New Keynesian Bastards?

When I teach the IS-LM model to my students, I am careful to describe it as "Keynesian" rather than Keynesian, in deference to the argument made by some that it does not accurately and/or fully represent what Keynes really meant. Although I still find that model framework quite useful for thinking about economic policy, I also explain to them why economic research has moved on from it.

Following the work of Friedman in the 1950's and 60's and Lucas in the 70's, there was an increasing emphasis on establishing microeconomic foundations for macroeconomics, and thinking seriously about expectations, with the idea of "rational expectations" becoming the new benchmark. This methodological revolution led to Real Business Cycle (RBC) models in the 1980's that explained economic fluctuations as the optimal responses of a forward-looking representative agent to productivity shocks. The models were "real" because monetary variables played no role. That ultimately proved too implausible for much of the profession to swallow (see e.g., Lawrence Summers (pdf)).

The real business cycle theorists did not succeed in taking over the field, but they did win the methodological war. It is now standard practice to derive macroeconomic models from the microeconomic foundations of optimizing behavior of agents with rational expectations. Much of the "New Keynesian" macroeconomics which is widespread today is essentially Real Business Cycle models with "sticky" prices grafted on (and the sticky prices mean that monetary policy has real effects).

In the FT, Roger Farmer argues that the "New Keynesians" aren't very good Keynesians, either:

For 30 years, macroeconomists have been of two stripes: new-classical and new-Keynesian. Neither has anything interesting to say about the current crisis.

In new-classical and new-Keynesian economics, all unemployment is temporary and unemployed workers will quickly find jobs. According to the Keynes of The General Theory, very high unemployment can persist forever. Nobody has taken this Keynesian idea seriously in respectable academic circles since the 1950s. But given the current jobless recovery, it’s an idea that makes sense and needs to be reconsidered.

Keynesian economics as we know it today is a watered down version of The General Theory given to us by American Keynesians like Paul Samuelson. Samuelson turned Keynesian economics into a digestible series of bite-sized pieces that the Cambridge economist and contemporary of Keynes, Joan Robinson, has referred to as “bastard Keynesianism”. Samuelson’s interpretation of Keynes evolved into a modern incarnation - new-Keynesian economics.

According to new-Keynesians, recessions occur because some firms are stubbornly unwilling to lower their prices in the face of a fall in demand. Workers quit their jobs and choose to take a prolonged vacation. This is not the main theme of The General Theory. But the idea that some firms are slow to change prices is central to new-Keynesian economics. To explain why firms don’t change prices, the new-Keynesians assume that a firm must wait until it’s randomly chosen to be given the privilege to change its price. This option is facetiously referred to as a ‘visit from the Calvo fairy’ after a paper by economist Guillermo Calvo who first introduced the idea into macroeconomics. I don’t believe in fairies.

The Calvo fairy is not the only unrealistic feature of new-Keynesian economics. Perhaps more damning is the fact that there is no unemployment in the benchmark new-Keynesian model. Instead, all variations in the employment rate occur as rational maximizing households choose to vary their hours in response to changes in the real wage. It is hard to take this model seriously as an explanation for the Great Depression or the current financial crisis. But it continues to dominate the discussion at academic conferences because - until now -there has been no good theoretical alternative.

While Farmer has his own alternative that involves more fundamental change, there is some progress being made on the labor market front within the existing New Keynesian paradigm. Several recent papers (which happen to be sitting on my desk right now) by Carl Walsh, Antonella Trigari and Olivier Blanchard and Jordi Gali include involuntary unemployment by integrating search and matching processes into the model.

It remains to be seen whether good "normal science" like this will save the New Keynesian framework in the wake of the global slump, or whether it is time for a scientific revolution...