New Keynesian Macroeconomics Economics

New Keynesian Economics and Coordination Failures

New Keynesian Macroeconomics

Other modern economists worked on developing foundations for macroeco­nomics from simulations, complexity, and agent-based models in which institu­tional characteristics were embedded within agents, and then, through simulations, one discovered what strategies survive. This work led to a new group, called new Keynesians, who argued that a new foundation for Keynesian-type economics could be developed. They reasoned that there was as much need for the macrofoundations of microeconomics as there was for microeconomic foundations. These modern economists are quite willing to accept the new classical criticism of the neo-Keynesian model, but they argue that there is nothing inherently contradictory between Keynesian economics and rational expectations. This leads them to believe that the appropriate response to the new classicals should not be to derive a more institutionally realistic microfoundation to macroeconomics. Instead, they argue that the key to understanding Keynesian macroeconomics is to recognize the need for a macrofoundation to microeco­nomics. One cannot analyze the choices of a representative agent independent of the macroeconomics context within which those choices are made. The aggregate production function cannot be derived from firm production func­tions, and output can shift around substantially for a variety of reasons, all concerning coordination failures. They contend that individual decisions are made contingent on others' expected decisions and that economies are likely to fall into expectation conundrums.

Hence a society of rational individuals can find itself in an expectational conundrum in which all individuals are making rational decisions, but the net result of those individually rational decisions is socially irrational. According to the new Keynesians, the rational expectations assumption leads to the new classical conclusion that monetary and fiscal policy are ineffective only if it is combined with an assumption that all markets clear at the collectively desired level of output. But, they argue, that is an ad hoc assumption, not something that logically follows from the analysis.

For example, individuals collectively may expect that demand will be low and collectively produce little because of that expectation: supply is low because expected demand is low. Unless a coordinating system for expectations exists so that when one person lowers his or her expectations of demand, some mecha­nism exists to offset the effect of that lowering of expectations on the individual's supply decision, supply will be too low because demand was expected to be too low. It is this assumption, that the economy will inevitably equilibrate at the collectively desired equilibrium, not the rational expectations assumption, that these new Keynesians cannot accept.

Most new Keynesian work is highly abstract and theoretical, starting with abstract game-theoretic models and demonstrating that multiple equili­bria are possible.21 For the most part these abstract models have not filtered down to introductory and intermediate textbooks, but they should eventually do so.

The revival of theoretical interest in Keynesian economics does not mean that what were known as Keynesian economic policies have regained their former status. In the 1970s there was growing concern about whether monetary and fiscal policy were politically effective tools, even if they were theoretically effective. Many Keynesians argued that monetary and fiscal policy were politi­cally impossible to utilize and that politics, not sound economic principles, was determining the size of the deficit and the growth of the money supply.

The arguments between new Keynesians and new classicals quickly be­come complicated. It is not appropriate for a course on the history of thought to examine them. What is important to point out is that most modern macro-economic research and most graduate training in macroeconomics consist of acquiring the technical background necessary to understand the modern debate.