What is New Keynesian Economics really about?

For economists. This post arose out of remark I made in response to comments. I’m not sure I want to defend the original remark too much, but I think there is a discussion here that some may find interesting.

In my discussion with heterodox economists, I was asked by someone whether I had actually read any major heterodox thinkers, or just looked at blogs. In response I listed some of those that I had read, including Axel Leijonhufvud. In passing I said I thought you could make a case for Leijonhufvud being the first New Keynesian economist. I guess this was a red rag to a bull, and Lars Syll wrote another post saying how wrong I was. (He is fast overtaking Scott Sumner in the perceived Wren-Lewis error count.)

So what did I mean? Of course I knew that Leijonhufvud is highly critical of much of modern macro. But what I had in mind was what I remembered of ‘Keynesian Economics and the Economics of Keynes’, which I read when young and which made a big impression. (For a more recent assessment, see this review by Howitt.) At the time there were attempts being made to partially microfound Keynesian economics by looking at rationing regimes where either goods or labour markets did not clear. Leijonhufvud was critical of this, and the earlier, emphasis on wage and price rigidity as being at the heart of Keynesian economics, both in terms of an interpretation of Keynes but also as useful macroeconomics. What I also remember, but did not fully appreciate at the time, was a good deal of discussion of the importance of intertemporal coordination failures, in which people’s expectations about long-term interest rates differ from the marginal efficiency of capital.

For many, New Keynesian economics is just a microfounded version of Old Keynesian economics. But what that means in practice is that New Keynesian theory is explicitly intertemporal, which IS-LM is not. Another way of describing New Keynesian theory, which I have used myself, is that it is a RBC analysis with price stickiness added on. In a technical sense that may be true, but I think it can be misleading in that it perpetuates the idea that these models are ‘all about’ wage and price rigidity.

Now it may or may not be the case that wage and price rigidities are preconditions for Keynesian analysis. I have argued elsewhere that a better way of saying it would be that price flexibility coupled with an appropriate monetary policy may rule out Keynesian problems, but that at the Zero Lower Bound (ZLB) inflation targeting does not. However it is also plausible to argue that the existence of money is a precondition for effective demand to matter in determining output, but not many people say that money is what New Keynesian analysis is all about. (Particularly as money is often not even part of the model.) You could also argue that imperfect competition was an essential ingredient in New Keynesian analysis, but again not many would characterise New Keynesian analysis as the macroeconomics of imperfect competition.

If I had to characterise New Keynesian theory by one thing, it would be the analysis of economies where the real rate of interest differed from the ‘natural’ real rate. The natural rate is the real interest rate that would obtain if output was determined by an RBC model – less precisely, if output was determined from the supply side. We often say the natural rate of interest is the real interest rate that would occur under flexible prices, but that is shorthand for the above, and perhaps misleading shorthand on occasion.

Once we have the ‘wrong’ real interest rate, then (using imperfect competition as a justification) New Keynesian analysis determines output and perhaps employment only from the demand side, and the determination of effective demand becomes critical to the model. Perhaps a better way of saying this is that if real interest rates are at their natural level, we do not need to think about demand when calculating output. In most cases, it is the job of monetary policy to try and get the economy back to this natural real interest rate. This gives you the key insight into why, ZLB problems apart, it is monetary rather than fiscal policy that is the primary stabilising policy.

We can make the same point another way. In the New Keynesian model, business cycles are generally an intertemporal mismatch between demand and supply (unless, for some reason, we get stuck with demand deficiency). What is the relevant price that influences this intertemporal allocation of demand? – the real interest rate, not the price or wage level. So if we have to think about New Keynesian economics as being about some price being wrong, that price is the real interest rate. And thinking in an explicitly intertemporal framework also makes you think twice about adding M/p into an IS curve, which is partly where the idea that sticky prices are crucial comes from.

Of course at some level the idea of characterising a class of models by one key idea is a bit pointless. But at another, more intuitive, level I think it can be helpful. In this case, for example, it suggests why monetary rather than fiscal policy is the policy of choice for stabilisation. This is also a good example of where IS-LM is less revealing: in this framework both policies look as good as each other within the context of the model itself.

This is why I claimed a connection between some of the ideas in Leijonhufvud’s Keynesian Economics and the Economics of Keynes and my interpretation of New Keynesian economics. I could now make sense of Leijonhufvud’s emphasis on talking about real interest rates, rather than wage and price rigidity. But I would be the first to admit that it is easy to see in what other people write what you want to see, so I have no problem with other people disagreeing with me on this interpretation. And even if there is something in what I say, I know of course that Leijonhufvud is highly critical of other aspects of New Keynesian analysis, and that his views may well have changed since that book. But what I do hope is true is that my interpretation of New Keynesian analysis is of some help to those who struggle to see what the nature of the market failure is in some modern Keynesian analysis.