Keynes and Classical Economics
Developments after Keynes
Post-war Keynesianism
In the post-WWII years, Keynes's policy ideas were widely accepted, with the substantial help of his followers. For the first time, governments prepared good quality economic statistics on an ongoing basis and had a theory that told them what to do. In this era of new liberalism and social democracy, most western capitalist countries enjoyed low, stable unemployment, and modest inflation.
Paul Samuelson used the term "neoclassical synthesis" to refer to the integration of Keynesian economics with neoclassical economics. The idea was that the government and the central bank would maintain rough full employment, so that neoclassical notions centered on the axiom of the universality of scarcity – would apply.
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, namely 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.
Then, 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 the simultaneous application of expansionary (anti-recession) and contractionary (anti-inflation) policies appeared to be necessary, a clear impossibility.
This dilemma led to the end of the Keynesian near-consensus of the 1960s, and the rise throughout the 1970s of ideas based upon more classical analysis.
New Keynesianism
"New Keynesianism," associated with Gregory Mankiw and others, is a response to Robert Lucas and the new classical school. That school criticized the inconsistencies of Keynesianism in the light of the concept of "rational expectations". The new classicals combined a unique market-clearing equilibrium (at full employment) with rational expectations. The New Keynesians use "microfoundations" to demonstrate that price stickiness hinders markets from clearing. Thus, the rational expectations-based critique does not apply.
The New Keynesians assumed that wages and prices cannot be adjusted instantly, which implies that the economy may fail to attain full employment. Because of this market failure, and other market imperfections considered in their models, New Keynesian economists argue that demand management by the government or its central bank can lead to more efficient macroeconomic outcomes than laissez faire policy would. However, New Keynesian economics is somewhat more skeptical of the benefits of activist policies than traditional Keynesian economics was. New Keynesian economists fully agree with New Classical economists that in the long run, changes in the money supply are neutral. However, because prices are sticky in the New Keynesian model, an increase in the money supply (or equivalently, a decrease in the interest rate) does increase output and lower unemployment in the short run.