First, Noah is more than a little confused about the genesis of sticky-price New Keynesian (NK) models. In particular, he thinks that Ball and Mankiw's "Sticky Price Manifesto" was a watershed in the NK revolution. Far from it. Keynesian economics went in several different directions after the theoretical and empirical revolution in macroeconomics. There was the coordination failure literature - Bryant, Diamond, and Cooper and John, for example. There was the sunspot literature. In addition, Mankiw, and Blanchard and Kiyotaki, among others, thought about menu costs. The "Sticky Price Manifesto" is in part a survey of the menu cost literature, but it reads like a religious polemic. You can get the idea from Ball and Mankiw's introduction to their paper:
There are two kinds of macroeconomists. One kind believes that price stickiness plays a central role in short-run economic fluctuations. The other kind doesn't... Those who believe in sticky prices are part of a long tradition in macroeconomics... By contrast, those who deny the importance of sticky prices depart radically from traditional macroeconomics. These heretics hold disparate views... heretics are united by their rejection of propositions that were considered well-established a generation or more ago. They believe that we mislead our undergraduates when we teach them models with sticky prices and monetary non-neutrality. A macroeconomist faces no greater decision than whether to be a traditionalist or a heretic. This paper explains why we choose to be traditionalists. We discuss the reasons, both theoretical and empirical, that we believe in models with sticky prices...This is hardly illuminating. There are (were) only two kinds of macroeconomists? I've known (and knew in 1993) more kinds of macros than you can shake a stick at, and most of them don't (didn't) define themselves in terms of how they think about price stickiness. Further, they don't ponder choices about research programs as if, for example, they are living in 1925 in Northfield Minnesota, and choosing between lifetime paths as Roman Catholics or Lutherans. Why should we care what Ball and Mankiw think is going on in the minds of their staw-men opponents, or in the classrooms of those straw-men? Why should we care what Ball and Mankiw "believe?" Surely we are (were) much more interested in figuring out what we can learn from them about recent (at the time) developments in the menu cost literature.
Bob Lucas discussed Ball and Mankiw's paper at the Carnegie-Rochester conference where it was presented, and had this to say:
The cost of the ideological approach adopted by Ball and Mankiw is that one loses contact with the progressive, cumulative science aspect of macroeconomics. In order to recognize the existence and possibility of research progress, one needs to recognize deficiencies in traditional views, to acknowledge the existence of unresolved questions on which intelligent people can differ. For the ideological traditionalist, this acknowledgement is too risky. Better to deny the possibility of real progress, to treat new ideas as useful only in refuting new heresies, in getting us back where we were before the heretics threatened to spoil everything. There is a tradition that must be defended against heresy, but within that tradition there is no development, only unchanging truth.Noah seems to think that Lucas was being unduly harsh, and that he was somehow feeling threatened by these "upstarts." It's pretty clear, actually, that Lucas just thinks it's a bad paper - religion, not science - and that Ball and Mankiw could do a lot better if they put their minds to it.
Where did NK come from? Which of the three threads in post-macro revolution Keynesian economics - coordination failures, sunspots, menu costs - morphs into Woodfordian NK models? To a first approximation, none of them. Perhaps NK owes a little to the menu cost approach, but it's really a direct offshoot of real business cycle theory. Take a Kydland and Prescott (1982) RBC model, eliminate some bells and whistles, add Dixit-Stiglitz monopolistic competition, and you have Rotemberg and Woodford's chapter from "Frontiers of Business Cycle Research." Add some price stickiness, and you have NK. So, NK basically leapfrogs most of the "Keynesian" literature from the 1980s. It's much more about RBC than about Ball and Mankiw.
Further, it's worth noting that Mike Woodford, the key player in NK macro, was at the University of Chicago from 1986 to 1992, the latter 3 years in the Department of Economics with - guess who - Bob Lucas. Indeed, they wrote a paper together. It's about - guess what - a kind of sticky price model with non-neutralities of money. Later on, Lucas wrote about sticky prices with Mike Golosov. So, I think we could make the case that the influence of Lucas on NK is huge, and that of Ball and Mankiw is tiny. Was it the case, as Noah contends, that Lucas was left, disappointed in the dust, by the purveyors of sticky price economics? Of course not - he was helping it along, and doing his own purveying.
How does a basic NK model - Woodford's "cashless" variety, for example - work? There is monopolistic competition, with multiple consumption goods, and the representative consumer supplies labor and consumes the goods. There's an infinite horizon, and we could add some aggregate shocks to total factor productivity (TFP) and preferences if we want. Without the price stickiness, in a competitive equilibrium there are relative prices that clear markets. There's no role for money or other assets (in exchange or as collateral), no limited commitment (everyone pays their debts) - no "frictions" essentially. Financial crises, for example, can't happen in this world. Then, what Woodford does is to add a numeraire object. This object is a pure unit of account, existing as something to denominate prices in terms of. We could call it "money," but let's call it "stardust," just for fun. So far, this wouldn't make any difference to our model, as it's only relative prices that matter - the competitive equilibrium relative prices and equilibrium quantities don't change as the result of adding stardust. What matters, though, is that Woodford assumes that firms in the model cannot change prices (at least sometimes) without bearing a cost. With Calvo pricing, that cost can either be zero or infinite, determined at random each period. Even better, the central bank now has some control over relative prices, as it has the power to determine the price of stardust tomorrow relative to stardust today.
Then, if there are aggregate shocks in this economy, we can do better with central bank intervention than without it. Shocks produce relative price distortions essentially identical to tax distortions, and central bank intervention can alter relative prices in beneficial ways, by reducing the distortions. Basically, it's a fiscal tax-wedge theory of monetary policy. Why monetary policy can do this job better than fiscal policy is not clear from the theory.
Noah tells us that "sticky-price models have become the dominant models used at central banks." You might ask what "used" means. Certainly Alan Greenspan wasn't "using" NK models. My best guess is that he wouldn't even want to hear about them, as he knows little about modern macroeconomics in the first place. Ben Bernanke, of course, is a different story - he clearly learned modern macro, published papers with serious models in them, and knows exactly what the working parts of an NK model are about. Which brings us to a post of his from last week.
The issue at hand is how central banks should think about financial stability. Is this solely the province of the financial regulators, or should conventional monetary policy intervention take into account possible effects on private-sector risk-taking? I think it's well-recognized, if not blatantly obvious, that there were regulatory failures that helped cause the financial crisis. Whether legislated financial reforms were adequate or not, I don't think any reasonable person would question the need for new types of financial regulation in the wake of the financial crisis. Also, most economists would not question the need for intervention by the central bank in a genuine financial crisis. The Fed was founded in part to correct problems of financial instability during the National Banking era (1863-1913) in the United States, and there was a well-established approach to banking panics by the Bank of England in the 19th century (which Bagehot, for example, wrote about). Friedman and Schwartz wrote extensively about how the failure of the Fed to intervene during the Great Depression helped to exacerbate the depth and length of the Depression.
But should a central bank intervene pre-emptively to mitigate financial instability or, for example, to reduce the probability of a financial crisis? That's an open question, and I don't think we have much to go on at this point in time. In any case, to think about this constructively, we would have to ask how alternative policy rules for the central bank jointly affect financial stability, asset prices, GDP, employment, etc., along with economic welfare, more generally. It would help a lot - indeed it seems it would be necessary - for the model we work with to have some working financial parts to it - credit, banks, collateral, the potential for default, systemic risk, etc. I actually have one of these handy. It's got no sticky prices, but plenty of other frictions. There's limited commitment, collateral, various assets including government debt, bank reserves, and currency, and private information. You can see that I didn't take either of the roads that Ball and Mankiw imagined I should be choosing, and I'm certainly not unique in that regard. The model I constructed tells us that conventional monetary policy can indeed exacerbate financial instability. There is an incentive problem in the model - households and banks may have the incentive to post poor-quality collateral to secure credit - and this incentive problem will tend to kick in when nominal interest rates are low.
Bernanke gives us some evidence from research which he claims informs us about the problem of financial stability and monetary policy. The paper he cites and summarizes is by Ajello et al. at the Board of Governors. Here's what Bernanke learned from that:
As academics (and former academics) like to say, more research on this issue is needed. But the early returns don't favor the idea that central banks should significantly change their rate-setting policies to mitigate risks to financial stability. Effective financial oversight is not perfect by any means, but it is probably the best tool we have for maintaining a stable financial system. In their efforts to promote financial stability, central banks should focus their efforts on improving their supervisory, regulatory, and macroprudential policy tools.I agree with the first sentence. But what about the rest of it, which is his takeaway from the Ajello et al. paper. Maybe we should check that out.
So, the Ajello et al. model is a kind of reduced-form NK model. For convenience, NK models - which at heart are well-articulated general equilibrium models - are sometimes (if not typically) subjected to linear approximation, and reduced to two equations. One is an "IS curve," which is basically a linearized Euler equation that prices a nominal government bond, and the other is a "NK Phillips curve" which summarizes the pricing decisions of firms. These two equations, given monetary policy, determine the dynamic paths for the inflation rate and the output gap - the deviation of actual output from its efficient level. Often, a third equation is added: a Taylor rule that summarizes the behavior of the central bank. The basic idea is that this reduced form model is fully grounded in the optimizing, forward-looking behavior of consumers and firms, and so conforms to how modern macroeconomists typically do things (for good reasons of course).
If Ajello et al. could get financial crises into a model of monetary policy, that would be very interesting. There is some work on this, for example Gertler and Kiyotaki's Handbook of Monetary Economics chapter, but that's not what Ajello et al. are up to. What they do is to take the first two equations in a standard reduced form NK model, and then append a third equation that captures the effects of financial crises. The financial part of the model isn't grounded in any economic theory - the authors are just taking the express route to the reduced form. There are two periods. The endogenous variables are the current output gap, the current inflation rate, and the probability of a financial crisis in the second period. The second period financial crisis state has exogenous output gap and inflation rate, and the second period non-crisis state has another exogenous output gap and inflation rate. The probability of a financial crisis depends on the first period nominal interest rate, inflation rate, and output gap. That's it. The authors then "calibrate" this model, and start doing policy experiments.
What's wrong with this model? For starters, there's no assurance that, if we actually take the trouble to figure out what a financial crisis is, how to model it at a fundamental level, and then somehow integrate that with basic NK theory, that we're going to get a reduced form in which we can separate the non-financial-frictions NK model from the financial frictions NK model in the way that the authors of the paper have done it. They appeal to a paper by Woodford, but Woodford doesn't help me much, as he's basically taking the express route too. Think about it. We're starting with a model that is frictionless, except for the sticky prices, and we're asking it to address questions that involve default and systemic financial risk. What grounds to we have for arguing that this involves tweaking an NK reduced form in a minor way? But, suppose that I buy the specification the authors posit? What grounds do we have for setting the parameters in the third equation? I'm not sure what the signs of the parameters should be, let alone the magnitudes, and it puzzles me that the authors can be confident about it either.
Bernanke is taking it seriously though, as you can see from the quote above. We can see that Bernanke has strong priors, but there is essentially zero take-away in the paper, so why is he trying to use the paper to convince us he's right?
So, as Noah says, NK models are "used" in central banks, and here's an example of what that can mean. There is nothing inherently offensive about work on sticky prices, just as there's nothing inherently offensive about cats. In fact, there is some very interesting work on sticky prices. Last week, I saw a paper by Fernando Alvarez and Francesco Lippi. They do very sophisticated work, with careful attention to the available data on product pricing, and I think a lot can be learned from what they're up to. But if we want to think about the effects of monetary policy, and how monetary policy should be conducted, we better be thinking about the details of central bank liabilities, central bank assets, the role of the central bank as a financial intermediary, private banks, collateral, government debt, credit, etc. A basic NK model throws all of that out and focuses exclusively on sticky price frictions. Why is that a problem? Well, suppose a financial crisis comes along. What then do you know about malfunctioning credit markets, the role of central bank lending vs. open market operations, the effects of unconventional monetary policies such as quantitative easing? Not much, right? And it's pretty clear that you're not going to learn much about these things by tweaking a reduced form NK model.
"A basic NK model throws all of that out and focuses exclusively on sticky price frictions. Why is that a problem? Well, suppose a financial crisis comes along. What then do you know about malfunctioning credit markets, the role of central bank lending vs. open market operations, the effects of unconventional monetary policies such as quantitative easing? Not much, right?"ReplyDelete
Exactly. You have expressed very well what a lot of people have been trying to say less effectively for a while. Will things change? I hope so, but I am not holding my breath.
Already see the headline in Krugman and de Long next screed: New Monetarists claim cats are offensive.ReplyDelete
Great post. Thank goodness for this blog, Andolfatto and Cochrane. The rest is noise
Reduced-form bricolage and sticky brainsReplyDelete
Comment on ‘Sticky Prices, Financial Frictions, and the Ben Bernanke Puzzle’
Stephen Williamson cannot explain how the monetary economy works, instead he tells us how economists work.
“For convenience, NK models -- which at heart are well-articulated general equilibrium models -- are sometimes (if not typically) subjected to linear approximation, and reduced to two equations. One is an "IS curve," which is basically a linearized Euler equation that prices a nominal government bond, and the other is a "NK Phillips curve" which summarizes the pricing decisions of firms. ... The basic idea is that this reduced form model is fully grounded in the optimizing, forwardlooking behavior of consumers and firms, and so conforms to how modern macroeconomists typically do things (for good reasons of course).” (See thread intro)
Unfortunately the basic idea is wrong and there is actually not one methodologically sound reason for how modern macroeconomists typically do things. No doubt about it, modern macroeconomists are irrecoverably lost in the proto-scientific woods (2014b; 2014a).
There are two kinds of macroeconomics: true or false. Clearly, NK-RBC-NC falls squarely into the second class. As a matter of principle, all well-articulated general equilibrium models are false. Hence it is pointless to discuss their irrelevant differences.
Kakarot-Handtke, E. (2014a). Objective Principles of Economics. SSRN Working Paper Series, 2418851: 1–19. URL http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2418851.
Kakarot-Handtke, E. (2014b). The Three Fatal Mistakes of Yesterday Economics: Profit, I=S, Employment. SSRN Working Paper Series, 2489792: 1–13. URL http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2489792.
Thanks for sharing.Delete
"A basic NK model throws all of that out and focuses exclusively on sticky price frictions. Why is that a problem? Well, suppose a financial crisis comes along. What then do you know about malfunctioning credit markets, the role of central bank lending vs. open market operations, the effects of unconventional monetary policies such as quantitative easing? Not much, right? And it's pretty clear that you're not going to learn much about these things by tweaking a reduced form NK model."ReplyDelete
Normally I totally disagree with you as you are a demand denialist.
But I totally agree that wages and price rigidity are most likely not the key market failure that can explain underemployment equilibria and that financial market imperfections are far more important.
It might also be worthwhile to point out that the New Keynesians are disagreeing with Keynes who did not think that morep rice/wage flexibility would be beneficial. Now the natural question is why this should matter? Who cares about an economist who is long dead except for people who are more into exegesis than econ.
Well, I think it matters as it is an index that the New Keynesians are oblivious of economic history. As you rightly pointed out, they have more in common with RBC than with the numerous Keynesian research lines from the 70s.
"New Keynesians are oblivious of economic history."Delete
As far as I can tell, that's false. I'm sure Mike Woodford knows economic history. But surely you can evaluate his work on its own merits. Maybe you think his model doesn't explain the Great Depression? If so, why would you want it to?
"explain underemployment equilibria"
We don't "explain" this any more than we "explain demand." These are not observables.
You might wanna take a look at e.g. the unemployment numbers of Geeece or Spain and then tell again with a straight face that underemployment equilibria are not observable.Delete
Good. What you see are the reported unemployment numbers. "Underemployment" is not the reported number, it's the difference between reported unemployment and something else. To measure that difference, you need a model.Delete
Right, 50% of young people in Greece or Spain chose to be unemployed. And food stamps caused the Great Depression.Delete
^Apparently you are choosing to be stupid, so why can't they choose to be unemployed? Or is your stupidity involuntary?Delete
"Basically, it's a fiscal tax-wedge theory of monetary policy. Why monetary policy can do this job better than fiscal policy is not clear from the theory."ReplyDelete
You want a microfounde political economy model inside your DSGE model as well? And how would you model political stupidity (maybe using Gabaix's model of sparse optimisation, or Sims' rational inattention model, assuming politicians have a more finite signal processing capacity than economists?).
Maybe because we don't trust politicians in congress/senate with the messed up US electoral system and their often meagre understanding of anything outside politics to successfuly implement a non-partisan countercyclical consumption or labour tax? Meanwhile mostly unelected central bank technocrats partially supported by economists with training in DSGE models can respond more quickly to economic conditions by adjusting policy to the wedges caused by sticky prices? Just a hypothesis. It's simpler to just assume monetary policy is better at handling these distortions and avoid complicating your model with a model of politicians.
"You want a microfounded political economy model inside your DSGE model..."Delete
I wouldn't go that far. I'm just thinking along these lines, for example:
"While asset purchases by the central bank involving only government debt act tochange the composition of the outstanding consolidated government debt, central bank purchases of what are essentially private assets puts monetary policy in potentially different territory."ReplyDelete
Not true at all. There are certainly cases of this form of open market operation being used outside the US. I am getting something on this proof-read at the moment.
"private asset purchases ...by the central bank..in general ... favor some credit market participants relative to others. If private assets are purchased by the central bank, some choices must be made about which assets to purchase,
and which assets not to purchase. If the purchase programs work as intended, this must have redistributional effects, and there are important issues that need to be addressed relating to political economy and central bank independence."
I really agree. And this will initially require some deeply and widely informed rational choice, model and other abstraction-free analysis that engages with the knowable and already accumulated knowledge on the subject. My own experience looking at this is that the use of private sector assets for open market operations has not been that central banks purchase risky assets. Quite to the contrary. They have purchased credit-worthy assets (but which are often questionably rated) of firms that are highly capitalised (very easy to show). The inclusion of these assets on the central bank balance sheet has over the long term has often led to the central bank credit supporting stagnant industries and "zombie firms" and an unhealthy relationship between the central bank, large banks, firms and governments actually impeding growth (ie the incentive and other such effects you allude to are important). It can actually worsens the problem we are trying to solve - ie overly risk averse lending in a liquidity glut. This is where the story really gets complicated and controversial. But there is a lot of material to go on, and you may be surprised how much we do know. We can get a good understanding of this subject without bringing in nonsense like rational expectations and irrelevant things like sticky prices or underpinning it on an empirically dubious and a peculiar morally repugnant theory that arose out of Victorian England. Models (meaning a mathematical expression of a systematically put together verbal presentation) come in later when we need quantitative estimates for forecasting and to formulate optimal policy purposes. But the facts must determine the model, not a model determine what facts to use. Our analysis must include non-quantifiable and mathematically expressible components, because most likely this an important, probably the most important, part of the story - and should not be reduced to a few lines or a footnote, but be central to the analysis. Mathematical devices for the sake of them come between us and the truth.
"Not true at all."Delete
And? What are you getting at? It's immediately obvious that purchases of MBS or Treasury securities have identical effects?
Sorry, I certainly did mess that up. While I would imagine their are some effects that arise from central bank purchases of long term government securities that are not trivial (a move away from the post -1951 Accord (US) practice which advocated a short term bills only policy - the basis in principle of a post-WWII convention in monetary policy - although not in practice worldwide) - I see your bigger point. Looking at a 1960 Congressional Report it says that the reasons for the restriction to short term bills were to limit interference with the market mechanism and to develop 'stronger' government security markets - although it is not at all specific.Delete
The bigger point I was trying to make (not very well) was that we have some concrete real world examples of private sector securities being used as the primary form of central bank operation - with a lot of lessons we can learn.
Yes. For example, the Swiss National Bank holds stocks.Delete
"We can get a good understanding of this subject without bringing in nonsense like rational expectations and irrelevant things like sticky prices or underpinning it on an empirically dubious and a peculiar morally repugnant theory that arose out of Victorian England."ReplyDelete
Nope. You cannot analyze monetary policy half-way decently if you ignore either expectations or the fact that prices are sticky.
"But the facts must determine the model, not a model determine what facts to use."
Yep. Now why don't you learn a little bit about some economic facts like price and wage rigidity? Of course you are free to remain ignorant about the subject like the entire freshwater crowd but then you are just another hack artist who ignores facts that do not match his ideology.
"You cannot analyze monetary policy half-way decently if you ignore either expectations or the fact that prices are sticky."Delete
Why price stickiness? What tells you that is necessary for analyzing monetary policy? We have plenty of monetary economics that proceeds without making the prices sticky. You figure we learn nothing from that?
"We have plenty of monetary economics that proceeds without making the prices sticky. You figure we learn nothing from that?"Delete
Yep. Lucasian "toy economies" that do not incorporate facts of actual economies might be mathematically elegant but are otherwise useless.
Well, "monetary economics" could mean a lot of things. Why do you think monetary economics has something specific to do with Lucas? Is there some monetary economics that you like? If not, what economics do you like? Do you like math, or do you just hate math when economists use it? What exactly do you have to contribute to humanity?Delete
"What exactly do you have to contribute to humanity?"Delete
Far more than anti-empirical economists like yourself.
You seem to like making unjustified claims with nothing at all to back them up. First, I have nothing against empirical work. Second, you haven't told me anything about what you do (see above), so that we can evaluate what you're saying. You seem pretty fearful. Don't worry, I won't bite your head off.Delete
^^ It seems you have nothing to contribute after all. Go away, John D.Delete
"Now why don't you learn a little bit about some economic facts like price and wage rigidity?"ReplyDelete
There are many cases of successful aggregate demand management in price variable economies. Before WWII prices were in most industrialised countries very variable. This obviously did not stop the successful implementation of the Keynesian counter-Depression policies. That is not to say that price and wage rigidity is always unimportant. But it will come up naturally in your investigation if it were - all I am saying is you do not have to start your analysis with a model that already concludes that it is. I was also pointing out what happens if you start any investigation with a model. Is there a study based on historical documentation and other substantial evidence that identified goods price and wage rigidity has having a key influence in events leading up to 2008, and the lack of very successful aggregate demand management since that you particularly like?
First of all, there is no such thing as a "price variable" economy. Prices and wages are sticky to a significant degree in all economies.ReplyDelete
Second, I would agree that price and wage rigidity are not the key market failure and that even without them udnermployment equilibria would exist.
But wage and price rigidity are in themselves the result of numerous market failures. Downward price rigidity emerges when produkt markets are imperfectly competitive and there are menu costs (or à la Akerlof&Yellen, agents are "near-rational" and do not react to small deviations from the optimum). Downward Wage rigidity emerges when workers are imperfectly rational and suffer from money illusion or when we have an efficiency wage situation (which is in my mind basically always the case).
I am all for models with financial market imperfections.
But I am against pretending that in a world without money we would not have underemployment equilibria as the market imperfections that condense into wage and price rigidity which I just listed above would suffice to create underemployment equilibria in a money-less world.
The key lesson from micro-founded macro is one that the Old Keynesians already made long ago: there are numerous micro market failures that "aggregate" into the nasty macro market failure.
The macroeconomist as a scientist might be interested in all of them but the macroeconomist as an engineer can stick to standard aggregate demand management rules.
"The opening up of Asia significantly increased the world's labor supply while the technology gains increased productivity growth. The uptick in productivity growth, which peaked between 2002 and 2004, was widely discussed in the early 2000s and raised long-run expected productivity growth at the time. This can be seen in the figure below which shows a consensus forecast of annual average productivity growth over a ten year horizon."ReplyDelete
This is an interesting potentially multi-disciplinary discussion which was touched on in comments on earlier posts on this blog re the causes of the stabilisation of post 1970s inflation and low interest rates during the Great Moderation. The monetary-superpower argument I thought was particularly interesting.
We should all pursue logic and consistency in our arguments. The work of Ajello et. al. is a good starting point (they are asking a very important question). However, it is clear -independently of our thoughts about how prices should be modeled- that the lack of a clear logic behind equation (3) is a huge drawback to their work (it is not justified as equations 1 and 2)
There can be great work using sticky prices or a different approach, depending which problem we are trying to address. I think that the perspective of Noah Smith is definitely not healthy. The word is not that simple. A good thought exercise would be the following: Assume that all macroeconomists work with sticky prices. Would that mean that we already know what exactly caused (and how to prevent) the Great Recession? Would that imply that the effects of QE are crystal clear?