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.