Winner of the New Statesman SPERI Prize in Political Economy 2016

Wednesday, 25 March 2015

Why do central banks use New Keynesian models?

And more on whether price setting is microfounded in RBC models. For macroeconomists.

Why do central banks like using the New Keynesian (NK) model? Stephen Williamson says: “I work for one of these institutions, and I have a hard time answering that question, so it's not clear why Simon wants David [Levine] to answer it. Simon posed the question, so I think he should answer it.” The answer is very simple: the model helps these banks do their job of setting an appropriate interest rate. (I suspect because the answer is very simple this is really a setup for another post Stephen wants to write, but as I always find what Stephen writes interesting I have no problem with that.)

What is a NK model? It is a RBC model plus a microfounded model of price setting, and a nominal interest rate set by the central bank. Every NK model has its inner RBC model. You could reasonably say that these NK models were designed to help tell the central bank what interest rate to set. In the simplest case, this involves setting a nominal rate that achieves, or moves towards, the level of real interest rates that is assumed to occur in the inner RBC model: the natural real rate. These models do not tell us how and why the central bank can set the nominal short rate, and those are interesting questions which occasionally might be important. As Stephen points out, NK models tell us very little about money. Most of the time, however, I think interest rate setters can get by without worrying about these how and why questions.

Why not just use the restricted RBC version of the NK model? Because the central bank sets a nominal rate, so it needs an estimate of what expected inflation is. It could get that from surveys, but it also wants to know how expected inflation will change if it changes its nominal rate. I think a central banker might also add that they are supposed to be achieving an inflation target, so having a model that examines the response of inflation to the rest of the economy and nominal interest rate changes seems like an important thing to do.

The reason why I expect people like David Levine to at least acknowledge the question I have just answered is also simple. David Levine claimed that Keynesian economics is nonsense, and had been shown to be nonsense since the New Classical revolution. With views like that, I would at least expect some acknowledgement that central banks appear to think differently. For him, like Stephen, that must be a puzzle. He may not be able to answer that puzzle, but it is good practice to note the puzzles that your worldview throws up.

Stephen also seems to miss my point about the lack of any microfounded model of price setting in the RBC model. The key variable is the real interest rate, and as he points out the difference between perfect competition and monopolistic competition is not critical here. In a monetary economy the real interest rate is set by both price setters in the goods market and the central bank. The RBC model contains neither. To say that the RBC model assumes that agents set the appropriate market clearing prices describes an outcome, but not the mechanism by which it is achieved.

That may be fine - a perfectly acceptable simplification - if when we do think how price setters and the central bank interact, that is the outcome we generally converge towards. NK models suggest that most of the time that is true. This in turn means that the microfoundations of price setting in RBC models applied to a monetary economy rest on NK foundations. The RBC model assumes the real interest rate clears the goods market, and the NK model shows us why in a monetary economy that can happen (and occasionally why it does not). 


  1. You're perhaps overly suspicious of my intentions. I do actually have some ideas about the answer to the question which is the title of your post. One of Mike Woodford's career goals was to take modern macro, adapt it to answer monetary policy questions, and then have central bankers adopt the product. He's been very successful . The people who make decisions in the central banks of the world are a diverse lot. Some of them are economists, some are lawyers, some come from the business community. Some are well-versed in modern macro, some were educated as economists before the macro revolution took hold in most graduate programs, some have econ 101, some have never taken an economics course. NK can appeal to all of them. It appeals to the high-tech macroeconomist who is looking for a framework which is consistent with modern macro ideas but in which monetary policy is not neutral. It appeals to the old-style Keynesian who thinks it's just IS-LM (even though it's not). It appeals to the non-economist who only thinks in terms of: interest rate up is tightening, interest rate down is easing. There are problems, though. (i) NK is all about relative price distortions (intertemporal and intratemporal). Not clear that is the margin on which monetary policy actually works. (ii) I've seen instances in which the high-tech people start taking NK - or the reduced form of it - way too seriously, and they make policy errors. That wouldn't be the first or last time that a central banker made a mistake. (iii) Sometimes NK is completely unhelpful - it tells you nothing about why central bank asset swaps for different kinds of assets (short vs. long maturity, government debt vs. private) should make a difference, or why it would make a difference if the central bank conducted direct lending to the financial sector or outright asset swaps. All of those things matter, particularly during financial crises (and in the aftermath apparently). You could say we just need to add that stuff to the model. But the NK people told us before the financial crisis that we didn't need to do it. I asked Mike about this once before the financial crisis and he said something like: Well there are a lot of frictions out there - too many to think about.

    So, I wouldn't take the wide adoption of NK as proof of its virtues.

    1. "So, I wouldn't take the wide adoption of NK as proof of its virtues."

      I think this is a very interesting and an astute remark from someone who is very likely to know what he is talking about. Some of these models are fine and have their place, but when it comes to understanding how the real world works, more often than not it is precisely what is not in these models which is what is most interesting and important. As a result their role for guiding policy makers is quite limited and in the end they just have to accept that they have to deal with real world mess as it is.

    2. "someone who is very likely to know what he is talking about"

      Nope. A few years ago this guy predicted hyperinflation while Keynesians like Krugman predicted low inflation / deflation. So far he has no acknowledges his very basic mistake.

      New Classical demand deniers are ideologically driven and not caring one iota about external consistency.

  2. I would like to extend RBC to a period that is marked by long trend interest rate movement, instead of just usual RBC period which average about 7 years. I have studied USA economy and observe trends in there not that of UK, so it might not correlate.

    What RBC period would that be? The period from 1945 - 2003. In 1945 long trend interest rate started upward untill 1980 and then goes down till 2003, but then it was extended by banking fraud (encouraged by politicians) allowing for more borrowing then normal regulated banking would allow. That would be from Minsky hypothesis.
    After 2003 when interest rates hit close to 0% first time, it was Ponzy lending that extended and pretended making colapse much much costly.

    What conclusion can be infered from this? It is that monetary policy is serving as adjuster to fiscal policy. Fiscal policy rules.
    From 1945- 1980 fiscal policy was demand sided with full employment policy and after 1980 turned supply sided and so monetary policy could only moderatly shave off extremes of miscalculations of robust and cumbersome fiscal policies that rule economics.

    Eastern countries never switched from demand sided policies to supply sided so their inflation have kept going up.

    What conclusions we would find if RBC is extended to 80 years period?

  3. The more pressing problem with all these models is the equation for the inter-temporal substitution of consumption. Households do not substitute consumption for savings in response to lower real interest rates, when real interest rates are already low - as we are learning. However, if our models don't assume that they do, changes in real interest rates do not bring the system into equilibrium. If anything, it appears that lower real interest rates raise desired savings.

  4. In fact, the effects of QE on demand may be based on a profound non-rationality. Because holders of equity do not know how to estimate expected returns they view temporary gains caused by a fall in the discount rate as permanent increases in wealth. Combined with exchange rate moves, asset prices are the main transmission mechanism for QE. Both RBC and NK models provide no insights into this, and therefore tell us little about how monetary policy may or may not be working.

  5. I am not a economist, but can you please explain to me in simple terms why we are in this awful mess. No work, people losing their homes. Will possibly never own a property ever again. So who is winning here the banks?


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