New Keynesian Economics

The two current leading views of business cycles are Real Business Cycle (RBC) Theory and New Keynesian Economics. Each of these schools of thought has a rich history marked by frequent vigorous debate between them. While a terse summary of their general views does not do them justice, we first briefly highlight the main difference between the two points of view. RBC Theory views periodic expansions and recessions as natural, indeed efficient, responses of the economy to the ups and downs of the state of “technology ” of the economy.72 As such, recessions are not dire events for the economy, but rather natural slowdowns which are preceded by an expansion and which will again be followed by future expansions. In terms familiar from microeconomics, pure RBC Theory maintains that the aggregate economy operates perfectly competitively on both the demand side and the supply side. 73 An important implication of RBC Theory, therefore, is that the government has no role to play in the macroeconomy – that is, neither fiscal policy nor monetary policy can be used to improve the macroeconomic condition. In contrast, New Keynesian Economics adopts the point of view that there are fundamental market failures in the aggregate economy which render business cycl