Neo-Keynesian Economics
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In the 1970s a series of economic developments occurred which shook classical Keynesian theory, particularly the existence of stagflation. The result would be a series of new ideas to bring tools to Keynesian analysis that would be capable of explaining economic events. This article covers the development of specifically Keynesian thought.
The Neo-Classical Synthesis
After Keynes, Keynesian analysis was combined with classical 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.
In the post-WWII 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.
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.
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 conservative economists which began in the late 1940s with Milton Friedman. 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 the "crowding out" effects discussed above 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. This monetarism had both an ideological appeal -- since monetary policy does not, at least on the surface, imply as much government intervention the economy. 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.
Neo-Keynesian Economics
Through the 1980s Keynesianism and "classical macro-economics" 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 non-military 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.
In the 1990s the "uncoupling" of money supply and inflation caused a increasing questioning of the original form of monetarism. The repeated failures of projections for economic recovery in Japan and the United States based on neo-classical synthesis models, as well as the failure 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. 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 quicky with changes in supply and demand, so that quantity adjustment prevails. This is a practice which, according to economist Paul Krugman "never works in theory, but works beautifully in practice." 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 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 that rational expectations will defeat any monetary or fiscal policy. But 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.
In the end, many 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, sometimes called the "natural rate of unemployment." This theory pointed to the dangers of getting unemployment too low, because accelerating inflation can result. However, it is unclear exactly what the value of the NAIRU is -- or whether it really exists or not. While the Keynesian triumphalism of the 1960s is certainly not due for a revival, Keynesian ideas persist, often used to attain very conservative goals. Many observers find it hard to distinguish the new Keynesianism from old monetarism, except that the latter's emphasis on the money supply has been dropped or downgraded.
Of course, for a relatively open economy such as that of the United Kingdom and almost all other countries, this simple Keynesianism must be complemented by considerations of foreign exchange markets, foreign exchange rates, and the balance of payments. Also needed is an understanding of issues of long-term growth of potential. The open economy considerations which were the basis of the conservative or neo-liberal revival of policy, were then codified by Keynesian economists.
See also Keynesian economics.