Policy Implications
New Keynesian economists fully agree with New Classical economists that in the long run, the classical dichotomy holds: changes in the money supply are neutral. However, because prices are sticky in the New Keynesian model, an increase in the money supply (or equivalently, a decrease in the interest rate) does increase output and lower unemployment in the short run.
Nonetheless, New Keynesian economists do not advocate using expansive monetary policy for short run gains in output and employment, as it would raise inflationary expectations and thus store up problems for the future. Instead, they advocate using monetary policy for stabilization. That is, suddenly increasing the money supply just to produce a temporary economic boom is not recommended as eliminating the increased inflationary expectations will be impossible without producing a recession. However when the economy is hit by some unexpected external shock, it may be a good idea to offset the macroeconomic effects of the shock with monetary policy. This is especially true if the unexpected shock is one (like a fall in consumer confidence) which tends to lower both output and inflation; in that case, expanding the money supply (lowering interest rates) helps by increasing output while stabilizing inflation and inflationary expectations.
Studies of optimal monetary policy in New Keynesian DSGE models have focused on interest rate rules (especially 'Taylor rules'), specifying how the central bank should adjust the nominal interest rate in response to changes in inflation and output. (More precisely, optimal rules usually react to changes in the output gap, rather than changes in output per se.) In some simple New Keynesian DSGE models, it turns out that stabilizing inflation suffices, because maintaining perfectly stable inflation also stabilizes output and employment to the maximum degree desirable. Blanchard and Galí have called this property the 'divine coincidence'. However, they also show that in models with more than one market imperfection (for example, frictions in adjusting the employment level, as well as sticky prices), there is no longer a 'divine coincidence', and instead there is a tradeoff between stabilizing inflation and stabilizing employment. Further, while some macroeconomists believe that New Keynesian models are on the verge of being useful for quarter-to-quarter quantitative policy advice, disagreement exists.
Read more about this topic: New Keynesian Economics
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