If Levine's piece were a prelim question, I'm afraid we would have to fail both Brad and Nick. Brad can't quite get off the ground, as he doesn't understand that Levine's model is indeed a monetary economy and not a barter economy. Nick achieves liftoff, and we can give him points for recognizing the double coincidence problem and that the phone is commodity money. But then he stalls and crashes, walking off in a huff complaining that Levine doesn't know what he's talking about. Levine has posted an addendum to his original post, which I think demonstrates that he does in fact have a clue.Simon says:
When we allow for the existence of money, it becomes quite clear how the ‘wrong’ real interest rate can lead to a demand deficient outcome. Brad DeLong takes Levine to task for trying to use a barter economy and Say’s Law to refute Keynesian ideas, and Nick Rowe turns the knife.So, Simon compared notes with Brad and Nick after the exam. Bad idea. Everyone knows that talking to the guys who failed isn't going to help you pass the retake.
What did Simon do on his exam? He followed the time-honored approach of not answering the question he was asked, but answering one he thought he knew the answer to instead. What he gives us is not a critique of what Levine did, but a discussion of New Keynesian (NK) vs. RBC models. To summarize his discussion, Simon thinks that people who work with competitive equilibrium business cycle models (RBC for example) are contradicting themselves. According to him, their models are supposed to be microfounded, but prices are set by some Walrasian auctioneer. That's pretty silly, he thinks. He argues that NK models are superior in this respect, as the suppliers of goods actually set prices in an NK model, just as suppliers do in the real world. He elaborates by saying that NK models
...replace the auctioneer with a more modern macroeconomics - a macroeconomics where firms set prices and central banks change interest rates to achieve a target.As well, repeating from above:
When we allow for the existence of money, it becomes quite clear how the ‘wrong’ real interest rate can lead to a demand deficient outcome.
First, as I explain in my last post, monetary exchange - whether it's commodity money or fiat money - is critical to how Levine's example works. That's how the "demand shock" propagates itself, and where the big multiplier comes from. Further, in Levine's sticky-price equilibrium, that the real interest rate is wrong is exactly the problem. In fact, the real interest rate is constrained to be zero in the sticky price equilibrium, when efficiency dictates that it should be lower. If you want to call that a "demand deficiency," I guess you can, but part of the point is that that terminology isn't actually descriptive of the basic inefficiency.
Since Simon brought up NK and RBC models, let's discuss that. First, there is in fact no Walrasian auctioneer in a competitive equilibrium. The Walrasian auction was a story thought up by someone (no idea who - anyone know?) to justify focusing attention on equilibrium outcomes - it's entirely outside the model. In a competitive equilibrium, everyone optimizes, markets clear, and that's it. But, does dropping competitive equilibrium make much difference? Well, not really. If we take Prescott's RBC model, and add Dixit-Stiglitz monopolistic competition, what do we get? The model behaves in roughly the same way, except there are some monopoly rents in the production of goods. For a lot of problems, we're not going to care about the difference between monopolistic competition and competitive equilibrium, so we might as well take the easy route, and use competitive pricing. But for Woodford's problem, he can't do that, because he is concerned with sticky prices and relative price distortions. You can't do that in competitive equilibrium, so he needs a technical device, and Dixit-Stiglitz works. He doesn't do that because it's somehow more realistic.
Further, if monetary exchange and central banking are so important to Simon, I'm not sure why he likes NK so much. A Woodford "cashless" model is just that. There's no money in sight, except that people quote prices in terms of some virtual unit of account, and the central bank determines an interest rate in terms of that unit of account. If this is realism, I'm confused. Actual central banks issue some liabilities, hold some assets, and their key policy actions involve swapping some of their liabilities for assets. I don't see that happening in an NK model. What I see is an assumption that the central bank can set a price. I have no idea why this central bank can do that - the model certainly doesn't tell me anything about it.
Here's something Simon says of Levine:
He does not talk about central banks, or monetary policy. If he had, he would have to explain why most of the people working for them seem to believe that New Keynesian type models are helpful in their job of managing the economy.I work for one of these institutions, and I have a hard time answering that question, so it's not clear why Simon wants David to answer it. Simon posed the question, so I think he should answer it.