New Keynesian macroeconomists don’t believe that markets clear continuously because of the existence of imperfect competition and menu costs, prices tend to be sticky and adjust slowly to changing economic conditions. If sudden shocks occur simultaneously, prices will not adjust quickly enough to clear markets, therefore economy can remain in a state of disequilibrium for years due to the failure of the prices to adjust quickly. Moreover, NKM believe that any unemployment caused in a recession is voluntary. Wages are quick to adjust with a substantial time lag to change in aggregate demand, due to long term labour contracts and implicit contracts New Keynesians don’t however simply assume wages are rigid and prices are sticky, they do recognise significance of rational expectations.
Therefore in terms of the business cycle, New Classicalists believe that since markets clear rapidly, only unexpected or unanticipated changes in economic variables will effect the economy. Since individuals and firms formulate their expectations rationally, his tends to impede any attempts to use fiscal and monetary policy to control the business cycle.
NMC argue that any systematic fiscal or monetary policy will prove to be effective due to a number of reasons: time consistency (i.e. it takes time to recognize that a problem exists, formulate a policy to correct the problem, and put the policy into effect), anticipation of any proposed policy by individuals and firms, and the credibility problem associated with discretionary monetary policies.
To use fiscal or monetary policy, it is important to promote credibility, which affects expectations and hence the behaviour of firms and consumers. Policymakers use rigid policy rules. Under such as scheme, individuals and firms would become convinced that these economic variables would in fact behave in accordance with these rules. NCM promotes non-activism over activism with respect to stabilisation policy.
An example of this is the UK’s monetary policy committee, it changes interest rates with the intention of controlling inflation, markets then react to accommodate this. In 2004 steady increases in interest rates has curbed inflationary pressure from consumer spending and housing market.
New Keynesians believe that changes in the attitudes and expectations of individuals and firms could result in substantial economic instability that must be offset by stabilization policy, therefore are not in favour of rigid policy rules. As a result of the existence of long term wages and price contracts impose rigidity in labour and product markets, New Keynesians believe that the issue of credibility of fiscal and monetary policies are not of great concern. They believe that because wages and prices tend to be sticky and inflexible, total real output tends to be affected not only by unanticipated or unexpected changes in economic variables but also by the actual behaviour of these economic variables. Hence, according to NKM, even under the assumption of rational expectations, systematic fiscal or monetary policies will have an effect on the economy, therefore advocates policy activism and argues for stabilisation policy to promote stability even if individuals and firms make their expectations not rationally.
The new classical model suggests that deviation from full employment should turn out to be small and very short-lasting, which doesn’t explain the periods of long recession. Furthermore, inertia in wages and prices are not ignored in this model.
