shaped line.|In this model of coordination failure, a representative firm e<sub>i</sub> makes its output decisions based on the average output of all firms (ē). When the representative firm produces as much as the average firm (e<sub>i</sub>=ē), the economy is at an equilibrium represented by the 45 degree line. The decision curve intersects with the equilibrium line at three equilibrium points. The firms could coordinate and produce at the optimal level of point B, but, without coordination, firms might produce at a less efficient equilibrium.<ref name="Cooper, Russel 1988 page 446">Cooper, Russel; John, Andrew (1988). "Coordinating Coordination Failures in Keynesian Models". The Quarterly Journal of Economics 103 (3): 441–463. {{doi|10.2307/1885539}}. {{JSTOR|1885539}}, page 446</ref>]]
[[Coordination failure (economics)|Coordination failure]] was another important new Keynesian concept developed as another potential explanation for recessions and unemployment.<ref>Mankiw, N. Gregory (2008). "New Keynesian Economics". The Concise Encyclopedia of Economics. Library of Economics and Liberty. Retrieved 27 September 2010.</ref> In recessions a factory can go idle even though there are people willing to work in it, and people willing to buy its production if they had jobs. In such a scenario, economic downturns appear to be the result of coordination failure: The invisible hand fails to coordinate the usual, optimal, flow of production and consumption.<ref>Howitt, Peter (2002). "Coordination failures". In Snowdon, Brian; Vane, Howard. An Encyclopedia of Macroeconomics. Cheltenham, UK: Edward Elgar Publishing. {{ISBN|978-1-84064-387-9}}, pages 140-1.</ref> [[Russell W. Cooper (economist)|Russell Cooper]] and Andrew John's 1988 paper ''Coordinating Coordination Failures in Keynesian Models'' expressed a general form of coordination as models with multiple equilibria where agents could coordinate to improve (or at least not harm) each of their respective situations.<ref name="Cooper, Russel 1988 page 446"/><ref>Howitt (2002), page142</ref> Cooper and John based their work on earlier models including [[Peter A. Diamond|Peter Diamond]]'s 1982 [[Diamond coconut model|coconut model]], which demonstrated a case of coordination failure involving [[Matching theory (macroeconomics)|search and matching theory]].<ref>Diamond, Peter A. (October 1982). "Aggregate Demand Management in Search Equilibrium". Journal of Political Economy 90 (5): 881–894. {{doi|10.2307/1837124}}.</ref> In Diamond's model producers are more likely to produce if they see others producing. The increase in possible trading partners increases the likelihood of a given producer finding someone to trade with. As in other cases of coordination failure, Diamond's model has multiple equilibria, and the welfare of one agent is dependent on the decisions of others.<ref>Cooper and John (1988), pages 452-3.</ref> Diamond's model is an example of a "thick-market [[externality]]" that causes markets to function better when more people and firms participate in them.<ref>Mankiw, N. Gregory; Romer, David (1991). New Keynesian economics 1. Cambridge, Mass: MIT Press. {{ISBN|0-262-13266-4}}, page 8</ref> Other potential sources of coordination failure include [[self-fulfilling prophecies]]. If a firm anticipates a fall in demand, they might cut back on hiring. A lack of job vacancies might worry workers who then cut back on their consumption. This fall in demand meets the firm's expectations, but it is entirely due to the firm's own actions.

==== Labor market failures: Efficiency wages ====

New Keynesians offered explanations for the failure of the labor market to clear. In a Walrasian market, unemployed workers bid down wages until the demand for workers meets the supply.<ref>Romer (2005), page 438</ref> If markets are Walrasian, the ranks of the unemployed would be limited to workers transitioning between jobs and workers who choose not to work because wages are too low to attract them.<ref>Romer (2005) pages 437–439</ref> They developed several theories explaining why markets might leave willing workers unemployed.{{sfn|Romer|2005|p=437}} The most important of these theories, new Keynesians was the [[efficiency wages|efficiency wage theory]] used to explain [[hysteresis (economics)|long-term effects of previous unemployment]], where short-term increases in unemployment become permanent and lead to higher levels of unemployment in the long-run.<ref>Snowdon, Brian; Vane, Howard (2005). Modern Macroeconomics. Cheltenham, UK: Edward Elgar. {{ISBN|978-1-84542-208-0}}, page 384</ref>

[[File:Efficiency wage Shapiro Stiglitz.svg|thumb|right|alt=Chart showing the relationship of the non-shirking condition and full employment.|In the Shapiro-Stiglitz model workers are paid at a level where they do not shirk, preventing wages from dropping to full employment levels. The curve for the no-shirking condition (labeled NSC) goes to infinity at full employment.]]
In efficiency wage models, workers are paid at levels that maximize productivity instead of clearing the market.<ref>Froyen, Richard (1990). Macroeconomics, Theories and Policies (3rd ed.). New York: Macmillan. {{ISBN|978-0-02-339482-9}}. page 357</ref> For example, in developing countries, firms might pay more than a market rate to ensure their workers can afford enough [[nutrition]] to be productive.<ref>Romer (2005), page 439</ref> Firms might also pay higher wages to increase loyalty and morale, possibly leading to better productivity.<ref>Froyen (1990), page 358</ref> Firms can also pay higher than market wages to forestall shirking. Shirking models were particularly influential.<ref>Romer (2005), page 448</ref>[[Carl Shapiro (professor)|Carl Shapiro]] and [[Joseph Stiglitz]]'s 1984 paper ''Equilibrium Unemployment as a Worker Discipline Device'' created a model where employees tend to avoid work unless firms can monitor worker effort and threaten slacking employees with unemployment.<ref>Shapiro, C.; Stiglitz, J. E. (1984). "Equilibrium Unemployment as a Worker Discipline Device". The American Economic Review 74 (3): 433–444. {{doi|10.2307/1804018}}</ref><ref>Snowden and Vane (2005), page 390</ref> If the economy is at full employment, a fired shirker simply moves to a new job.<ref>Romer (2005), page 453.</ref> Individual firms pay their workers a premium over the market rate to ensure their workers would rather work and keep their current job instead of shirking and risk having to move to a new job. Since each firm pays more than market clearing wages, the aggregated labor market fails to clear. This creates a pool of unemployed laborers and adds to the expense of getting fired. Workers not only risk a lower wage, they risk being stuck in the pool of unemployed. Keeping wages above market clearing levels creates a serious disincentive to shirk that makes workers more efficient even though it leaves some willing workers unemployed.<ref>Snowden and Vane (2005), page 390.</ref>

===1990s===

====The new neoclassical synthesis====

In the early 1990s, economists began to combine the elements of new Keynesian economics developed in the 1980s and earlier with [[Real Business Cycle Theory]].  RBC models were dynamic but assumed perfect competition; new Keynesian models were primarily static but based on imperfect competition.  The [[New neoclassical synthesis]] essentially combined the dynamic aspects of RBC with imperfect competition and nominal rigidities of new Keynesian models. Tack Yun was one of the first to do this, in a model which used the [[Calvo (staggered) contracts|Calvo pricing]] model.<ref>Yun, Tack, (1996). "Nominal price rigidity, money supply endogeneity, and business cycles," Journal of Monetary Economics, Elsevier, vol. 37(2-3), pages 345-370, April.</ref> Goodfriend and King proposed a list of four elements that are central to the new synthesis: intertemporal optimization, rational expectations, imperfect competition, and costly price adjustment (menu costs).<ref>Goodfriend, Marvin; King, Robert G (1997), "The New Neoclassical Synthesis and the Role of Monetary Policy", NBER Macroeconomics Annual, NBER Chapters (National Bureau of Economic Research) 12: 231–83, {{JSTOR|3585232}}.</ref><ref>Snowden and Vane 2005, page 411</ref>  Goodfriend and King also find that the consensus models produce certain policy implications:  whilst monetary policy can affect real output in the short-run, but there is no long-run trade-off: money is not [[neutrality of money|neutral]] in the short-run but it is in the long-run.  Inflation has negative welfare effects. It is important for central banks to maintain credibility through rules based policy like inflation targeting.

====Taylor Rule====

In 1993,<ref>{{cite paper |last=Taylor |first=John B. |year=1993 |title=Discretion versus Policy Rules in Practice |work=Carnegie-Rochester Conference Series on Public Policy |volume=39 |url=http://www.stanford.edu/~johntayl/Papers/Discretion.PDF |pages=195–214 }} (The rule is introduced on page 202.)</ref> John B Taylor formulated the idea of a '''[[Taylor rule]]''', which is a reduced form approximation of the responsiveness of the [[nominal interest rate]], as set by the [[central bank]], to changes in [[inflation]], [[Gross Domestic Product|output]], or other economic conditions. In particular, the rule describes how, for each one-percent increase in inflation, the central bank tends raise the nominal interest rate by more than one percentage point. This aspect of the rule is often called the '''Taylor principle'''. Although such rules provide concise, descriptive proxies for central bank policy, they are not, in practice, explicitly proscriptively considered by central banks when setting nominal rates.

Taylor's original version of the rule describes how the nominal interest rate responds to
divergences of actual inflation rates  from ''target'' inflation rates and of actual [[Gross Domestic Product]] (GDP) from ''potential'' GDP:

:<math>i_t = \pi_t + r_t^* + a_\pi  ( \pi_t - \pi_t^* )  + a_y ( y_t - y_t^* ).</math>

In this equation, <math>\,i_t\,</math> is the target short-term [[nominal interest rate]] (e.g. the [[federal funds rate]] in the US, the [[Official bank rate|Bank of England base rate]] in the UK), <math>\,\pi_t\,</math> is the rate of [[inflation]] as measured by the [[GDP deflator]], <math>\pi^*_t</math> is the desired rate of inflation, <math>r_t^*</math> is the assumed equilibrium real interest rate, <math>\,y_t\,</math> is the logarithm of real [[Gross Domestic Product|GDP]], and <math>y_t^*</math> is the logarithm of [[potential output]], as determined by a linear trend.

====The New Keynesian Phillips curve====

The New Keynesian Phillips curve was originally derived by Roberts in 1995,<ref>{{cite journal |last=Roberts |first=John M. |year=1995 |title=New Keynesian Economics and the Phillips Curve |journal=[[Journal of Money, Credit and Banking]] |volume=27 |issue=4 |pages=975–984 |jstor=2077783 |doi=10.2307/2077783}}</ref> and has since been used in most state-of-the-art New Keynesian DSGE models.<ref>{{cite book |last=Romer |first=David |year=2012 |chapter=Dynamic Stochastic General Equilibrium Models of Fluctuation |title=Advanced Macroeconomics |publisher=McGraw-Hill Irwin |location=New York |pages=312–364 |isbn=978-0-07-351137-5 }}</ref> The new Keynesian Phillips curve says that this period's inflation depends on current output and the expectations of next period's inflation. The curve is derived from the dynamic Calvo model of pricing and in mathematical terms is:

:<math>\pi_{t} = \beta E_{t}[\pi_{t+1}] + \kappa y_{t}</math>

The current period t expectations of next period's inflation are incorporated as <math>\beta E_{t}[\pi_{t+1}]</math>, where <math>\beta</math> is the discount factor. The constant <math>\kappa</math> captures the response of inflation to output, and is largely determined by the probability of changing price in any period, which is <math>h</math>:
 
:<math>\kappa = \frac{h[1-(1-h)\beta]}{1-h}\gamma</math>.

The less rigid nominal prices are (the higher is <math>h</math>), the greater the effect of output on current inflation.

====The Science of Monetary Policy====

The ideas developed in the 1990s were put together to develop the new Keynesian [[Dynamic stochastic general equilibrium]] used to analyze monetary policy.  This culminated in the three equation new Keynesian model found in the survey by [[Richard Clarida]],  [[Jordi Gali]], and [[Mark Gertler (economist)|Mark Gertler]] in the [[Journal of Economic Literature]],.<ref>Clarida, Galí, and Gertler (2000)</ref><ref>{{cite journal |last=Clarida |first=Richard |last2=Galí |first2=Jordi |last3=Gertler |first3=Mark |year=2000 |title=Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory |journal=[[The Quarterly Journal of Economics]] |volume=115 |issue=1 |pages=147–180 |doi=10.1162/003355300554692 |citeseerx=10.1.1.111.7984 }}</ref>  It combines the two equations of the new Keynesian Phillips curve and the Taylor rule with the ''dynamic IS curve'' derived from the optimal [[Random walk model of consumption|dynamic consumption equation]] (household's Euler equation).

:<math>y_{t}=y_{t+1}+\frac{1}{\sigma}(i_{t} - E_{t}\pi_{t+1})+v_{t}</math>

These three equations formed a relatively simple model which could be used for the theoretical analysis of policy issues. However, the model was oversimplified in some respects (for example, there is no capital or investment). Also, it does not perform well empirically.

===2000s===

In the new millennium there have been several advances in new Keynesian economics.

====The introduction of imperfectly competitive labor markets====
Whilst the models of the 1990s focused on sticky prices in the output market, in 2000 Christopher Erceg, Dale Henderson and Andrew Levin adopted the Blanchard and Kiyotaki model of unionized labor markets by combining it with the Calvo pricing approach and introduced it into a new Keynesian DSGE model.<ref>Erceg C, Henderson D, and Levin A. (2000), Optimal monetary policy with staggered wage and price contracts, Journal of Monetary Economics, 46, pages 281-313</ref>

====The development of complex DSGE models.====
In order to have models that worked well with the data and could be used for policy simulations, quite complicated new Keynesian models were developed with several features. Seminal papers were published by Frank Smets and Rafael Wouters<ref>Frank Smets & Raf Wouters, 2003. "An Estimated Dynamic Stochastic General Equilibrium Model of the Euro Area," Journal of the European Economic Association, MIT Press, vol. 1(5), pages 1123-1175, {{doi|10.1162/154247603770383415}}.</ref><ref>Frank Smets & Rafael Wouters, 2007. "Shocks and Frictions in US Business Cycles: A Bayesian DSGE Approach," American Economic Review, American Economic Association, vol. 97(3), pages 586-606, June.</ref> and also [[Lawrence J. Christiano]], [[Martin Eichenbaum]] and Charles Evans<ref>{{cite journal | last1 = Christiano | first1 = Lawrence | last2 = Eichenbaum | first2 = Martin | last3 = Evans | first3 = Charles | year = 2005 | title = Nominal rigidities and the dynamic effects of a shock to monetary policy | url = http://faculty.wcas.northwestern.edu/~yona/research/paperaugust262003.pdf | journal = Journal of Political Economy | volume = 113 | issue = 1| pages = 1–45 | doi=10.1086/426038| citeseerx = 10.1.1.320.606 }}</ref> The common features of these models included:

*habit persistence.  The marginal utility of consumption depends on past consumption.
*Calvo pricing in both output and product markets, with indexation so that when wages and prices are not explicitly reset, they are updated for inflation.
*capital adjustment costs and variable [[capacity utilization|capital utilization]].
*new shocks
**demand shocks, which affect the marginal utility of consumption
** [[Markup (business)|markup shocks]] that influence the desired markup of price over marginal cost.
*monetary policy is represented by a Taylor rule.
*[[Bayes estimator|Bayesian estimation]] methods.

====Sticky information====
The idea of Sticky information found in Fischer's model was later developed by Gregory Mankiw and [[Ricardo Reis]].<ref>{{cite journal |last=Mankiw |first=N. G. |first2=R. |last2=Reis |year=2002 |title=Sticky Information Versus Sticky Prices: A Proposal To Replace The New Keynesian Phillips Curve |journal=[[Quarterly Journal of Economics]] |volume=117 |issue=4 |pages=1295–1328 |doi=10.1162/003355302320935034 |url=http://nrs.harvard.edu/urn-3:HUL.InstRepos:3415324 }}</ref> This added a new feature to Fischer's model: there is a fixed probability that you can replan your wages or prices each period. Using quarterly data, they assumed a value of 25%: that is, each quarter 25% of randomly chosen firms/unions can plan a trajectory of current and future prices based on current information. Thus if we consider the current period: 25% of prices will be based on the latest information available;  the rest on information that was available when they last were able to replan their price trajectory. Mankiw and Reis found that the model of sticky information provided a good way of explaining inflation persistence.

Sticky information models do not have nominal rigidity: firms or unions are free to choose different prices or wages for each period. It is the information that is sticky, not the prices. Thus when a firm gets lucky and can re-plan its current and future prices, it will choose a trajectory of what it believes will be the optimal prices now and in the future. In general, this will involve setting a different price every period covered by the plan.  This is at odds with the empirical evidence on prices.<ref>{{cite journal |first=V. V. |last=Chari |first2=Patrick J. |last2=Kehoe |first3=Ellen R. |last3=McGrattan |year=2008 |url=http://www.minneapolisfed.org/research/sr/sr409.pdf |title=New Keynesian Models: Not Yet Useful for Policy Analysis |journal=Federal Reserve Bank of Minneapolis Research Department Staff Report 409 }}</ref><ref name="Knotec2010">{{cite journal |first=Edward S. II |last=Knotec |year=2010 |title=A Tale of Two Rigidities: Sticky Prices in a Sticky-Information Environment |journal=Journal of Money, Credit and Banking |volume=42 |issue=8 |pages=1543–1564 |doi=10.1111/j.1538-4616.2010.00353.x }}</ref> There are now many studies of price rigidity in different countries: the United States,<ref name="KlenowKryvtsov2008">{{cite journal |first2=Oleksiy |last2=Kryvtsov |first=Peter J. |last=Klenow |year=2008 |title=State-Dependent or Time-Dependent Pricing: Does It Matter For Recent U.S. Inflation? |journal=[[The Quarterly Journal of Economics]] |volume=123 |issue=3 |pages=863–904 |doi=10.1162/qjec.2008.123.3.863 |citeseerx=10.1.1.589.5275 }}</ref> the Eurozone,<ref>{{cite journal |first=Luis J. |last=Álvarez |first2=Emmanuel |last2=Dhyne |first3=Marco |last3=Hoeberichts |first4=Claudia |last4=Kwapil |first5=Hervé |last5=Le Bihan |first6=Patrick |last6=Lünnemann |first7=Fernando |last7=Martins |first8=Roberto |last8=Sabbatini |first9=Harald |last9=Stahl |first10=Philip |last10=Vermeulen |first11=Jouko |last11=Vilmunen |year=2006 |title=Sticky Prices in the Euro Area: A Summary of New Micro-Evidence |journal=[[Journal of the European Economic Association]] |volume=4 |issue=2–3 |pages=575–584 |doi=10.1162/jeea.2006.4.2-3.575 |url=http://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp563.pdf }}</ref> the United Kingdom<ref>{{cite journal |first=Philip |last=Bunn |first2=Colin |last2=Ellis |year=2012 |title=Examining The Behaviour Of Individual UK Consumer Prices |journal=[[The Economic Journal]] |volume=122 |issue=558 |pages=F35–F55 |doi=10.1111/j.1468-0297.2011.02490.x }}</ref> and others. These studies all show that whilst there are some sectors where prices change frequently, there are also other sectors where prices remain fixed over time. The lack of sticky prices in the sticky information model is inconsistent with the behavior of prices in most of the economy. This has led to attempts to formulate a "dual stickiness" model that combines sticky information with sticky prices.<ref name="Knotec2010" /><ref>{{cite journal |first=Bill |last=Dupor |first2=Tomiyuki |last2=Kitamura |first3=Takayuki |last3=Tsuruga |title=Integrating Sticky Prices and Sticky Information |journal=[[Review of Economics and Statistics]] |year=2010 |volume=92 |issue=3 |pages=657–669 |doi=10.1162/REST_a_00017 |citeseerx=10.1.1.595.2382 }}</ref>

==Policy implications==

New Keynesian economists agree with [[New Classical Macroeconomics|New Classical]] economists that in the long run, the [[classical dichotomy]] holds: changes in the [[money supply]] are [[neutrality of money|neutral]]. However, because prices are sticky in the New Keynesian model, an increase in the money supply (or equivalently, a decrease in the interest rate) does increase output and lower unemployment in the short run. Furthermore, some New Keynesian models confirm the non-neutrality of money under several conditions.<ref>Benchimol, J., Fourçans, A. (2012), [https://ideas.repec.org/a/eee/jmacro/v34y2012i1p95-111.html Money and risk in a DSGE framework : A Bayesian application to the Eurozone], [[Journal of Macroeconomics]], vol. 34, pp. 95-111.</ref><ref>Benchimol, J., 2015, [https://ideas.repec.org/a/sej/ancoec/v821y2015p152-184.html Money in the production function: a new Keynesian DSGE perspective], [[Southern Economic Journal]], Volume 82, Issue 1, pp. 152-184.</ref>

Nonetheless, New Keynesian economists do not advocate using expansive monetary policy for short run gains in output and employment, as it would raise inflationary expectations and thus store up problems for the future. Instead, they advocate using monetary policy for [[stabilization policy|stabilization]].  That is, suddenly increasing the money supply just to produce a temporary economic boom is not recommended as eliminating the increased inflationary expectations will be impossible without producing a recession.

However, when the economy is hit by some unexpected external shock, it may be a good idea to offset the macroeconomic effects of the shock with monetary policy. This is especially true if the unexpected shock is one (like a fall in consumer confidence) which tends to lower both output and inflation; in that case, expanding the money supply (lowering interest rates) helps by increasing output while stabilizing inflation and inflationary expectations.

Studies of optimal monetary policy in New Keynesian DSGE models have focused on interest rate rules (especially '[[Taylor rule]]s'), specifying how the central bank should adjust the [[nominal interest rate]] in response to changes in [[inflation]] and output. (More precisely, optimal rules usually react to changes in the [[output gap]], rather than changes in output ''per se''.)  In some simple New Keynesian DSGE models, it turns out that stabilizing inflation suffices, because maintaining perfectly stable inflation also stabilizes output and employment to the maximum degree desirable. Blanchard and Galí have called this property the ‘divine coincidence’.<ref>{{cite journal |doi=10.1111/j.1538-4616.2007.00015.x |last=Blanchard |first=Olivier |authorlink= |author2=Galí, Jordi |year=2007 |title=Real wage rigidities and the New Keynesian model |journal=Journal of Money, Credit, and Banking |volume=39 |issue=1 |pages=35–65 |id= |url= http://www.nber.org/papers/w11806.pdf|accessdate= |quote= }}</ref>

However, they also show that in models with more than one market imperfection (for example, frictions in adjusting the employment level, as well as sticky prices), there is no longer a 'divine coincidence', and instead there is a tradeoff between stabilizing inflation and stabilizing employment.<ref name="blanchardgali_nkunemp">{{cite journal | last=Blanchard | first=Olivier |author2=Galí, Jordi | title=A New Keynesian model with unemployment | version= | pages= | publisher=CFS working paper 2007/08, Center for Financial Studies, Goethe University, Frankfurt | year=2007 | doi= | url=http://www.ifk-cfs.de/fileadmin/downloads/publications/wp/07_08.pdf | format= | id= | accessdate= }}</ref> Further, while some macroeconomists believe that New Keynesian models are on the verge of being useful for quarter-to-quarter quantitative policy advice, disagreement exists.<ref>[http://www.minneapolisfed.org/research/wp/wp664.pdf Federal Reserve Bank of Minneapolis, ''New Keynesian Models: Not Yet Useful for Policy Analysis'', July 2008]</ref>

Recently, it was shown that the divine coincidence does not necessarily hold in the non-linear form of the standard New-Keynesian model.<ref>Alves, S. A. L., 2014, "Lack of Divine Coincidence in New-Keynesian Models", Journal of Monetary Economics 67: 33-46.</ref> This property would only hold if the monetary authority is set to keep the inflation rate at exactly 0%. At any other desired target for the inflation rate, there is an endogenous trade-off, even under the absence real imperfections such as sticky wages, and the divine coincidence no longer holds.

==Relation to other macroeconomic schools==
Over the years, a sequence of 'new' macroeconomic theories related to or opposed to [[Keynesian economics|Keynesianism]] have been influential.<ref>Michael Woodford (1999), [http://www.columbia.edu/%7Emw2230/macro20C.pdf  'Revolution and evolution in 20th century macroeconomics], ''mimeo'', Columbia University.</ref> After [[World War II]], [[Paul Samuelson]] used the term ''[[neoclassical synthesis]]'' to refer to the integration of Keynesian economics with [[neoclassical economics]]. The idea was that the government and the central bank would maintain rough full employment, so that [[neoclassical economics|neoclassical]] notions—centered on the axiom of the universality of [[scarcity]]—would apply. [[John Hicks]]' [[IS/LM]] model was central to the neoclassical synthesis.

Later work by economists such as [[James Tobin]] and [[Franco Modigliani]] involving more emphasis on the [[microfoundations]] of consumption and investment was sometimes called [[neo-Keynesianism]]. It is often contrasted with the [[Post-Keynesian economics|post-Keynesianism]] of [[Paul Davidson (economist)|Paul Davidson]], which emphasizes the role of fundamental [[uncertainty]] in economic life, especially concerning issues of private [[fixed investment]].

New Keynesianism is a response to [[Robert Lucas, Jr.|Robert Lucas]] and the [[new classical economics|new classical]] school.<ref>Gali, Jordi (2015). ''Monetary Policy, Inflation and the Business Cycle: An Introduction to the New Keynesian Framework and Its Applications'' (second edition), Princeton University Press, Princeton and Oxford, {{ISBN|978-0-691-16478-6}}. Pages 5-6.</ref> That school criticized the inconsistencies of Keynesianism in the light of the concept of "[[rational expectations]]". The new classicals combined a unique [[market clearing|market-clearing]] equilibrium (at [[full employment]]) with rational expectations. The New Keynesians use "microfoundations" to demonstrate that price stickiness hinders markets from clearing. Thus, the rational expectations-based equilibrium need not be unique.

Whereas the neoclassical synthesis hoped that [[fiscal policy|fiscal]] and [[monetary policy]] would maintain [[full employment]], the [[new classical economics|new classicals]] assumed that price and wage adjustment would automatically attain this situation in the short run. The new Keynesians, on the other hand, see full employment as being automatically achieved only in the long run, since prices are "sticky" in the short run. Government and central-bank policies are needed because the "long run" may be very long.

[[John Maynard Keynes|Keynes']] stress on the importance of centralized coordination of macroeconomic policies (e.g., monetary and fiscal stimulus) and of international economic institutions such as the [[World Bank]] and [[International Monetary Fund]] (IMF), and of the maintenance of a controlled trading system was emphasized during the 2008 global financial and economic crisis. This has been reflected in the work of IMF economists<ref>''Fiscal Policy for the Crisis'', prepared by the IMF Fiscal Affairs and Research Departments (Antonio Spilimbergo, Steve Symansky, Olivier Blanchard, and Carlo Cottarelli)December 29, 2008 [https://blogs.wsj.com/economics/2008/12/29/imf-what-kind-of-stimulus-will-work/]</ref> and of [[Donald Markwell]].<ref>[[Donald Markwell]], '' [[John Maynard Keynes]] and International Relations: Economic Paths to War and Peace'', Oxford University Press, 2006.</ref>

==Major New Keynesian economists==
{{category see also|New Keynesian economists}}

* [[Jordi Galí]]
* [[Mark Gertler (economist)|Mark Gertler]]
* [[Nobuhiro Kiyotaki]]
* [[Michael Woodford (economist)|Michael Woodford]]

==See also==
* [[Calvo (staggered) contracts]]
* [[2008–2009 Keynesian resurgence]]
* [[New neoclassical synthesis]]
* [[Nominal rigidity|Sticky prices]]
* [[Welfare cost of business cycles]]
* [[Taylor Contracts (economics)]]

==References==
{{Reflist|30em}}

==Further reading==
* {{cite journal |last=Clarida |first=Richard |last2=Galí |first2=Jordi |last3=Gertler |first3=Mark |title=The Science of Monetary Policy: A New Keynesian Perspective |journal=[[Journal of Economic Literature]] |volume=37 |issue=4 |year=1999 |pages=1661–1707 |jstor=2565488 |doi=10.1257/jel.37.4.1661|citeseerx=10.1.1.199.3912 }}
* [[Robert J. Gordon]] Gordon, Robert (1990), [https://www.jstor.org/stable/2727103 What is New-Keynesian Economics?], ''Journal of Economic Literature''.
* [[Huw Dixon|Dixon, Huw]] (2008), [http://www.dictionaryofeconomics.com/article?id=pde2008_N000166 New Keynesian Economics], [http://www.dictionaryofeconomics.com/dictionary New Palgrave Dictionary of Economics] [http://huwdixon.org/SurfingEconomics/newkeynesianeconomics.pdf New Keynesian macroeconomics]. {{doi|10.1057/9780230226203.1184}}.
* {{cite encyclopedia |last1=Mankiw |first1=N. Gregory  |authorlink1= Greg Mankiw|authorlink2= |editor= [[David R. Henderson]]|encyclopedia=[[Concise Encyclopedia of Economics]] |title=New Keynesian Economics |url=http://www.econlib.org/library/Enc/NewKeynesianEconomics.html |year=2008 |edition= 2nd |publisher=[[Library of Economics and Liberty]] |location=Indianapolis |isbn=978-0865976658 |oclc=237794267}}
* {{cite web|last1=Rowe|first1=Nick|title=The Growth Stages of the New Keynesian Model|url=http://worthwhile.typepad.com/worthwhile_canadian_initi/2014/07/the-growth-stages-of-the-new-keynesian-model.html|website=Worthwhile Canadian Initiative|accessdate=24 July 2014}}

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[[Category:New Keynesian economics| ]]