Since Keynes wrote his General Theory, other economists have tried, in various ways, to formalize what Keynes appeared to have had in mind. Hicks constructed the IS-LM model, which is a static framework in which prices are fixed in nominal terms. In the 1980s, Mankiw and Blanchard and Kiyotaki, among others, thought about Keynesian menu-cost models in which it is costly to change prices. John Bryant,Peter Diamond, Cooper and John, and the authors represented in this JET volume studied equilibrium coordination failure models with Keynesian features. Mike Woodford, among others, modified the neoclassical growth model, using some of the insights from the menu cost literature, to develop sticky-price New Keynesian models.
The followers of Keynes are sometimes motivated strongly by belief. You can see this, for example, in Ball and Mankiw's Sticky Price Manifesto. Some Keynesians look at a contractionary episode - the Great Depression or the recent recession - and cannot see anything other than Keynesian economics to explain it. The "fundamentals" in 1933 looked about the same is in 1929, so how could real GDP have been 40% lower, except as the result of a "deficient demand" phenomenon? There is also empirical evidence, for example on the stickiness in prices. Prices of goods are certainly much smoother than the prices of assets, and this forthcoming chapter from the new Handbook of Monetary Economics summarizes what is known about the empirical regularities in the changes in prices over time and across goods. Another interesting regularity is that much of the variability in the real exchange rate between two countries, even in close proximity (e.g. the U.S. and Canada), is explained by variability in the nominal exchange rate. Thus, it seems to matter how prices are denominated - e.g. in U.S. or Canadian dollars.
What do we want from an economic model? First, we want it to explain something to us. Why are people unemployed? Why do economies grow? Why is there inflation? Second, we would like to ask the model questions. In macroeconomics, some of the key questions are policy questions. How, if at all, can fiscal and monetary policy be used to make us better off? The answers to the first set of questions can have a lot to do with the answers to the second set. Once I understand what causes inflation and why it is bad for us, this can tell me how monetary policy should be conducted to control it.
Now, the class of coordination failure models I mentioned above explains something. These models tell us that aggregate fluctuations can arise due to people coordinating on extraneous information. Further, these fluctuations are generally inefficient. What should we do about this problem? Typically, fiscal and monetary policy rules in these models can be set in ways that eliminate undesirable equilibria. Coordination failure models are certainly Keynesian. Indeed, one can find passages in the General Theory that are essentially coordination failure stories. However, in spite of the large coordination failure literature, and some success in fitting these models to the data, most Keynesians are currently uninterested in coordination failures. This may be because of the technical demands required to work with these models. However, full-blown New Keynesian models appear no less demanding. To me, it's a puzzle.
The New Keynesian models in wide use now typically rely on Calvo pricing (a form of time-dependent pricing), whereby monopolistically-competitive firms receive random opportunities to change prices. Upon receiving an opportunity to change its price, a firm does this optimally (taking into account that it may not be able to change it again for a while), but is otherwise stuck with the price it charged last period. Some New Keynesian models go deeper and use state-dependent pricing, under which there is a menu cost, and a firm changes its price when it is optimal to do so. Time-dependent pricing and state-dependent pricing are just special cases of the same model. With time-dependent pricing the menu cost is random - it is either zero or infinite. With state-dependent pricing the menu cost is constant.
Neither state-dependent or time-dependent pricing actually explains why prices are sticky. Why should it be costly to change a price? This can't literally be the cost of posting a price schedule - surely that is trivial relative to other costs of producing and selling a good or service. Keynesians must have something else in mind, if they have thought about it. But what is it? And surely what is causing the price stickiness has to matter for whether and how policy should fix any inefficiencies arising from sticky prices.
The typical argument seems to be that actually explaining the sources of price stickiness is too hard - otherwise someone would have solved the problem. As the argument goes, a useful shortcut is to just fix the prices, perhaps in a Calvo fashion, and go from there. With the world falling apart and large numbers of people unemployed, why should we have to wait while the theorists work out the details? Of course, the problem could be that, once we know all the details, we might change our minds about how the policies work.
What would a theory of price stickiness, or more appropriately a general theory of pricing, look like? First, we have to have a model in which sellers want to quote prices in units of "money." While we have models of media of exchange, models of the unit of account do not exist, to my knowledge. In any monetary model I know about, the numeraire could be anything. It is irrelevant whether we quote prices in units of money, goats, or soccer teams. Clearly though, how we write contracts and quote prices has a lot to do with what we use as a medium of exchange. We want an environment that will imply that contracts with few contingencies are optimal, and possibly the nominal contracts can then be derived as optimal risk-sharing arrangements. Clearly, though, you have to be a long way from complete Arrow-Debreu contracts. The frictions will be critical.
Now, once we are past the nominal-contract hurdle (a very serious one at that), we have to worry about the stickiness. Suppose that I am selling toothbrushes at a particular location. There are many ways to determine how many toothbrushes I sell at what price. I could haggle with each customer who comes in the door concerning how many toothbrushes I will exchange for how many dollars. I could specify a time each day when I will auction off so many toothbrushes, possibly selling them individually using an English or Dutch auction. I could also post a price and sell toothbrushes at that price to whoever comes in the door. Of course we all know that it is not efficient to haggle over a toothbrush, or to sell toothbrushes in an auction (unless it's Elvis's toothbrush). However, haggling may be efficient when I am buying a house, and an auction may be efficient when I want to sell an idiosyncratic object. Surely, part of what the theory needs to tell me are the characteristics of a good or service that determines how it is exchanged - using price posting, an auction, one-on-one haggling, or some other mechanism.
Now, in the case where prices are posted, why would firms want keep a posted price unchanged for months at a time. It could be that it just does not matter much. Maybe the firm has other more important things to think about (inventory control, shoplifting, shirking employees) than the price of toothbrushes. Maybe the firm is trying to minimize effort for repeat customers. If I know that firms (such as the grocery store, where I buy the same goods with some regularity) are changing prices frequently, as a buyer I will have to reoptimize more frequently to make sure that I am purchasing the optimal basket of goods. Maybe I would rather buy at a store where the prices change infrequently.
Now, what could go wrong here? How are firms going to get the prices wrong, so that the government needs to step in to fix things? Possibly with infrequent price setting, we get phenomena like those in Calvo-pricing setups, where firms make staggered price adjustments, and relative prices are distorted. This is far from clear, but suppose that relative price distortions are the difficulty. Now, if the government has all the information, this problem is easy to solve. The government knows what the correct prices are, and it forces firms to price correctly. Of course that seems silly, as it is unrealistic to think that the government has access to enough information to accomplish this. We all know that market economies solve very complex allocation and pricing problems that it would be impossible for a central planner to solve.
If the relative prices are distorted, the government must necessarily rely on some indirect mechanism for dealing with this. If the prices are distorted due to inflexibility, why not subsidize flexibility? But how would this be done? Do some sectors of the economy need larger subsidies than others? Could firms game the system by making a price change today and reversing it tomorrow? How does the government monitor all these price changes? The more I think about this, the more unworkable it seems.
Now, the solutions that Keynesians, new and old, have come up with for solving the relative price distortion problem seem odd. First, Old Keynesians tended to (and tend to) focus on fiscal policy remedies. Why should the provision of public goods and services be an important element in correcting a relative price distortion? I know how typical Keynesian models work, but when I think more deeply about the pricing problem, this does not make sense. Second, New Keynesians argue for the use of monetary policy (within the constraint determined by the zero lower bound on the nominal interest rate) to correct the problem, when it seems that indexation would be feasible, and in fact optimal for the firms involved.
We need a serious theory that explains the behavior of the prices of goods and services. Such a theory is necessary, as it is far from clear that the observed behavior of prices implies some market failure and, even if it did, it is also not clear that standard Keynesian prescriptions would solve the problem. In the absence of the theory, I think there are good reasons to be skeptical about what Old and New Keynesians have delivered thus far.