Neo Classical vs Keynesian School
We know that Keynesian economics was propounded as a revolution against the then prevailing orthodoxy of the classical school. In time, however, the Keynesians themselves established orthodoxy. The Keynesians were helped in establishing their own orthodoxy, initially through the neoclassical synthesis of the classical and Keynesian schools involving the IS-LM model, and then through the AS-AD model. This latter synthesis through the AS-AD curves produced a model that had Keynesian properties in the short-run and classical properties in the long run. As aggregate demand falls, the downward rigidities of prices and wages produces unemployment in the short-run, but full employment is restored in the long run as prices and wages adjust slowly. The Keynesian revolution was appropriated within the mainstream through the AS-AD model.
The ideas of rational expectations and real business cycles (see Block 5) that came up in the 1970s developed into the New Classical School. This School was a revolution against the Keynesian orthodoxy that had by now established itself. It propounded wage-price flexibility in a perfectly competitive setting of optimising individuals so that there was no basis for the existence of Keynesian unemployment even in the short run.
The New Classical ideas, though theoretically elegant and intellectually appealing, flew in the face of empirical realities in a world characterised by periodic booms and busts. The Keynesian ideas, on the other hand, attempted to explain the real world, but did not rely on the tools of mainstream economics like optimisation in the context of individuals who form expectations rationally. We can say that the microeconomic foundations underlying the Keynesian macroeconomics were weak. Thus, a question could be asked to the Keynesians: Why would rational firms not increase product prices when money supply is known to have increased, since economic theory predicts that prices would ultimately increase as a consequence of increase in money supply and rationally formed expectations require the individuals to increase prices? We understand this particular question to a greater extent in Sections 15.3 and 15.4. It suffices to say, for now, that the New Keynesian School emerged in the 1980s as a counter-revolution against the New Classical ideas of the 1970s. The New Keynesians attempted to construct models that were empirically well grounded in the sense that they made more realistic assumptions about the macroeconomic world. Moreover, these models were theoretically elegant in that they explained through models of rational optimising individuals why firms would not, increase prices in the face of increased money supply. Upward rigidity in prices would prevail in spite of the fact that not increasing prices could, apparently at least, lead to a fall in profits. You should note two characteristics of the New Keynesian School at this. point. The first makes it very different and the second not so different, from the New Classicals:
i) We have beenlasking questions like why do firms not change prices. This presumes that the firm have the power not to change prices if they so wish, i.e., they have the power to set prices. Unlike in the New Classical world, the New Keynesian firms are operating in markets with some degree of monopoly power. That is an important difference between the two schools: the New Classicals assume perfect competition and the New Keynesians work in the context of imperfectly competitive markets. We also had this in mind when we said that the New Keynesian models are empirically well grounded.
ii) Yet when it comes to the use of analytical tools, the New Keynesians are no different from the New Classicals. They build models to show why optimising, rational individuals do hold prices fixed when macroeconomic conditions demand that prices be changed. In setting up their counter- revolution, the New Keynesians meet the New Classicals on their home grounds, using the same tools of optimising behaviour of individuals in their models. You must note, in this context, that though we have associated the rational expectations revolution (along with the real business cycle theory) with the New Classical School, there is nothing intrinsic about rationally- formed expectations that make them any closer to the New Classical way of doing things than to the New Keynesian. The New Keynesian models can as much be propelled by individuals who are not only rational in the sense that they optimise, but also in the sense that they form expectations rationally.