‘New Keynesianism’ — an unpleasant macroeconomic fairy-tale3 February, 2016 at 12:38 | Posted in Economics | 2 Comments
The so-called new-Keynesian (or NK) model, has emerged and become a workhorse for policy and welfare analysis … The model starts from the RBC model without capital, and, in its basic incarnation, adds only two imperfections. It introduces monopolistic competition in the goods market. The reason is clear: If the economy is going to have price setters, they better have some monopoly power. It then introduces discrete nominal price setting, using a formulation introduced by Calvo, and which turns out to be the most analytically convenient.
The model is simple, analytically convenient, and has largely replaced the IS-LM model as the basic model of fluctuations in graduate courses (although not yet in undergraduate textbooks). Like the IS-LM model, it reduces a complex reality to a few simple equations. Unlike the IS-LM model, it is formally rather than informally derived from optimization by firms and consumers … The costs are that, while tractable, the first two equations of the model are patently false … The aggregate demand equation ignores the existence of investment, and relies on an intertemporal substitution effect in response to the interest rate, which is hard to detect in the data on consumers. The inflation equation implies a purely forward looking behavior of inflation, which again appears strongly at odds with the data …
One striking (and unpleasant) characteristic of the basic New Keynesian model is that there is no unemployment! Movements take place along a labor supply curve, either at the intensive margin (with workers varying hours) or at the extensive margin (with workers deciding whether or not to participate). One has a sense, however, that this may give a misleading description of fluctuations, in positive terms, and, even more so, in normative terms: The welfare cost of fluctuations is often thought to fall disproportionately on the unemployed.