The New Keynesian Approach to Business Cycle Theory: Nominal and Real Rigidities

At the heart of the Neoclassical synthesis lies the assumption that prices do not adjust instantly to equilibrate supply and demand. Under these circumstances, once the synthesis failed, economists naturally started to investigate whether the imperfect adjustment of prices could be logically inferred from realistic assumptions regarding the microeconomic environment, and subsequent research led to a variety of new non-walrasian theories regarding the functioning of markets. Thus, the non-walrasian analyses of the labour market suggested that wages could perform other functions than to equilibrate labour supply and demand. For instance, in models focused on labour contracts, wages are regarded as an „insurance” provided by the employer to the workers, while in efficiency wage models, wages are determinants of labour productivity. Such models have the ability to account for unemployment, but they are not able to explain the failure of the classical dichotomy. The paper aims to investigate the theoretical progress achieved during the past 3 decades, to clarify nominal and real rigidities and evaluate their impact on the business cycle and finally, to evaluate the theoretical aspects which need further analyses and refinements.