Introduction
New Keynesian Economists believe that in the long run the economy will behave as described in the proceeding articles, with it naturally moving toward a state of full employment and stable prices. However, as the economy is very rarely in these states, New Keynesian Economics proposes a series of ways in which the economy will behave differently over a shorter time frame. These real world ‘frictions’ as they are called, prevent the mechanisms of the long-run models I discussed from working smoothly and so can cause the economy not to be at full employment or to have stable prices. I will briefly describe the main friction next.
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Short-Run Frictions
The main friction is ‘price stickiness’. In the long-run it is assumed that prices adjust so that supply always equals demand in the market for goods and services. However, in the short-run it is not easy for many firms to actually adjust their prices quickly. For example, firms will often set their sales price annually on a cost-plus strategy, say the total costs of producing a good plus a 30% mark up. They then invest in catalogues, adverts and other marketing promotions declaring what their price will be. If they suddenly experience a cost increase (say caused by a sudden rise in oil prices bought on by a war in the middle-east) then they cannot change their prices overnight. More importantly, customers do not like prices to change regularly so firms will often absorb increased costs for a long time period before increasing their prices. Hence prices are often slow to adjust, or ‘sticky’. They will eventually adjust to match the long-run equilibrium, but there is a period where prices are ‘fixed’ and the economy behaves differently.
What Effect Does Price Stickiness Have?
Let’s look at some examples to answer this question. We’ll start by asking ourselves what would happen if the government increased the money supply (which could be done in a variety of ways, such as the bank of England deciding to buy back long-term government debt issued to the public). The long-run view believes that economy is at full capacity and so printing money will just lead to rising prices (inflation). However, in the short-run prices cannot change instantly, so there is a period where prices stay the same and there is more money in the economy. People will feel temporarily better off and it is likely that they will consume more (as consumption is a function of income). So, in the short-run printing money leads to increased levels of transactions (or in normal language a boom). Likewise, if the government decreased the money supply prices would stay fixed in the short-run and people would feel worse off (as in the long-run prices should be lower given the reduced money supply – but they stay fixed at a higher level in the short-run).
The Structure of the Short-Run – Aggregate Demand and Aggregate Supply
The short-run is founded on the idea that aggregate demand needs to equal aggregate supply. This makes sense as one person’s spending is another person’s income, so when this is summed up for everyone in the economy the same should be true. There is a particular focus on aggregate demand, and ways in which economic shocks can cause aggregate demand to contract in the short-run, which leads to a reduction in how much stuff is produced (aggregate supply), which means less workers needing to be employed and falling living standards (most severely felt in a recession).
This focus on aggregate demand is the ‘Keynesian’ element of New Keynesian Economics. New Keynesians believe that active monetary policy intervention can be used in the short-run to reduce the severity of recessions and to push the economy more quickly toward its natural long-run equilibrium of full employment. What do I mean by monetary policy? In this case I’m talking about the interest rate. New Keynesians don’t endorse the use of the government printing press to boost aggregate demand (which would be called fiscal policy), instead they believe in influencing the interest rate so that it will in turn influence the amount that businesses invest (a component of aggregate demand). Keynes proposed this as a mechanism but also stated his belief that business investment would not be responsive enough to the interest rate, and that influencing the interest rate would not materially change aggregate demand.
Keynes actually argued for Fiscal policy to be used in a recession, by which we effectively mean the government should print money to boost demand when it is low. Hence many people (myself included) do not consider New Keynesian Economics to be based on the ideas of John Maynard Keynes.
Aggregate Demand – IS-LM
The most important part to conceptually understand in the short-run theory is aggregate demand. New Keynesian Economics uses a model called IS-LM to explain what the level of aggregate demand will be given certain economics conditions. The next article will be dedicated to this topic in detail.