New Keynesian economics
Economic theory based on the ideas of Keynesian economics, which aimed at developing microeconomic theory to explain macroeconomic phenomena, such as persistent involuntary unemployment and business cycle fluctuations, that classical economics was unable to explain in a satisfactory way. The main components of the New Keynesian theory are the capital market imperfections stemming from the information asymmetry between lenders and borrowers, and price rigidities. One explanation of price rigidities offered in this theory is that not all firms adjust their prices simultaneously in response to the changes in economic environment; examples of staggered price-setting models are Calvo contract and Taylor contract. Price-setting behaviour of any given firm, by exerting externalities on other firms, leads to the possibility of multiple equilibria, and. In particular, a coordination failure may result in a recession. Wage rigidity, explained in the efficiency wages framework, does not allow wages to fall to the market-clearing level and thus leads to unemployment, while interest rate rigidity leads to credit rationing. An adverse external shock affecting the working capital of the firms and increasing their risk of bankruptcy reduces their willingness to produce, and it takes time for the working capital to recover, thus leading to business cycle fluctuation. A monetary policy, by influencing the lenders’ decision to extend credit to the firms, can therefore have real economic effect. This provides a rationale for active policy intervention in an economy. Mathematical formulation of New Keynesian economic framework is presentee primarily in the dynamic stochastic general equilibrium (DSGE) model.
Reference: Oxford Press Dictonary of Economics, 5th edt.