Advancedmacroeconomics
New Keynesian Economics: Sticky Prices, Modern Foundations
Overview
New Keynesian economics is the operating system of modern central banking: it keeps Keynes's core insight — that sticky prices make aggregate demand matter — but rebuilds it on rigorous microfoundations with forward-looking, optimizing agents. If you have ever heard a central banker discuss the output gap or forward guidance, you have heard New Keynesianism. This lesson explains sticky-price microfoundations, the three-equation model, and how the school answered its critics.
Learning objectives
- Explain how New Keynesians derive price stickiness from optimizing behavior.
- Describe the three-equation New Keynesian model (IS, Phillips curve, Taylor rule).
- Explain forward guidance and the zero-lower-bound problem in this framework.
- Contrast New Keynesian with old Keynesian and new classical economics.
The project: Keynesian results, rigorous foundations
Old Keynesian models were accused of assuming what they needed: arbitrary consumption functions, unexplained stickiness, no role for expectations. New Keynesians, from the 1980s onward (Mankiw, Blanchard, Clarida-Galí-Gertler, Woodford), rebuilt the edifice: households optimize intertemporally, firms set prices strategically, expectations are rational — and yet, because changing prices is costly or staggered, demand shocks still move output. The Keynesian conclusions survived; the hand-waving did not.
Sticky prices + optimizing agents + rational expectations = demand matters in the short run, money is non-neutral temporarily, stabilization policy works — now derived, not assumed.
Microfoundations of stickiness: menu costs and Calvo pricing
Why don't firms just cut prices in a slump? Menu costs: physically and cognitively repricing is costly, so small shocks are absorbed in output instead. Staggered contracts (Taylor) and Calvo pricing — each period only a random fraction of firms can reset prices — mean the aggregate price level moves sluggishly even when individual firms are rational. Near-rational inattention adds that tracking every shock is not worth managers' time. Small frictions at the firm level aggregate into large macroeconomic stickiness.
Mankiw's insight: tiny menu costs can cause large output fluctuations because firms ignore the small social benefit of price adjustment — a pecuniary externality.
The three-equation model
The workhorse model has three blocks. A forward-looking IS curve: today's output gap depends on expected future gaps and the real interest rate. A New Keynesian Phillips curve: inflation depends on expected future inflation and the current output gap — expectations are the anchor. A Taylor-type rule: the central bank sets rates responding to inflation and the output gap. Together they describe how demand shocks propagate and how credible policy stabilizes — the model inside most central bank forecasting systems.
Policy: inflation targeting and forward guidance
In this framework the central bank's main job is anchoring expectations: credible commitment to low inflation makes the Phillips curve flat and shocks painless. At the zero lower bound, conventional cuts are exhausted — but promises about future policy (forward guidance) still work by shaping expectations of future rates and inflation. Quantitative easing operates partly through the same expectations channel. The framework thus rationalizes the entire post-2008 central banking toolkit.
Forward guidance only moves expectations if the promise is believed. Time-inconsistency — the temptation to renege later — is why institutional independence and clear mandates matter.
Answering the critics
New classicals charged Keynesianism with ignoring expectations (Lucas critique); New Keynesians built rational expectations in from the start. Real business cycle theorists said fluctuations are optimal; New Keynesians showed sticky prices make them inefficient and policy-improvable. Austrians warned of malinvestment; New Keynesians reply that demand collapses are the empirically dominant shock. Each critique was absorbed rather than dodged — which is why the school, unlike its 1970s predecessor, survived contact with its enemies.
Limits and frontiers
The framework struggles where its assumptions bite: financial crises (the basic model has no banks), heterogeneity (one 'representative agent' misses distributional channels now known to matter — the HANK frontier), and supply shocks that force ugly inflation-output tradeoffs. Behavioral variants relax full rationality. Yet for demand-driven fluctuations — the bread and butter of stabilization policy — the New Keynesian core remains the best-tested apparatus economics has.
Key points
- New Keynesianism = Keynesian sticky-price results derived from optimizing, forward-looking agents.
- Stickiness microfoundations: menu costs, staggered/Calvo pricing, rational inattention.
- Three-equation core: forward-looking IS curve, expectations-augmented Phillips curve, Taylor rule.
- Policy works through expectations: credibility anchors inflation; forward guidance fights the ZLB.
- Absorbed its critics (Lucas critique, RBC) — the dominant framework in central banks today.
Common misconceptions
✓ Truth: The math changed the substance: rational expectations, intertemporal optimization, and explicit policy rules produce different — and testable — predictions about credibility, forward guidance, and the Lucas critique.
✓ Truth: The whole point of the microfoundations literature is deriving stickiness from rational behavior: repricing is costly, information is limited, contracts stagger. Irrationality is not required.
✓ Truth: It says systematic, credible, rules-like policy stabilizes better than discretion — while emphasizing lags, uncertainty, and the zero bound as hard limits on what policy can achieve.
Practice questions
Q1. The defining New Keynesian move was to:
- Abandon Keynes entirely
- Derive Keynesian sticky-price results from optimizing agents with rational expectations
- Assume prices never change
- Reject mathematics in economics
The school's achievement is microfoundations: menu costs, Calvo pricing, and forward-looking behavior generate demand-driven fluctuations without assuming irrationality or arbitrary functions.
Q2. In the New Keynesian Phillips curve, inflation depends on:
- Only past inflation
- Expected future inflation and the current output gap
- The money supply alone
- Government debt levels
Forward-looking price-setters embed expectations of future conditions: π = βE[π'] + κ(output gap). Anchored expectations are therefore the central bank's most valuable asset.
Q3. Forward guidance is most valuable when:
- Inflation is high and rising
- Policy rates are at the zero lower bound and cannot be cut further
- The economy is at full employment
- Expectations are already perfectly anchored
With current rates floored, shaping expectations of future rates is the remaining lever: credible promises of extended ease lower long-term real rates and stimulate demand today.
Click a question to reveal the answer and explanation.
Frequently asked questions
What is the New Keynesian Phillips curve?
Inflation today depends on expected future inflation plus the current output gap. Unlike the old curve, expectations are forward-looking and central: anchored expectations flatten the tradeoff, de-anchored expectations steepen it.
What is forward guidance?
Central bank communication about the future path of interest rates. By promising low rates for longer, the bank lowers expected future real rates, stimulating spending today — a key tool when current rates are stuck at zero.
What does HANK add to the framework?
Heterogeneous-Agent New Keynesian models replace the single representative household with diverse agents facing credit constraints. This restores realistic MPC differences and distributional channels — making fiscal transfers and inequality part of monetary transmission.
How do New Keynesians differ from monetarists?
Both prize credibility and rules, but New Keynesians give demand shocks and sticky prices the starring role and endorse active stabilization, while monetarists emphasize money growth and are warier of fine-tuning.