Why we care about the ‘New Keynesian’ labour market flimflam

4 May, 2014 at 22:14 | Posted in Economics | 1 Comment

Simon Wren-Lewis, seeks a serious debate with our heterodox colleagues … This is a welcome debate.

Simon defends his view of orthodoxy, by which he means New Keynesian economics. In its simplest form, New Keynesian economics is a three-equation model that explains the behavior of the nominal interest rate, the “output gap” and the inflation rate …

Let me take up just one point from Simon’s post. Are the demand and supply of labor always equal and should we care?

In the NK model, the answer to this question is YES: the demand and supply of labor are always equal. There is no involuntary unemploy-ment as defined in the General Theory. Why does that matter?

The notion of continuous market clearing adds a mechanism to the NK model that works to restore full employment through wage and price adjustment. That mechanism is the basis for the NK Phillips curve which asserts that prices will rise whenever output is above potential. Since potential output cannot be independently measured, that assertion becomes a tautological definition of the output gap.

The NK economist accepts Milton Friedman’s concept of the natural rate of unemployment which asserts that, in the long run, there is a unique equilibrium level of unemployment associated with stable inflationary expectations. If inflation appears, following a recession, a policy maker who accepts NK economics will infer that the economy is operating above potential. If unemployment is now 6%, rather than 3%, it must be that the natural rate of unemployment has increased.

If the NRH hypothesis is wrong … the NK policy maker will allow the economy to operate permanently below its long-run potential and society will suffer permanent non-recoverable losses in output.

Roger Farmer

[h/t Tom Hickey]