‘New Keynesianism’ — an unpleasant macroeconomic fairy-tale

3 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.

(0) PaperBackFrontCover-FFF•e.inddThe 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.

Olivier Blanchard



  1. Lucas and Sargent 1979 present RBC as something for ‘normal times’, when everyone (other than perhaps policy makers) can ignore radical uncertainty and get away with it. Maybe we can think of troubling unemployment as a lack of clearing of the labour market, in which case such unemployment may be associated with a type of uncertainty that is significantly different from that which RBC theorists consider?

    • Maybe, we could consider that many markets do not clear — including but not limited to labor markets — and therefore changes in prices may not be sufficient to bring about a coordinated equilibrium of markets featuring a collective and optimal intertemporal substitution without deliberate, centralized governance. Yes, Lucas, in his saner moments, has a cautious eye on a corridor hypothesis. If a deflation drags down prices and activity enough, and the only full-employment equilibrium is at a generally higher price level, how are markets where prices are falling going to achieve the necessary buoyancy? Among lesser minds, the dilemma pits faith in the law of downward sloping demand against the arithmetic of effective demand.
      The actual economy features the kind of uncertainty where various people have different and conflicting interests as well as differing and limited access to knowledge and none to future learning. And prices are administered — not just because of monopoly power, but because cost structures under uncertainty generally feature a declining marginal cost less than average cost — a circumstance that implies a market equilibrium in price does not exist. People do not know what the other guy knows and are uncertain about what each may learn tomorrow. People piling up money is not intertemporal optimization; it is hedging and strategic maneuver in a sometimes greedy struggle for advantage.
      It is simply not possible to exaggerate the extent to which mainstream macroeconomics theory takes place in a fact-denying fantasy world. That a figure like Olivier Blanchard thinks there is no alternative to cruel policy rationalized by such nonsense on stilts is a measure of the extent to which we are willing to yield authority to nonsense in academic garb.

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