REVIEW

Basic Concepts of Economics

OBJECTIVES:
▪ Explore the basic concepts of Economics
▪ Understand why we should be engaged in
the study of Economics
▪ Enhance our knowledge about the Basic
Economic Principles
▪ Explain how the economic system works
▪ Relate economics to our life experiences
ECONOMY
comes from the Greek word
oikonomos

which means
“one who manages a
household”
DEFINITIONS OF ECONOMICS
 “
Economics is the study
of how society manages
its scarce resources.

G. Mankiw
 “
Economics is the study of the
proper allocation and
efficient use of resources
to produce commodities for
the satisfaction of unlimited
needs and wants of man.

Gabay, et al.
 “
Economics is the social science
that studies the choices that
individuals, businesses,
governments, and entire
societies make as they cope
with scarcity and the incentives
that influence and reconciles
those choices.

Michael Parkin
Our inability to satisfy all our wants is called
scarcity.

With this, we c h o o s e among the available

alternatives.

The choices that we make depend on the

i n c e n t i v e s that we face.
 GOAL OF EC ON OMIC S

▪ To strengthen economic freedom

▪ Promote economic efficiency
▪ Promote economic stability
▪ To improve economic security
▪ Attaining a high level of growth

Gabay, B., R. R., Jr., & Uy, E. (2010). Economics: Its Concepts and Principles. Rex Bookstore.
❖ To strengthen economic freedom

This includes freedom

▪ of consumer choice
▪ of occupational choice
▪ to consume or save
Goals of
▪ of enterprise 11

Economics
❖ Promote Economic Efficiency

-making most out of the resources

available
Goals of
Economics 12
❖ Promote Economic Stability

-Stability
means there is no violent ups and
downs in the economy.
Goals of
Economics 13
❖ Promote Economic Security

Our government is providing us

economic security.
-by keeping the unemployment at low
level
-by ensuring price stability to control Goals of
inflation Economics 14

-by enforcement of contracts

-by preservation of environment

There should have an assurance that

goods and services will be available,
payments will be made and a safety net
will assist in case of disaster.
❖ To attain a high level of growth in the
economy

Assurance of economic growth and innovation.

Innovation leads to growth. Growth leads to Goals of
higher standard of living Economics 15
Basic Economic 16

Principles
How People Make Decision

▪ People face trade- offs

Basic
▪ The cost of something is what you
give up to get it Economic
▪ Rational people think at the margin Principles
▪ People respond to incentives
How People Interact

▪ Trade can make everyone better off Basic

▪ Markets are usually a good way to Economic
organize economic activity Principles
▪ Government can sometimes
improve market outcomes
How the Economy as a Whole Works

▪ A country’s standard of living depends

on its ability to produce goods and
Basic
services Economic
▪ Prices rise when the government prints Principles
too much money
▪ Society faces a short-run trade off
between inflations and unemployment
MICROECONOMICS
VS
MACROECONOMICS
 Economics is divided into two branches:

👪 🌏
MICROECONOMICS MACROECONOMICS
study of how households and study of economy wide
firms make decisions and how phenomena, including inflation,
they interact in the markets unemployment, and economic
growth
deals with the behavior of
individual component deals with the behavior of the
economy as a whole
 METHODOLOGIES OF ECONOMICS

NORMATIVE POSITIVE
ECONOMICS ECONOMICS

has something to do with has something to do with what is

what ought to be, concerned with the way
how the world should be economic relationships are
attempts to describe the world
as it is
 FACTORS OF PRODUCTION

LAND LABOR CAPITAL ENTERPRENEUR

Economic Models
Circular-Flow Diagram
The Production Possibilities Frontier
https://study.com/academy/lesson/circular-flow-diagram-in-economics-definition-example.html
 PRODUCTION
POSSIBILITIES
FRONTIER

a curve depicting all

maximum output
possibilities for two
or more goods given
a set of inputs
(resources, labor,
etc.)

assumes that all

inputs are used
efficiently
https://economics4u.weebly.com/production-possibility-frontier-ppf.html
1. What to produce?
2. How much to produce?
Basic
3. How to produce? Economic
4. For whom to produce? Problems

???
EC ON OMIC SYSTEMS
▪ Traditional Economic System
▪ Command Economy
▪ The Market System/Free
Enterprise
▪ The Mixed economy
▪ Classical School
▪ Neo Classical
▪ New Classical ECONOMICS
▪ Keynesian Economics SCHOOL OF
▪ Monetarist THOUGHTS

▪ New Keynesian

https://www.economicsonline.co.uk/Economic_schools.html
Classical School

The Classical school, which is regarded as the first school of economic thought, is associated with the
18th Century Scottish economist Adam Smith, and those British economists that followed, such as
Robert Malthus and David Ricardo.

The main idea of the Classical school was that markets work best when they are left alone, and that
there is nothing but the smallest role for government. The approach is firmly one of laissez-faire and a
strong belief in the efficiency of free markets to generate economic development. Markets should be
left to work because the price mechanism acts as a powerful ‘invisible hand’ to allocate resources to
where they are best employed.

In terms of explaining value, the focus of classical thinking was that it was determined mainly by scarcity
and costs of production.

In terms of the macro-economy, the Classical economists assumed that the economy would
always return to the full-employment level of real output through an automatic self-adjustment
mechanism.

It is widely recognised that the Classical period lasted until 1870.

Neo-classical

The neo-classical school of economic thought is a wide ranging school of ideas from which modern
economic theory evolved. The method is clearly scientific, with assumptions, and hypothesis and
attempts to derive general rules or principles about the behaviour of firms and consumers.

For example, neo-classical economics assumes that economic agents are rational in their behaviour, and
that consumers look to maximise utility and firms look to maximise profits. The contrasting objectives of
maximising utility and profits forms the basis of demand and supply theory. Another important
contribution of neo-classical economics was a focus on marginal values, such as marginal cost and
marginal utility.

Neo-classical economics is associated with the work of William Jevons, Carl Menger and Leon Walras.

New classical

New classical macro-economics dates from the 1970s, and is an attempt to explain macro-economic
problems and issues using micro-economic concepts like rational behaviour, and rational expectations.
New classical economics is associated with the work of Chicago economist, Robert Lucas.

Keynesian economics

Keynesian economists broadly follow the main macro-economic ideas of British economist John
Maynard Keynes. Keynes is widely regarded as the most important economist of the 20th Century,
despite falling out of favour during the 1970s and 1980s following the rise of new classical economics.
In essence, Keynesian economists are skeptical that, if left alone, free markets will inevitably move
towards a full employment equilibrium.

The Keynesian approach is interventionist, coming from a belief that the self interest which governs
micro-economic behaviour does not always lead to long run macro-economic development or short run
macro-economic stability. Keynesian economics is essentially a theory of aggregate demand, and how
best best to manipulate it through macro-economic policy.
The Price Mechanism

The interaction of buyers and sellers in free markets enables goods, services, and resources to be
allocated prices. Relative prices, and changes in price, reflect the forces of demand and supply and help
solve the economic problem. Resources move towards where they are in the shortest supply, relative to
demand, and away from where they are least demanded.

The rationing function of the price mechanism

Whenever resources are particularly scarce, demand exceeds supply and prices are driven up. The
effect of such a price rise is to discourage demand, conserve resources, and spread out their use over
time. The greater the scarcity, the higher the price and the more the resource is rationed. This can be
seen in the market for oil. As oil slowly runs out, its price will rise, and this discourages demand and
leads to more oil being conserved than at lower prices. The rationing function of a price rise is
associated with a contraction of demand along the demand curve.

The signalling function of the price mechanism

Price changes send contrasting messages to consumers and producers about whether to enter or leave a
market. Rising prices give a signal to consumers to reduce demand or withdraw from a market
completely, and they give a signal to potential producers to enter a market. Conversely, falling prices
give a positive message to consumers to enter a market while sending a negative signal to producers to
leave a market. For example, a rise in the market price of 'smart' phones sends a signal to potential
manufacturers to enter this market, and perhaps leave another one. Similarly, the provision of
'free' healthcare may signal to 'consumers' that they can pay a visit to their doctor for any minor
ailment, while potential private healthcare providers will be deterred from entering the market. In terms
of the labour market, a rise in the wage rate, which is the price of labour, provides a signal to the
unemployed to join the labour market. The signalling function is associated with

shifts in demand and supply curves.

The incentive function of the price mechanism

An incentive is something that motivates a producer or consumer to follow a course of action or to

change behaviour. Higher prices provide an incentive to existing

producers to supply more because they provide the possibility or more revenue and
increased profits. The incentive function of a price rise is associated with an extension of supply along
the existing supply curve.

Diagrammatic explanation

A market starts with a stable equilibrium, where demand equals supply. A supply shock reduces supply
at each and every price. This creates an excess of demand at the existing price.
The price is now forced up to a new price (P1) where the market clears. At the new price, demand and
supply are brought into equilibrium through a contraction of demand (the rationing effect) and an
extension of supply (the incentive effect).

In the long run, the higher price sends out signals, either for existing firms to introduce better
production methods or by new firms entering the market. This causes the supply curve to shift to the
right. Eventually, price may return to its existing level.

In conclusion, the price mechanism is said to work effectively through a combination of rationing,
incentives and signals.
What’s it: Monetarist school of thought is one of the mainstream macroeconomic thought. It believes
that money supply is the primary determinant of economic growth. Those who hold this view we call
monetarists or monetary economists.

Monetarists believe monetary policy is more effective in influencing economic activity. Money has a
significant role to play in the modern economy. Money is not only as a means of payment, but it also
becomes a commodity to be transacted. The money’s demand and supply determine the interest rate in
the economy.

Ultimately, interest rates influence decisions, such as consumption and investment. Some household
purchases rely on bank loans, as well as investments by businesses.

Monetary policy affects the amount of money circulating in the economy. During periods of weak
growth, policymakers should increase the money supply. And, during an economic boom, policymakers
reduce the money supply, thereby slowing the inflation rate.

The modern economy cannot run without money. Money represents the monetary (financial) side of the
economy, complementing the non-financial side (goods and services). Without it, you cannot buy goods
and services or save for retirement.

The root of the monetarist school of thought

Monetarism has its roots in the thinking of Milton Friedman. He and Anna Schwartz wrote the famous
book “A Monetary History of The United States, 1867 – 1960“. They argued that inflation is a monetary
phenomenon.

Due to monetary phenomena, the key to influencing inflation is the amount of money in the economy.
The policy to influence the money supply is what we call monetary policy.

Friedman advises central banks to maintain growth in the money supply at a rate consistent with growth
in productivity and demand for goods. Otherwise, it can produce negative consequences such as
hyperinflation and deflation.

Monetary and Keynesian differences

The main difference between Monetary and Keynesian lies in what drives the economy. Both of them
then formulate several solutions on how policymakers should influence economic activity.

Monetarism gave birth to monetary policy. Meanwhile, Keynesian gave birth to fiscal policy. Both are
mainstream policies in today’s modern economy.

Under the monetary policy, the central bank or monetary authority takes a role. They influence the
economy through instruments such as policy interest rates, open market operations, and reserve
requirements.
Under the fiscal policy, the government influences the economy through its budget. They can change
expenditures or taxes to influence economic activity.

Monetary criticism of Keynesians

Friedman criticized Keynes’s solution on how to influence the economy. The three main criticisms are:

First, Keynesians put money aside.

They do not explain how money affects decisions by economic actors. Of course, these decisions
ultimately affect economic activity.

Friedman views money as another essential facet of the modern economy. Households take into
account the money they have before making decisions to buy goods and services. Likewise, businesses
look at money and its price (interest rate) when deciding on investments.

Second, Keynesians fail to explain the impact of government debt on interest rates and economic
activity.

In the Keynesian argument, to stimulate economic growth, the government increases spending or
decreases taxes. That often leads to a higher budget deficit.

The government covers the budget deficit through debt. Rising taxes in the future to cover the deficit is
less popular politically. Therefore, a more comfortable option is debt.

Well, here is the point. Keynesians do not explain how debt affects the economy.

The increase in debt by the government pushed up interest rates in the domestic economy. Rising
interest rates affect the cost of capital and private sector investment decisions (via the crowding-out
effect).

Third, fiscal policy involves a longer lag. It is ineffective to have an immediate impact on the economy.

Budgeting (taxes and expenses) takes longer and is more complicated because it involves a political
process. So, when implemented, the economy has likely changed course.

Monetary school ideas

The theoretical foundation of monetarism is the Quantity Theory of Money. This theory tries to link the
amount of money circulating in the economy with nominal GDP.

They also view that government intervention should be minimal. Interventions often have no better
consequences. Therefore, the market should be allowed to work on its own.

Regarding the long-run and short-term Keynesian concepts, monetarists believe that the economy is
inherently stable. They view the aggregate supply curve as more vertical, indicating the economy is
always close to or rapidly approaching full employment. Therefore, fiscal stabilization policies are not so
important in directing the economy towards long-run macroeconomic equilibrium.

The quantity theory of money

Monetarists view the money supply and its circulation as a function of the economy’s price level and
real output. They then formulated the formula for the quantity theory of money as follows:

M×V=P×Y

Where:

• M = money supply

• V = Velocity of money

• P = Price level

• Y = Real output

The velocity of money shows you the number of times the same money changed hands during the year.
Meanwhile, the product of the price level and real output represents nominal GDP.

To explain this formula, I will try to take a simple example. Assume that the economy’s output comes
from one producer. Let’s say a manufacturer produces 100 units and sells them at $200. So, in other
words, the nominal GDP is $10,000 (100 units x $200).

Say, the central bank supplies $500 in the economy. Thus, the money supply will change hands 20 times
($10,000 / $500) to purchase the same item.

Furthermore, the central bank increased the money supply to $1,000. Assume that the velocity of
money is fixed (20 times) and that real output is stagnant (100 units). Thus, it will push up the price from
$200 to $2,000 (20x $1,000 / 100).

The short-run quantity theory of money

Monetarists assume that the velocity of money in the short run is constant. Therefore, from the above
equation, we know that an increase in the money supply is the primary determinant of nominal GDP.
For this reason, monetarists view that the key to stabilizing the economy is controlling the money
supply.

Increasing the money supply will have two possible consequences: an increase in the price level
(inflation), an increase in real output, or both. If the economy can increase real output, the effect of
increasing the money supply on inflation is relatively minimal.

Conversely, if the real output is stagnant, then an increase in the money supply will only result in high
inflation. However, suppose the central bank reduces the money supply. In that case, it will only result in
a decrease in the price level (deflation). This is why, during stagflation, economic stimulus
through expansionary monetary policy was not the right choice.

The long-run quantity theory of money

Long-run real output is constant, as reflected by the vertical line of the long-run aggregate supply curve.
Velocity is also constant.

Hence, an increase in the money supply (M) will only increase the price level. That explains why
Friedman views that inflation has always existed because it is a monetary phenomenon. Changes in the
money supply will only cause inflation in the long run.

Monetary policy

Monetarists view changes in the money supply as the key to influencing economic activity. To influence
economic growth, the central bank must adjust the money supply at an appropriate growth rate.

The central bank must consider real output in the economy to determine the money supply’s growth
rate. For example, if the real output is stagnant, the increase will only increase inflation. Conversely, if
the central bank reduces the money supply, it will lead to deflation. Thus, the central bank must change
the money supply at a rate consistent with real output growth.

The two types of monetary policy are:

• Expansionary monetary policy is to encourage economic growth and stimulate the inflation
rate. In this case, the central bank increases the money supply. Another term for expansionary
monetary policy is a loose monetary policy or an easy monetary policy.

• Contractionary monetary policy is to avoid an unsustainable inflation rate. In this case, the
central bank reduces the money supply. You may be familiar with the terms tight monetary
policy or restrictive monetary policy.

How monetary policy affects the economy

As I have already mentioned, under the monetary policy, the central bank influences the money supply.
This can be done through three monetary policy tools. The three affect economic activity
through monetary policy transmission channels such as financial market interest rates, the balance of
payments, exchange rates, wealth, equity, and bank loans.

The first is the policy rate. This is the official interest rate to influence short and long term interest rates
on financial markets.

The specific definition varies between countries. One of them is the central bank’s interest rate on
overnight loans to banks if their reserves fall below the required level.

An increase in the policy rate reduces the money supply. Conversely, if it falls, it increases the money
supply.
The second is the reserve requirement ratio. This is the deposit portion that the bank has to keep and
should not be borrowed or invested. For example, a 10% ratio means that the bank has to set aside
Rp10 of the Rp100 deposit as reserves. The rest, they can lend it.

So when the ratio falls, the bank has more money to lend, increasing the economy’s money supply. The
opposite effect applies when the central bank increases the ratio.

The third is the open market operation. In this case, the central bank sells and buys government
securities. When done massively, we call it quantitative easing.

When buying securities from a bank, money goes from the central bank to banks. They can use it to
make loans. That, in turn, increases the money supply.

Conversely, if the central bank sells securities, money goes from the banks to the central bank’s pockets.
The money supply decreases, and banks have less cash to lend.

Expansionary monetary policy

When the economy contracts, the central bank stimulates economic growth by increasing the money
supply. Say, the central bank chooses to cut policy rates.

The decline in policy interest rates pushed down bank lending rates. It stimulates households to apply
for new loans to buy durable goods like houses and cars.

Lower interest rates decrease the cost of capital. It stimulates businesses to invest in capital assets.
Initially, they will buy more light equipment, which contributes to operational efficiency.

An increase in consumption and investment drives up aggregate demand in the economy. It stimulates
producers to increase production. Initially, they will increase overtime hours instead of adding a new
workforce.

So, at the beginning of the economic recovery, the unemployment rate is still relatively high. However,
the income outlook improves as overtime hours increase.

If demand gets stronger, businesses will increase their production again. They also start to recruit more
workers and order heavy capital goods (such as machinery) to increase production. The unemployment
rate falls. The economy then entered an expansion phase. In this phase, the inflation rate begins to
creep up.

The fall in the unemployment rate leads to a tighter supply in the labor market. That pushes the nominal
wage up, resulting in an increase in the cost of production. Businesses pass higher production costs on
to consumers by raising selling prices.

Higher prices create upward pressure on the price level. The inflation rate starts to surge. This situation
usually occurs during an economic boom, the final part of the expansion phase before the peak.
To avoid an overheated economy, the central bank put a brake on the money supply’s growth rate. If
uncontrolled, the inflation rate can lead to hyperinflation. To prevent this, the central bank adopts a
contractionary monetary policy.

Contractionary monetary policy

During the economic boom, the inflation rate goes so high that it overheats the economy. That forces
the central bank to implement a contractionary monetary policy.

An overheated economy could cause a burst if not appropriately handled. The effects can be severe and
often lead to hyperinflation.

Under contractionary policies, the central bank can take the following policy alternatives:

• Raising the policy rate

• Increasing the reserve requirement ratio

• Selling government securities

Say, the central bank chooses to raise policy rates. That pushed up interest rates on financial markets.
Higher interest rates make new loans more expensive.

Consumers reduce lending to banks. They delay the purchase of durable goods. Likewise, businesses
delay investing because the cost of capital becomes higher. As a result, aggregate demand weakens.
Weak demand prompts producers to reduce production rates.

Monetarist view over the business cycle

Monetarists believe that variations in the growth rate of the money supply cause business cycles. The
decision to change the money supply causes aggregate demand to fluctuate.

An economic boom occurs because the growth in the money supply exceeds the growth in real output.
It generates upward pressure on the price level.

Conversely, during a recession, growth in the money supply cannot keep pace with real output growth.
The quantity of goods and services is increasing rapidly, but the economy does not have the money to
buy them. That results in a decrease in aggregate demand and forces producers to cut production.
New Keynesian economics is the school of thought in modern macroeconomics that evolved from the
ideas of John Maynard Keynes. Keynes wrote The General Theory of Employment, Interest, and
Money in the 1930s, and his influence among academics and policymakers increased through the 1960s.
In the 1970s, however, new classical economists such as Robert Lucas, Thomas J. Sargent, and Robert
Barro called into question many of the precepts of the Keynesian revolution. The label “new Keynesian”
describes those economists who, in the 1980s, responded to this new classical critique with adjustments
to the original Keynesian tenets.

The primary disagreement between new classical and new Keynesian economists is over how quickly
wages and prices adjust. New classical economists build their macroeconomic theories on the
assumption that wages and prices are flexible. They believe that prices “clear” markets—
balance supply and demand—by adjusting quickly. New Keynesian economists, however, believe that
market-clearing models cannot explain short-run economic fluctuations, and so they advocate models
with “sticky” wages and prices. New Keynesian theories rely on this stickiness of wages and prices to
explain why involuntary unemployment exists and why monetary policy has such a strong influence on
economic activity.

A long tradition in macroeconomics (including both Keynesian and monetarist perspectives) emphasizes
that monetary policy affects employment and production in the short run because prices respond
sluggishly to changes in the money supply. According to this view, if the money supply falls, people
spend less money and the demand for goods falls. Because prices and wages are inflexible and do not
fall immediately, the decreased spending causes a drop in production and layoffs of workers. New
classical economists criticized this tradition because it lacks a coherent theoretical explanation for the
sluggish behavior of prices. Much new Keynesian research attempts to remedy this omission.

Menu Costs and Aggregate-Demand Externalities

One reason prices do not adjust immediately to clear markets is that adjusting prices is costly. To change
its prices, a firm may need to send out a new catalog to customers, distribute new price lists to its sales
staff, or, in the case of a restaurant, print new menus. These costs of price adjustment, called “menu
costs,” cause firms to adjust prices intermittently rather than continuously.

Economists disagree about whether menu costs can help explain short-run economic fluctuations.
Skeptics point out that menu costs usually are very small. They argue that these small costs are unlikely
to help explain recessions, which are very costly for society. Proponents reply that “small” does not
mean “inconsequential.” Even though menu costs are small for the individual firm, they could have large
effects on the economy as a whole.

Proponents of the menu-cost hypothesis describe the situation as follows. To understand why prices
adjust slowly, one must acknowledge that changes in prices have externalities—that is, effects that go
beyond the firm and its customers. For instance, a price reduction by one firm benefits other firms in the
economy. When a firm lowers the price it charges, it lowers the average price level slightly and thereby
raises real income. (Nominal income is determined by the money supply.) The stimulus from higher
income, in turn, raises the demand for the products of all firms. This macroeconomic impact of one
firm’s price adjustment on the demand for all other firms’ products is called an “aggregate-demand
externality.”

In the presence of this aggregate-demand externality, small menu costs can make prices sticky, and this
stickiness can have a large cost to society. Suppose General Motors announces its prices and then, after
a fall in the money supply, must decide whether to cut prices. If it did so, car buyers would have a higher
real income and would therefore buy more products from other companies as well. But the benefits to
other companies are not what General Motors cares about. Therefore, General Motors would
sometimes fail to pay the menu cost and cut its price, even though the price cut is socially desirable. This
is an example in which sticky prices are undesirable for the economy as a whole, even though they may
be optimal for those setting prices.

The Staggering of Prices

New Keynesian explanations of sticky prices often emphasize that not everyone in the economy sets
prices at the same time. Instead, the adjustment of prices throughout the economy is staggered.
Staggering complicates the setting of prices because firms care about their prices relative to those
charged by other firms. Staggering can make the overall level of prices adjust slowly, even when
individual prices change frequently.

Consider the following example. Suppose, first, that price setting is synchronized: every firm adjusts its
price on the first of every month. If the money supply and aggregate demand rise on May 10, output will
be higher from May 10 to June 1 because prices are fixed during this interval. But on June 1 all firms will
raise their prices in response to the higher demand, ending the three-week boom.

Now suppose that price setting is staggered: half the firms set prices on the first of each month and half
on the fifteenth. If the money supply rises on May 10, then half of the firms can raise their prices on May
15. Yet because half of the firms will not be changing their prices on the fifteenth, a price increase by
any firm will raise that firm’s relative price, which will cause it to lose customers. Therefore, these firms
will probably not raise their prices very much. (In contrast, if all firms are synchronized, all firms can
raise prices together, leaving relative prices unaffected.) If the May 15 price setters make little
adjustment in their prices, then the other firms will make little adjustment when their turn comes on
June 1, because they also want to avoid relative price changes. And so on. The price level rises slowly as
the result of small price increases on the first and the fifteenth of each month. Hence, staggering makes
the price level sluggish, because no firm wishes to be the first to post a substantial price increase.

Coordination Failure

Some new Keynesian economists suggest that recessions result from a failure of coordination.
Coordination problems can arise in the setting of wages and prices because those who set them must
anticipate the actions of other wage and price setters. Union leaders negotiating wages are concerned
about the concessions other unions will win. Firms setting prices are mindful of the prices other firms
will charge.
To see how a recession could arise as a failure of coordination, consider the following parable. The
economy is made up of two firms. After a fall in the money supply, each firm must decide whether to cut
its price. Each firm wants to maximize its profit, but its profit depends not only on its pricing decision but
also on the decision made by the other firm.

If neither firm cuts its price, the amount of real money (the amount of money divided by the price level)
is low, a recession ensues, and each firm makes a profit of only fifteen dollars.

If both firms cut their price, real money balances are high, a recession is avoided, and each firm makes a
profit of thirty dollars. Although both firms prefer to avoid a recession, neither can do so by its own
actions. If one firm cuts its price while the other does not, a recession follows. The firm making the price
cut makes only five dollars, while the other firm makes fifteen dollars.

The essence of this parable is that each firm’s decision influences the set of outcomes available to the
other firm. When one firm cuts its price, it improves the opportunities available to the other firm,
because the other firm can then avoid the recession by cutting its price. This positive impact of one
firm’s price cut on the other firm’s profit opportunities might arise because of an aggregate-demand
externality.

What outcome should one expect in this economy? On the one hand, if each firm expects the other to
cut its price, both will cut prices, resulting in the preferred outcome in which each makes thirty dollars.
On the other hand, if each firm expects the other to maintain its price, both will maintain their prices,
resulting in the inferior solution, in which each makes fifteen dollars. Hence, either of these outcomes is
possible: there are multiple equilibria.

The inferior outcome, in which each firm makes fifteen dollars, is an example of a coordination failure. If
the two firms could coordinate, they would both cut their price and reach the preferred outcome. In the
real world, unlike in this parable, coordination is often difficult because the number of firms setting
prices is large. The moral of the story is that even though sticky prices are in no one’s interest, prices can
be sticky simply because price setters expect them to be.

Efficiency Wages

Another important part of new Keynesian economics has been the development of new theories of
unemployment. Persistent unemployment is a puzzle for economic theory. Normally, economists
presume that an excess supply of labor would exert a downward pressure on wages. A reduction in
wages would in turn reduce unemployment by raising the quantity of labor demanded. Hence, according
to standard economic theory, unemployment is a self-correcting problem.

New Keynesian economists often turn to theories of what they call efficiency wages to explain why this
market-clearing mechanism may fail. These theories hold that high wages make workers more
productive. The influence of wages on worker efficiency may explain the failure of firms to cut wages
despite an excess supply of labor. Even though a wage reduction would lower a firm’s wage bill, it would
also—if the theories are correct—cause worker productivity and the firm’s profits to decline.
There are various theories about how wages affect worker productivity. One efficiency-wage theory
holds that high wages reduce labor turnover. Workers quit jobs for many reasons—to accept better
positions at other firms, to change careers, or to move to other parts of the country. The more a firm
pays its workers, the greater their incentive to stay with the firm. By paying a high wage, a firm reduces
the frequency of quits, thereby decreasing the time spent hiring and training new workers.

A second efficiency-wage theory holds that the average quality of a firm’s workforce depends on the
wage it pays its employees. If a firm reduces wages, the best employees may take jobs elsewhere,
leaving the firm with less-productive employees who have fewer alternative opportunities. By paying a
wage above the equilibrium level, the firm may avoid this adverse selection, improve the average quality
of its workforce, and thereby increase productivity.

A third efficiency-wage theory holds that a high wage improves worker effort. This theory posits that
firms cannot perfectly monitor the work effort of their employees and that employees must themselves
decide how hard to work. Workers can choose to work hard, or they can choose to shirk and risk getting
caught and fired. The firm can raise worker effort by paying a high wage. The higher the wage, the
greater is the cost to the worker of getting fired. By paying a higher wage, a firm induces more of its
employees not to shirk, and thus increases their productivity.

A New Synthesis

During the 1990s, the debate between new classical and new Keynesian economists led to the
emergence of a new synthesis among macroeconomists about the best way to explain short-run
economic fluctuations and the role of monetary and fiscal policies. The new synthesis attempts to merge
the strengths of the competing approaches that preceded it. From the new classical models it takes a
variety of modeling tools that shed light on how households and firms make decisions over time. From
the new Keynesian models it takes price rigidities and uses them to explain why monetary policy affects
employment and production in the short run. The most common approach is to assume monopolistically
competitive firms (firms that have market power but compete with other firms) that change prices only
intermittently.

The heart of the new synthesis is the view that the economy is a dynamic general equilibrium system
that deviates from an efficient allocation of resources in the short run because of sticky prices and
perhaps a variety of other market imperfections. In many ways, this new synthesis forms the intellectual
foundation for the analysis of monetary policy at the Federal Reserve and other central banks around
the world.

Policy Implications

Because new Keynesian economics is a school of thought regarding macroeconomic theory, its
adherents do not necessarily share a single view about economic policy. At the broadest level, new
Keynesian economics suggests—in contrast to some new classical theories—that recessions are
departures from the normal efficient functioning of markets. The elements of new Keynesian
economics—such as menu costs, staggered prices, coordination failures, and efficiency wages—
represent substantial deviations from the assumptions of classical economics, which provides the
intellectual basis for economists’ usual justification of laissez-faire. In new Keynesian theories recessions
are caused by some economy-wide market failure. Thus, new Keynesian economics provides a rationale
for government intervention in the economy, such as countercyclical monetary or fiscal policy. This part
of new Keynesian economics has been incorporated into the new synthesis that has emerged among
macroeconomists. Whether policymakers should intervene in practice, however, is a more difficult
question that entails various political as well as economic judgments.

About the Author

N. Gregory Mankiw is a professor of economics at Harvard University. From 2003 to 2005, he was the
chairman of President George W. Bush’s Council of Economic Advisers.
New Keynesian Economics is a school of thought in modern macroeconomics that is derived from
Keynesian Economics. The original Keynesian economic theory was published in the 1930s; however,
classical economists in the 1970s and 1980s critiqued and adjusted Keynesian Economics to create New
Keynesian Economics.
New Keynesian Assumptions

New Keynesian Economics comes with two main assumptions. First, that people and companies behave
rationally and with rational expectations. Second, New Keynesian Economics assumes a variety of
market inefficiencies – including sticky wages and imperfect competition.

Sticky wages refer to when employee wages don’t necessarily reflect their company’s or the economy’s
performance; moreover, wages are said to be stickier downwards than upwards due to the
unwillingness of employees to receive lower nominal pay. Also, the employees’ unwillingness to receive
lower wages can result in involuntary unemployment.

In addition to sticky wages, the New Keynesian Economics assumption of imperfect competition refers
to market situations that can include monopolies, duopolies, cartels, and collusion. It can help explain
the varying effects of fiscal policy on different companies in the same industry.

New Keynesian Menu Costs

New Keynesian economics also supports the idea of sticky prices through a concept called menu costs
and that menu costs contribute to market inefficiencies. For a company to change the price of a good or
service, costs must be incurred, i.e., changing the price in catalogs or a menu. Some argue that menu
costs are small and negligible to macroeconomics.

However, others argue that though menu costs are typically low for companies, it is not negligible. Also,
those who argue the importance of menu costs push the idea that changing the prices of a good or
service serves as an externality. By decreasing the cost of a good, the consumers’ real income increases,
considering the good isn’t an inferior good, and the demand for the good in the entire industry will
increase, as the average cost of the good in the industry slightly decreases.

Thus, one company decreasing its prices slightly stimulates the economy. However, companies typically
do not account for such externality when deciding whether the costs to change the price are larger than
the cost to not change it. Consequently, companies may not change their prices quickly to meet the
changes in demand.

Imperfect Competition

Imperfect competition is another cause of market inefficiency that New Keynesian Economics explains.
A study by Huw Dixon and Gregory Mankiw in the 1980s found that a fiscal multiplier could increase
inefficiencies brought on by fiscal policy changes. In imperfect competition, i.e., a monopoly, fiscal
policy doesn’t affect every company equally, resulting in the idea of a fiscal multiplier.
New Keynesian supporters argue that the reason a fiscal multiplier could increase inefficiencies is that
real wages tend to decrease in imperfect competition and that households tend to choose leisure over
consumption in imperfect competition.

Supporters further argue that when governments impose fiscal policy to increase spending, leisure and
consumption both decrease, so households are working more but consuming less. Consequently, the
greater imperfection in competition, the greater the fiscal multiplier.

Efficiency Wages

New Keynesian Economics argues that unemployment is caused by the efficiency in wages. Other
macroeconomic theories argue that unemployment is a self-correcting mechanism where large labor
supplies would put downward pressure on wages; consequently, as companies offer a lower wage, their
demand for labor would increase, thus reducing the labor supply and unemployment.

However, New Keynesian Economics argues that wages drive worker productivity and efficiency. The
effect of wages on productivity is what causes companies to not decrease their wages, which would
reduce the labor supply and unemployment. Additionally, though decreasing wages may lead to lower
wage costs for the company, decreasing the wages may also lower productivity, thus decreasing
corporate profits.

In addition to higher wages increasing productivity, New Keynesian supporters also argue that higher
wages decrease employee turnover. If wages are decreased, skilled employees of the company may
leave to find a better wage elsewhere. Also, turnover is costly for companies due to the rehiring and
retraining costs of new employees.