Question

what is the implication of the new Keynesian economics on the role of monetary policy in stimulating economic growth.(please explain in detail)

Answer 1

New Keynesian models are followed by most central banks around the world as the primary tools for managing the policy rates. To get some more context, it is important to understand the evolution of economics. The dominant policy framework post-world war II was Keynesian, i.e demand-driven economy with a major role for the fiscal policy. The stagflation of the 1970s made a dent in this theory and led to the emergence of monetarists like Milton Friedman. Itw as finally after a few years of experiments with monetarist policy where the major control variable was the money supply, neo-classical models were introduced. A major feature of neo-classical models is that they have various kinds of frictions like labor market frictions, financial frictions etc which gives rise to business cycles.

In neo-classical models, monetary policy is the main tool for policy with fiscal policy only playing a secondary role. The The policy rate is set through some form of a Taylor rule where rates depend on the output gap and expected inflation. It is a majorly a tool to control inflation and support the economy when growth is particularly disappointing. Interest rate cust are used to boost the economy in the short run from time to time as long as inflation is kept under control. A major assumption of neo-classical economics is of the natural rate of interest and the natural rate of unemployment which states that these are only short term tools as in the long run the economy always reaches an equilibrium.