Tuesday, June 15, 2010

Kocherlakota Sells Out

In the middle of an otherwise innocuous educational piece, Narayana Kocherlakota, President of the Minneapolis Fed, in discussing "successes" in macroeconomic modeling, has a section on "Pricing Frictions: The New Keynesian Synthesis." Here is Narayana's description of how the "real world" works:
If the Federal Reserve injects a lot of money into the economy, then there is more money chasing fewer goods. This extra money puts upward pressure on prices. If all firms changed prices continuously, then this upward pressure would manifest itself in an immediate jump in the price level. But this immediate jump would have little effect on the economy. Essentially, such a change would be like a simple change of units (akin to recalculating distances in inches instead of feet).

In the real world, though, firms change prices only infrequently. It is impossible for the increase in money to generate an immediate jump in the price level. Instead, since most prices remain fixed, the extra money generates more demand on the part of households and in that way generates more production. Eventually, prices adjust, and these effects on demand and production vanish. But infrequent price adjustment means that monetary policy can have short-run effects on real output.
This is a more-or-less mainstream textbook description of how the Keynesian "transmission mechanism" works in some kind of IS-LM, AD-AS model, or (as of course is no accident) the so-called "microfounded" version in Woodford's Interest and Prices, or Clarida, Gali, and Gertler's survey piece in the Journal of Economic Literature.

For me, this was more than a little puzzling, as the Narayana I knew would have thought the worldview represented in standard Keynesian economics was hopelessly naive. But read on, it gets better (or worse, depending on whether you want a good chuckle or actually care about the state of policymaking in the world). We then get this:
Because of these considerations, many modern macro models are centered on infrequent price and wage adjustments. These models are often called sticky price or New Keynesian models. They provide a foundation for a coherent normative and positive analysis of monetary policy in the face of shocks. This analysis has led to new and important insights. It is true that, as in the models of the 1960s and 1970s, monetary policymakers in New Keynesian models are trying to minimize output gaps without generating too much volatility in inflation. However, in the models of the 1960s and 1970s, output gap refers to the deviation between observed output and some measure of potential output that is growing at a roughly constant rate. In contrast, in modern sticky price models, output gap refers to the deviations between observed output and efficient output. The modern models specifically allow for the possibility that efficient output may move down in response to adverse shocks. This difference in formulation can lead to strikingly different policy implications.
1. "...a foundation for a coherent normative and positive analysis..." No way. Woodford's view of the world is not coherent, and it certainly isn't a normative theory - the Taylor rule has never been shown to be an optimal response to anything. Also forget the "positive analysis." One would think that New Keynesians would be thoroughly embarrassed by the financial crisis, which obviously has nothing to do with sticky prices, and left them at a loss for policy prescriptions. What is most laughable are the attempts of people like this to make sense out of estimated Taylor rules that predict (very) negative nominal interest rates currently.
2. "This analysis has lead to new and important insights." First, there is nothing new in New Keynesian economics, which is successful in good part because it is completely unobjectionable to (i.e. the same as) Old Keynesian economics. Some people might tell you that it's forward looking price-setting that makes the difference, but I don't buy it. Second, New Keynesian economics leaves me empty. There is nothing "important" going on there.
3. As implemented by policymakers, there is absolutely no difference in the old notion of the output gap and the new one. It may be the case that, in Woodford's "Interest and Prices," the core model is essentially a monopolistic-competition real-business-cycle framework, and the output gap is clearly defined as the difference between what output is, and what it would be with flexible prices. In practice, take a look at how Glenn Rudebusch does it here. Rudebusch's output gap is the difference between the unemployment rate and the CBO's measure of the natural rate. But that seems to come from this paper, where the natural rate is
the unemployment rate that arises from all sources other than fluctuations in demand associated with business cycles.
This is basically an Old Keynesian natural rate, and if you look at the time series for the natural rate in the paper, it's clear that it will not differ much from what you get from fitting something like an HP filter to the unemployment rate series. So much for progress.

However you look at this, it's not good. Narayana either believes these things, or he doesn't. If he does, too bad for us. If not, maybe this sells well with some people but, again, too bad for us.

10 comments:

  1. So what do you as a new monetarist advocate we do now for the recession? and how is this policy prescription different from what say Krugman and Blinder recommend?

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  2. Oh, snap. I hope this post gets a reply.
    In any case,

    >> "If the Federal Reserve injects a lot of money into the economy, then there is more money chasing fewer goods."

    But why? Money does nothing in that model, other than the fact that people like to consume it.

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  3. Hi Richard,

    1. We are not in a recession anymore; real GDP has been growing for 3 quarters, and there is recent strength there. I'm not worried about the unemployment rate.
    2. I'm most qualified to comment on monetary policy, and I've done a lot of that, if you read through my blog archive.
    3. Krugman is not a serious macroeconomist. I can't be bothered commenting on the tripe that he writes. The last time I saw Blinder talk, he did not have a lot to say outside of standard views about the financial crisis and policy during the crisis. I prefer to deal directly with what people who make policy are saying.

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  4. For good or bad, the new keynesian model allows policy makers to talk based on an internally consistent framework. The alternatives (new monetarism, crystal balls, behavioral theories) have no role for policy.

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  5. "However you look at this, it's not good. Narayana either believes these things, or he doesn't."

    Or you missed the point, which isn't good either. I didn't read this as an endorsement of sticky price models, and I don't know why you did. To say a theory provides a coherent foundation for policy analysis doen't mean its a good theory, even if it is an improvement over advocating policies on faith.

    Did you miss the citations of Chari-Kehoe-McGrattan, or of Kocherlakota's own critical take on the Smets-Wouters model? What about the discussion of models with financial frictions? And his stress on the need to incorporate financial intermediation, did you catch that?

    I can only guess that, as those came after the quoted passages dealing with New Keynsian models, the latter sent you into such a rage you were unable to concentrate on the rest, overcome with the need to publicaly brand a colleage and (presumably) friend a sell-out for his apostasy.

    It really is too bad. I've been enjoying your blog because you present a perspective that is sadly underrepresented perspective in the econoblogosphere without the usual vitriol and personal attacks. I hope you can keep that up.

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  6. "I'm not worried about the unemployment rate."

    I guess your employed...

    Should public policy ever be worried about the unemployment rate? If not now, when?

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  7. This post could have been more interesting if it had more substance and less name calling.

    For the uninitiated:

    1) Why is Woodford's view of the world not coherent?

    2) What is laughable about "the attempts of people like this to make sense out of estimated Taylor rules that predict (very) negative nominal interest rates currently"?

    3) What do you propose that is better?

    4) In the comments you say "I'm not worried about the unemployment rate". Since Kocherlakota mentions in his piece that we should be more worried about unemployment than GDP, it would be interesting to know why you think unemployment is not an issue.

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  8. Yikes. This post is truly idiotic. Have you actually read anything? You say

    ""...a foundation for a coherent normative and positive analysis..." No way. Woodford's view of the world is not coherent, and it certainly isn't a normative theory - the Taylor rule has never been shown to be an optimal response to anything. Also forget the "positive analysis." One would think that New Keynesians would be thoroughly embarrassed by the financial crisis, which obviously has nothing to do with sticky prices, and left them at a loss for policy prescriptions."

    Okay, just a few observation, one could go on forever, based on some of the other things I've read here.

    1. Woodford never claimed the Taylor rule is a normative prescription. Not even Taylor said that. Taylor said it was a positive one. Woodford, on the other hand, has a painfully long analysis of Ramsey allocation in the New Keynesian model in his book Interest and Prices. He has also numerous papers about it. But I suppose you never got to that part in his book. Although, I think, it is even referred to on the jacket of the book that he studies optimal policy.
    2. Oh, and the second part. New Keynesian modelers have always been talking about how "banking crisis", in conjunction with price rigidities can lead to a collapse. Thats what the literature on the zero bound is all about.


    Before writing these silly rants, it would make sense to do some basic background research.

    Does anybody read this stuff, or did I just stumble in here by a coincidence?

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  9. As far as the claim goes that the current crisis was thoroughly embrrassing for New Keynesians and left them at a loss for policy prescriptions, I don't see how. After significant surprise deflation, Keynesian models predict higher unemployment, and that's exactly what happened. Moreover, there is in fact a policy prescription, it's for the central bank to raise MV back to trend level (level targeting).

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    ReplyDelete