IAI Actuarial Core Principles · Business Economics · Main economic schools and their key features
A New Keynesian economist explains why a fall in aggregate demand can reduce output for a long time. Which explanation is most consistent with that school?
New Keynesians argue that menu costs, efficiency wages and staggered contracts make prices and wages sticky. Firms therefore respond to falling demand by cutting output and employment rather than prices, so demand shocks can have lasting real effects even though expectations are rational.
- AMenu costs and staggered contracts make prices and wages sticky, so firms adjust quantities rather than pricesCorrect
- BAgents systematically mispredict policy, so they are repeatedly fooled
- CReal shocks to technology are the only source of fluctuations
- DMoney is neutral and super-neutral in both the short and long run
- Credit expansion by the central bank created malinvestments that must be liquidated
Explanation
New Keynesians keep rational expectations but add micro-founded price and wage rigidities such as menu costs, efficiency wages and overlapping contracts. Hence demand shocks can have real effects. Real business cycle theory is the technology-shock option and the malinvestment option is Austrian.
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