Keynesian vs. Neo-Keynesian Economics: What’s the Difference?

Reviewed by Robert C. KellyFact checked by Michael RosenstonReviewed by Robert C. KellyFact checked by Michael Rosenston

Keynesian vs. Neo-Keynesian Economics: An Overview

Classical economic theory presumed that if demand for a commodity or service was raised, then prices would rise correspondingly and companies would increase output to meet public demand. The classical theory did not differentiate between microeconomics and macroeconomics.

However, during the Great Depression of the 1930s, the macroeconomy was in evident disequilibrium. This led John Maynard Keynes to write “The General Theory of Employment, Interest, and Money” in 1936, which played a large role in distinguishing the field of macroeconomics as distinct from microeconomics. The theory centers on the total spending of an economy and the implications of this on output and inflation.

Key Takeaways

• Keynesian theory does not see the market as being able to naturally restore itself.
• Neo-Keynesian theory focuses on economic growth and stability with a greater emphasis on using monetary policy rather than full employment.
• Keynesian and Neo-Keynesian theory identifies the market as not self-regulating.

Keynesian Economics

One point of departure from neoclassical economics in Keynesian theory was that it did not see the market as possessing the capacity to restore itself to equilibrium naturally. For this reason, Keynes believed that the government had to act to repair the economy during downturns.

Keynesian theory favors fiscal intervention to push the system towards full employment or to provide stimulus to exit a recession. Once stabilized, these measures should be tapered and removed.

Neo-Keynesian Economics

Just as Keynes posited his theory in response to gaps in classical economic analysis, Neo-Keynesianism derives from observed differences between Keynes’s theoretical postulations and real economic phenomena.

The Neo-Keynesian theory was articulated and developed mainly in the U.S. during the post-war period. Neo-Keynesians did not place as heavy an emphasis on the concept of full employment but instead focused on economic growth and stability.

The reasons that Keynes and the Neo-Keynesians alike identified that the market was not self-regulating were manifold. First, monopolies may exist, which means the market is not competitive in a pure sense. This also means that certain companies have discretionary powers to set prices and may not wish to lower or raise prices during periods of fluctuations to meet demands from the public.

Labor markets are also imperfect. Second, trade unions and other companies may act according to individual circumstances, resulting in a stagnation in wages that does not reflect the actual conditions of the economy. Neo-Keynesians advocated using monetary policy to achieve desirable economic conditions in addition to fiscal policy.

Important

The tools of fiscal policy are public spending and tax control by the government and the tools of monetary policy are controlling interest rates, reserve requirements, and open market operations.

In the 1960s, Neo-Keynesianism began to examine the microeconomic foundations that the macroeconomy depended on more closely. This led to a more integrated examination of the dynamic relationship between microeconomics and macroeconomics, which are two separate but interdependent strands of analysis.

The two major areas of microeconomics, which may significantly impact the macroeconomy as identified by Neo-Keynesians, are price rigidity and wage rigidity. Both of these concepts intertwine with social theory negating the pure theoretical models of classical Keynesianism.

For instance, in the case of wage rigidity, as well as influence from trade unions (which have varying degrees of success), managers may find it difficult to convince workers to take wage cuts on the basis that it will minimize unemployment, as workers may be more concerned about their own economic circumstances than more abstract principles. Lowering wages may also reduce productivity and morale, leading to overall lower output.

Key Differences

Keynesian and Neo-Keynesian economics differ in how they address economic instability and growth. Keynesian economics, developed during the Great Depression, sees government intervention through fiscal policy, such as public spending and tax cuts, as the way to boost economic growth and achieve full employment.

Neo-Keynesian economics, which developed in the mid-20th century, refines Keynesian economics by adding monetary policy into the mix. Monetary policy can be used to manage inflation and stabilize the economy, reducing the need for government intervention.

Neo-Keynesian economics also adds microeconomic aspects, such as price and wage stickiness to address why markets fail to adjust efficiently.

What Is Keynesian Economics?

Keynesian economics is economic theory as presented by economist John Maynard Keynes. A key aspect of Keynesian economics is the need for governments to intervene in the economy through fiscal policy to achieve economic stability. Fiscal policy includes public spending and taxes.

Is Keynesian Economics Socialism or Capitalism?

Keynesian economics is firmly rooted in capitalism, however, it does not promote pure capitalistic ideals. A cornerstone of Keynesian economics is government intervention, which it believes can stabilize an economy. True capitalism believes that markets are self-correcting and do not need government intervention. Keynesian economics, however, does not believe in government control of resources, as seen in socialism.

So Keynesian economics believes in government intervention to address market failures and reduce unemployment while maintaining the broader capitalistic framework of private ownership and market competition.

What Is the Difference Between Neoclassical and Neo-Keynesian Economics?

Neoclassical economics believe that markets are self-correcting and that prices and wages will adjust on their own due to changes in supply and demand. Neo-Keynesian economics does not believe that markets are self-correcting and believes that both fiscal and monetary policy are needed to achieve economic stability.

The Bottom Line

Both Keynesian and Neo-Keynesian economics agree that markets are not self-regulating, but they differ in their approaches on how to address economic instability. Keynesian theory argues the need for government intervention, primarily through fiscal policy, to stimulate demand and achieve full employment.

Neo-Keynesian theory focuses more on economic growth and stability, relying on monetary policy more so than fiscal policy. Neo-Keynesians also incorporate price and wage rigidity as key factors affecting microeconomic behavior and macroeconomic outcomes.

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