James Galbraith on flim-flamming “New Keynesianism”2 May, 2014 at 11:55 | Posted in Economics | 56 Comments
Dear Simon Wren-Lewis:
You ask for some help with Keynesian views. Here are my thoughts:
“What New Keynesian theory does need is that falls in real interest rates stimulate aggregate demand (i.e. some form of IS curve), and in the basic model this comes from changing the intertemporal pattern of consumption. Is that wrong?”
Yes, it’s wrong. Keynes’s theory is a theory of consumption, based on income. Saving is the residual. Interest rates do not affect aggregate saving; hence the intertemporal pattern of planned consumption plays no role.
“What explains cyclical unemployment is real interest rates being at the wrong level. Movements in wages and prices get us out of a recession because they lead the central bank to reduce real interest rates. At the zero bound they cannot do that, and in those circumstances wage and price flexibility could make things worse. Is that wrong?”
Yes. Keynes did not offer a theory of “cyclical unemployment.” He offered a theory of underemployment equilibrium. Interest rates do affect business investment, and in the modern world, household durable-goods consumption. But that effect, which bears on cost, is usually small compared to that of the “marginal efficiency of capital,” also known as animal spirits. A decline in wages and prices per se increases the real interest rate (measured ex post), so the action by the central bank that you describe merely offsets this increase, but in any event, the effect is small since the psychology of a slump is overwhelming. Downward wage and price flexibility always makes things worse, not merely at the zero bound, since it always increases the real burden of debt.
“Now it is true that the standard New Keynesian model assumes a labour market that clears, but a model that replaces this with labour market imperfect competition would not behave very differently. That is what I actually teach.”
Chapter Two of the General Theory abolished the supply curve of labor, hence the “labor market”, and transferred the determination of employment to the domain of effective demand. Businesses hire when they can sell the goods that their employees make, and not otherwise. Any model with a “labor market” is an anti-Keynesian model.
“Equally the basic New Keynesian model assumes rational expectations, but if we want to change this to a case where agents make predictable errors that is easy enough to do.”
Rational expectations does not belong in any model that calls itself Keynesian. For a Keynesian theory, you do need to assess expectations, but whether they are found to have errors, ex post, is not important. What matters is the state of belief at the time decisions are made.
“(I think what I teach is pretty close to how many central bankers think, if not the rest of ‘my tribe’!)”
Not in my experience, though I may have known a different generation of central bankers. But that’s a detail.
I hope this helps clarify some of the key issues.