John Maynard Keynes is considered a foundational source in the understanding of macroeconomics. After performing research outside the textbook, explain the basic principles of New Keynesian Economics and how it addresses perceived limitations to classic Keynesian theory.

New Keynesian theory addresses limitations of classic Keynesian theory to explain stagflation. New Keynesian theory explains that despite higher price levels, wages and employment can be “sticky” for a while as individual businesses take a “wait and see” approach before hiring new workers or investing in growth and raising their own prices. Businesses also often wait to see what competitors do before acting themselves, which leads to a staggered implementation of price increases and new hiring.

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John Maynard Keynes laid out his theory of economics in the 1930s during and immediately after the Great Depression. His writings include A Treatise on Money, published in 1930, and perhaps his most influential book, The General Theory of Employment, Interest, and Money , published in 1936. In the...

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John Maynard Keynes laid out his theory of economics in the 1930s during and immediately after the Great Depression. His writings include A Treatise on Money, published in 1930, and perhaps his most influential book, The General Theory of Employment, Interest, and Money, published in 1936. In the aftermath of the Great Depression, economists and regulators were debating ways to avert an economic crisis of that magnitude in the future.

Keynes theorized that government intervention could help stabilize the economy and prevent another severe depression. Keynes’s theory asserts that aggregate demand is comprised of C + I + G + X, which is the total of spending by consumer households (C), the government (G), and net exports less imports plus total investment.

Keynes posited that markets often do not have self-regulating mechanisms that lead to full employment. For instance, in an economic pullback that increases unemployment, as consumer spending falls, reflecting people’s concerns about future economic trends, the aggregate response of businesses to reduce their own spending in order to conserve capital can further increase unemployment and magnify the economic overhang.

Thus, Keynes’s view was that government intervention was often necessary to smooth out the business cycles that could hurt employment and price levels. He supported government’s use of fiscal policies aimed at raising employment and stabilizing price levels. Although fiscal policy might not be able to fully eradicate economic ups and downs (boom and bust cycles), Keynes believed it could mitigate the extreme fluctuations. He advocated that governments proactively intercede to help stabilize economies.

The New Deal is a good example of Keynesian theory at play. Keynes advocated deficit spending on infrastructure projects to create jobs during economic downturns. The New Deal Works Projects Administration (WPA) created millions of jobs and also built projects to improve infrastructure.

New Keynesian economics evolved to address perceived limitations of classic Keynesian theory to explain certain economic anomalies. Specifically, classic Keynesian theory was perceived as limited in its ability to explain stagflation, those periods characterized by the combination of rising price levels, or inflation, and slow economic growth.

Under classical thinking, rising price levels on a macroeconomic level would induce businesses to hire and expand to benefit from higher prices. There have been times, however, when rising price levels have been accompanied by slow economic growth and higher-than-expected unemployment.

New Keynesian theory explains that general price levels can be “sticky” for a while. Although businesses theoretically should respond through growth measures to benefit from general economic price increases, individual businesses sometimes take a “wait and see” attitude before hiring new workers or investing in growth, particularly as it can be costly to change prices.

Thus, New Keynesian economists believe that wages and prices are sticky because price adjustments sometimes occur more slowly than expected. Moreover, price adjustments do not all occur simultaneously, but are “staggered” by individual business operators, who often wait to see what competitors do before acting themselves. This also can slow expected adjustments of the aggregate price level.

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