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).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.
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.
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.