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.