Learn the basics of New Keynesian models without hard math

This post by Miles Kimball is a master class in how to explain ideas effectively. In one post, he explains the core ideas of what he calls "Neomonetarism", which I tend to just call "monetarism", and which most economists would refer to as "New Keynesian models with investment". This sort of model is squarely in the mainstream of what modern business cycle theory. Miles' academic work on Neomonetarism in the 1990s is heavily cited by Frank Smets and Raf Wouters, creators of the workhorse New Keynesian model used by central banks.

Miles manages to explain the ideas of the model without any reference to difficult math, while providing a clear and lucid description of most of the "microfoundations". He also explains what the "natural rate of interest" means in the context of these models (hint: there are actually two of them). Note that the policy recommendations that pop out of Miles' model are only slightly different from what Scott Sumner, David Beckworth, and other "market monetarists" have been advocating through their blogs.

So if you want to understand the way that mainstream business cycle theorists think about the macroeconomy, but you don't have the time or expertise to pick through a DSGE model, Miles Kimball's explanation is your constrained-optimal strategy for achieving understanding.

OK, that was a short post.

What, you wanted me to argue with the model? OK, OK, I guess I can play Devil's Advocate.

What are the potential shortcomings of this sort of model? In a 2012 speech (flagged helpfully by Steve Williamson), Charles Plosser lays out a number of them. Note that Plosser is a pioneer of the rival Real Business Cycle type of modeling, which generally lost out to New Keynesian models as the dominant form of business cycle theory, though it remains a substantial minority view. 

Plosser:

A...friction often assumed in Keynesian DSGE models is that firms and households have to wait a fixed interval of time before they can reset their prices and wages...A rule of the game in these models is that the interactions of these nominal frictions with real frictions give rise to persistent monetary nonneutralities over the business cycle... 

[Realistic price adjusting strategies] are ruled out by the “rules of the game” of New Keynesian DSGE modeling. 

Another important rule of the game prescribes that monetary policy is represented by [a rule] that policymakers are committed to follow and that everyone believes will, in fact, be followed...[T]his commitment is assumed to be fully credible according to the rules of the game of New Keynesian DSGE models. Policy changes are then evaluated as deviations from the invariant policy rule to which policymakers are credibly committed. 

I have always been uncomfortable with the New Keynesian model’s assumption that wage and price setters have market power but, at the same time, are unable or unwilling to change prices in response to anticipated and systematic shifts in monetary policy. This...raises questions about the mechanism by which monetary policy shocks are transmitted to the real economy in these models... 

From a policy perspective, the assumption that a central bank can always and everywhere credibly commit to its policy rule is, I believe, also questionable...[C]ommitment is a luxury few central bankers ever actually have, and fewer still faithfully follow...Policy actions have become increasingly discretionary... 

Given that central bankers are, in fact, acting in a discretionary manner...how are we to interpret policy advice coming from models that assume full commitment to a systematic rule? [A] number of central banks have been openly discussing different regimes, from price-level targeting to nominal GDP targeting. In such an environment where policymakers actively debate alternative regimes, how confident can we be about the policy advice that follows from models in which that is never contemplated?

What Plosser is arguing is that New Keynesian models have unrealistic microfoundations. Specifically, the "sticky price" mechanism and the "monetary policy rule" mechanism, both highly important for New Keynesian models, don't seem realistic to Plosser.

On one hand, this sort of criticism might sound a bit rich coming from a pioneer of RBC theory, whose microfoundations - perfectly flexible prices, technology that vanishes from human knowledge, etc. - are even less realistic. But I think the criticism itself is worthwhile.

The "monetary policy rule" is not as big of a problem as Plosser thinks, because more recent New Keynesian models, like the aforementioned Smets-Wouters model, allow the monetary policy "rule" to fluctuate randomly, meaning that they don't assume that the central bank can perfectly commit to future policy.

But the "sticky price" microfoundation remains troubling. You really do need sticky prices for these models to work. More specifically, as Miles points out in another paper with Bob Barsky and Chris House, you need durable goods prices - houses, cars, TVs, etc. - to be sticky. But why these prices would be sticky, and when they would be more sticky or less sticky, is not well understood.

Yes, sticky-price models do appear to fit the macroeconomic facts much better than do "flexible-price" models like Plosser's RBC. But sticky prices could just be a stand-in for something else. As Greg Mankiw and Ricardo Reis point out, "sticky information" - i.e., people simply not paying enough attention to price changes -  gets you similar results.

So I'm not saying I think we should chuck the models of Miles, Smets/Wouters, etc. out the window. Far from it. First of all, they may allow slight improvements in forecasting (and I am not as quick as most macroeconomists to dismiss the importance of forecasting!). And on the policy advice front, well, the evidence is strong that monetary policy sometimes really does work in the way we think it should (a clear and simple example being the Volcker disinflations; more complicated examples involving impulse responses and event studies and moments of aggregate joint time series are also available).

I just think we don't yet really know why monetary policy sometimes works. And because we don't know why it works, there's the possibility that monetary policy will do screwy things, or fail to work the way we think it should, in some situations. A liquidity trap situation, with prolonged deflation, may be one of those situations. I think Miles' "electronic money" idea should be tried (especially in Japan), but I'm not as confident as Miles that it will work as advertised!