New Keynesian Economics

The new Keynesian economics developed in response to the new classical

macroeconomics. Like the new classicals (NCs), new Keynesians (NKs)
build macroeconomics on explicit microfoundations governing individual
wage, price and expectation formation. They also typically share the NC
view that these microfoundations should be based on an assumption of
individual optimizing behaviour. Despite these similarities, the NKs
produce an analysis of the macroeconomy that revives Keynesian insights
and so lends support to forms of government activism.
It does some injustice to the variety of NK ideas, but there is one key to
these diferences: NKs recognize some information problems which the
NCs do not. The remainder of this entry will sketch how the presence of
these problems can create the scope for government activism to stabilize
unemployment at a low level in a market economy (see Gordon, 1990;
Hargreaves Heap, 1995, for more detailed accounts).
Where the NCs assume that agents are price takers and that prices move
to clear markets, the NKs typically have agents that set prices and markets
that fail to clear. There are many possible sources of this switch to imperfectly
competitive microfoundations but one is the fact that information is
rarely freely available. For example, in a market where knowledge of prices
is not freely available, individuals face varying search costs and are unlikely
to desert en masse a frm which raises its price modestly. Hence the frm
faces a downward-sloping demand curve and has discretion over what price
to set.
In a similar fashion, when a frm lacks information over the efort
expended by its workers, it may set a wage above the market-clearing value
even though the labour market is in other respects perfectly competitive.
This is because a frm may respond to this lack of information by attempting
to raise its wage relative to others in order to create a cost to shirking
when there is at least some chance of a shirker being caught ex post and
fred. Of course, when all frms attempt this, relative wages will not change.
But as each frm boosts its wage, the general wage is bid up above the
market-clearing value and, when this happens sufciently, the pressure to
increase wage subsides because the prospect of involuntary unemployment,