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Many of the theories that make up modern macroeconomic study are based on ideas put forth by John Maynard Keynes during the 1930s. Keynesian economics serves as the basis for many other economic theories, and is based on the idea that prices and wages automatically adjust based on market influences. During the late 20th century, however, modern economists published a series of criticisms aimed at classical Keynesian models. These critiques form a new school of economic theory known as new Keynesian economics. Under new Keynesian economics, prices and wages adjust much more slowly than they did under the classic Keynesian models, resulting in a certain unavoidable level of involuntary unemployment.
The classical Keynesian economic model assumes that prices and wages adjust instantly in the short run. For example, during an inflationary period when people are spending money freely, demand for products in all industries will be relatively high. High demand signals firms to hire more workers and increase production, resulting in higher wages. These higher wages, combined with high demand, will then lead the firm to charge more for its products by raising prices.
Based on Keynes' theories, as prices rise, demand will start to decrease, leading firms to layoff workers and cut wages. Changes in price and wages will then cause this cycle to repeat again. According to this model, the economy is self-adjusting in the short run, and government intervention is not needed.
Based on new Keynesian economics, prices and wages do not adjust automatically as they did under the classical model. Instead, new Keynesian economics assumes that prices and wages are sticky, and take time to adjust. This means that people will be unemployed for longer than they would be under classic Keynesian theories. One of the major concepts of new Keynesian economics is that a large percentage of unemployment is involuntary, and that many people who want to work are unable to find jobs.
These neoKenesian models attempt to define exactly why prices and wages are so slow to react to changes in the market. One idea is that price changes take time due to menu costs, or the expenses a business faces as it reprints in brochures, menus or other cost data sheets. Another suggestion is that businesses are slow to drop prices when demand decreases because they can't be sure how it will impact their bottom line. Theoretically, consumers will buy more as a whole when prices drop, but models do not indicate exactly how this will impact individual suppliers or businesses.
New Keynesian economics highlights the need for greater government intervention in the short run. This includes changing interest rates to increase or decrease the money supply and spur job creation. Under classic Keynesian models, this type of intervention is only needed to spur long term changes, not short term ones.
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