Skip to content

Business Economics · Main economic schools and their key features

New Classical, New Keynesian and Austrian Schools Explained

Updated 11 October 2026 · Fact-checked

New classical economists assume rational expectations and flexible prices, so predictable policy cannot move output. New Keynesians accept rational expectations but add sticky prices and wages, such as menu costs, so policy can matter. Austrians, such as Hayek, blame credit booms for cycles and trust market prices over planning.

Understand New Classical, New Keynesian and Austrian Schools

These three schools react to earlier ideas. The new classical school came from criticism of Keynesian and monetarist models in the 1970s. Its core idea is rational expectations: people use all available information, including what they know about policy, to form forecasts. On average they are not wrong in a systematic way. They can still make random errors.

From this, new classical economists (Lucas, Sargent, Wallace are the usual names) draw the policy ineffectiveness proposition. If markets clear and prices are flexible, only unanticipated money or policy shocks change real output, and only in the short run. A change that people expect is built into prices and wages at once. So systematic policy cannot be used to keep output above its natural level. Output moves with real shocks, which links to real business cycle thinking. The Lucas critique says that relationships estimated from past data may break down when policy changes, because people change their behaviour.

New Keynesian economists keep rational expectations but drop the assumption of perfectly flexible prices. They give micro-level reasons why prices and wages are sticky. Menu costs are the costs of changing prices, such as reprinting catalogues. Even small menu costs can make a firm leave prices unchanged, and that has large effects across the economy. Other reasons are long-term wage contracts, efficiency wages (higher pay raises effort and cuts turnover) and imperfect competition. With sticky prices, demand changes move output, so monetary and fiscal policy can stabilise the economy, even if expected.

The Austrian school (Mises, Hayek) is different in method. It stresses individual choice, subjective value and the role of market prices in spreading knowledge that no planner holds. Its business cycle theory says that credit expansion by banks and central banks, with interest rates pushed below the natural rate, misdirects investment into unsustainable projects. The bust is the needed correction. Austrians therefore oppose active stabilisation policy and central planning, and favour sound money and limited intervention. They also use less formal mathematics than the other two schools.

Key rules to remember

Rational expectations
Expected value = actual outcome + random error, with the error having mean zero and being unrelated to available information
Forecast errors are not systematic. This does not mean people are always right.
Policy ineffectiveness proposition
Output deviation from natural level arises only from unanticipated shocks: Y − Y* = f(actual price level − expected price level)
This is the Lucas-type supply idea. Anticipated policy changes Y − Y* by zero when prices are flexible.
Menu cost condition
Firm leaves price unchanged if the profit gain from changing it < menu cost
Individually small gains can mean large aggregate effects through demand spillovers.
School comparison rule
New classical: rational expectations + flexible prices. New Keynesian: rational expectations + sticky prices. Austrian: credit-driven cycle + market knowledge
Use this one-line summary to place any question quickly.

How to solve New Classical, New Keynesian and Austrian Schools questions

Use this method for any question on these schools, whether multiple-choice or written.

  1. 1Identify which school the question points to from its keywords: rational expectations, menu costs, credit boom, natural rate, knowledge.
  2. 2State the school's core assumptions about expectations and price flexibility.
  3. 3Say whether markets clear and how fast prices adjust.
  4. 4Apply those assumptions to the policy or shock in the question. Ask: is it anticipated or unanticipated?
  5. 5State the short-run and long-run effect on output and prices.
  6. 6Give the policy conclusion: effective, ineffective or harmful.
  7. 7If asked to compare, name one similarity and one key difference.
  8. 8Close with one limitation or criticism if the marks allow.

Quickest way: Two-question sort

When to use it: Multiple-choice questions and short written parts under time pressure.

  1. Ask 1: are prices flexible or sticky? Flexible points to new classical. Sticky points to new Keynesian.
  2. Ask 2: is the explanation about credit, interest rates and misallocated investment? That points to Austrian.
  3. Ask 3: is the policy anticipated? If yes and prices are flexible, expect no real effect.
  4. Check the options for a word that matches the school, such as menu costs or Lucas critique, and eliminate the rest.

Common mistakes in New Classical, New Keynesian and Austrian Schools

  • Saying new Keynesians reject rational expectations.

    Students assume anything Keynesian rejects the new classical approach entirely.

    Fix: New Keynesians accept rational expectations. They differ by adding price and wage stickiness.

  • Claiming policy is always ineffective under new classical theory.

    The proposition is shortened to a slogan.

    Fix: State the condition: anticipated policy is ineffective when prices are flexible. Unanticipated shocks can change output in the short run.

  • Saying rational expectations means people never make errors.

    The word rational suggests perfection.

    Fix: Say forecast errors are random and not systematically related to known information.

  • Treating menu costs as the only cause of sticky prices.

    It is the best known example.

    Fix: List others too: long-term contracts, efficiency wages and imperfect competition.

  • Describing Austrian theory as the same as monetarism or Keynesianism.

    Both Austrians and monetarists dislike inflationary policy.

    Fix: Austrians focus on credit-driven misallocation of investment and the knowledge role of prices. They reject fine-tuning and see the bust as a correction.

Worked examples

Example 1

A central bank announces in advance a rise in the money supply. Explain the likely effect on output and prices under (a) the new classical school and (b) the new Keynesian school.

Show the solution
  1. New classical: the announcement makes the increase anticipated, and expectations are rational.
  2. Workers and firms raise wage and price expectations straight away, and prices are flexible.
  3. So the price level rises and real output stays at its natural level.
  4. New Keynesian: expectations are also rational, but prices and wages are sticky because of contracts and menu costs.
  5. Prices cannot fully adjust at once, so real money balances and demand rise.
  6. Output rises in the short run before prices catch up.

Answer: New classical: prices rise, output unchanged (policy ineffective). New Keynesian: output rises in the short run, then prices adjust.

Example 2

Explain how the Austrian school accounts for a boom followed by a bust, and how its policy view differs from the new Keynesian view.

Show the solution
  1. Austrians start with credit expansion that pushes market interest rates below the natural rate.
  2. Cheap credit sends investment into long-term projects that savers do not really support.
  3. Resources are misallocated, which creates an unsustainable boom.
  4. When credit tightens or the projects fail, the bust occurs. It exposes and corrects the earlier errors.
  5. Austrians therefore favour sound money and little intervention, and say stimulus delays the correction.
  6. New Keynesians instead see recessions as demand shortfalls made worse by sticky prices, so they support active stabilisation.

Answer: For Austrians, the cycle comes from credit-driven malinvestment and the bust is a necessary correction, so they oppose stimulus. New Keynesians support policy to stabilise demand.

Exam tips

  • Learn one clear sentence for each school. Most multiple-choice items test recognition of keywords.
  • In written answers, always say whether a policy is anticipated or unanticipated.
  • For comparison questions, use the same two or three headings for each school: expectations, prices, policy.
  • Name the thinkers only when sure: Lucas, Sargent, Wallace for new classical; Mises and Hayek for Austrian.
  • Add a brief criticism, such as the doubt about whether people form fully rational forecasts.

Practice questions from Main economic schools and their key features

New Classical, New Keynesian and Austrian Schools: frequently asked questions

What is rational expectations theory in simple words?

It says people use all available information, including knowledge of policy, to form forecasts. Their errors are random, not systematic. So policy that people expect cannot easily fool them.

What is the main difference between new classical and new Keynesian economics?

Both accept rational expectations. New classical economists assume flexible prices and market clearing, so anticipated policy has no real effect. New Keynesians stress sticky prices and wages, so policy can affect output in the short run.

What are menu costs?

They are the costs a firm faces when changing prices, such as reprinting lists or updating systems. Even small costs can stop firms changing prices, which makes prices sticky across the economy.

What are the key features of the Austrian school?

Austrians stress individual choice, subjective value and the knowledge carried by market prices. Their business cycle theory blames credit expansion for misallocated investment. They prefer sound money and limited intervention.