New Keynesians and Inflation

This chapter reviews the basic tenets of the New Keynesians (NK); i.e. the school of thought that sought to preserve the insights of Keynes on the desirability of activist stabilization policy, but taking on board the methodological and other advances of the New Classicals. As markets do not clear due to price stickiness, the latter is thoroughly reviewed: causes, including ‘menu costs’, empirical evidence, and implications for price level dynamics are outlined. Other models of wage rigidity as well as new directions of NK theory are also reviewed. Furthermore, the chapter reviews inflation: its costs, causes, and recent ‘great moderation’. It concludes with a critical analysis of the NK model of inflation, and with a review of how this model of inflation can be incorporated into a baseline ‘three-equation New Keynesian model’.