Winner of the New Statesman SPERI Prize in Political Economy 2016

Friday, 11 November 2016

Do New Keynesians assume full employment?

I’ve tried to write this as jargon free as I can, but it is mainly for economists

Nick Rowe claims that the New Keynesian model assumes full employment. I think he is onto something, but while he treats it as a problem with the model, I think it is a problem with the real world.

Nick sets up a simple consumption only economy with infinitely lived self employed workers, where we are at the steady state (=long run) level of consumption C(t)= output Y(t)=100. Then something bad happens (what macroeconomists call a shock):
every agent has a bad case of animal spirits. There's a sunspot. Or someone forgets to sacrifice a goat. So each agent expects every other agent to consume at C(t)=50 from now on. ... So each agent expects his income to be 50 per period from now on. So each agent realises that he must cut his consumption to 50 per period from now on too, otherwise he will have to borrow to finance his negative saving and will go deeper and deeper into debt, till he hits his borrowing limit and is forced to cut his consumption below 50 so he can pay at least the interest on his debt.”

To put it more formally: each agent believes the steady state level of output has fallen. That in turn has to imply that everyone makes a mistake about the desired labour supply of everyone else. I assume this is a mistaken belief. If the belief was correct, then there is no problem: the steady state level of output should fall, because people want more leisure and less work.

Nick says that there is nothing a monetary authority that controls the real interest rate can do about this mistaken belief about the steady state, because changing real rates only changes the profile of consumption (shifting consumption from the future to the present) and not its overall level. That is correct. Furthermore if each individual simply assumes what they think is true, and does not even bother to offer his pre-shock level of labour to others, then this is indeed a new equilibrium which the monetary authority can do nothing about.

But people and economies are not like that. Each agent wants to work at the pre-shock level, and will signal that in some way. They will see that the economy had widespread underemployment, and as a result they will revise their expectations about the steady state. I think Nick knows that, because he writes that the NK model needs “to just assume the economy always approaches full employment in the limit as time goes to infinity, otherwise our Phiilips Curve tells us we will eventually get hyperinflation or hyperdeflation, and we can't have our model predicting that, can we.”

He treats that as if it were a problem, but I do not see that it is. After all, we have no problem with the idea that consumers will revise down their expectations of their future income if they unexpectedly find they are always in debt. Equally I have no problem with the idea that in Nick’s economy with widespread and visible involuntary underemployment consumers might think they had made a mistake about others desired labour supply.

Let me put it another way. In a single person economy we never get underemployment. The problem arises because in a real economy we need to form expectations about what others will do. But if there exist signals which help us get our expectations right, that should shift us out of a mistaken belief equilibrium.

Which gets us to why I think Nick is on to something about the real world. Suppose there is a shock like a financial crisis, which for the sake of argument just temporarily reduces demand by a lot and creates unemployment. Central banks cannot cut real interest rates enough to get rid of the unemployment because of the zero lower bound. Inflation falls, but because everyone initially thinks this is all temporary, and maybe also because of an aversion to nominal wage cuts, we get a modest fall in inflation.

Now suppose people erroneously revise down their beliefs about steady state output, to be more like current output. Suppose also that visible unemployment goes away, because firms substitute labour for capital (UK) or workers get discouraged (US). We get to what looks like Nick’s bad equilibrium. Even inflation moves back to target, because the current output gap appears to disappear. We no longer have any signals that there is an alternative, better for everyone, inflation at target equilibrium with higher output.

Now we could get out of this bad equilibrium, if some positive shock or monetary/fiscal policy raised demand ‘temporarily’ and people saw that, because firms substituted capital for labour, or discouraged workers came back into the labour force, inflation did not rise well above target. But suppose policymakers also start to hold these erroneous beliefs, and so do not try and get us out of the bad equilibrium. Could that describe the secular stagnation we are in?



25 comments:

  1. I'm not sure this is quite getting Nick's point about how NK models work. I think he's saying that NK models assume long-run full employment / return to same equilibrium output and then everything that happens in the short-run is driven by backwards induction from that future fixed point, via the Euler equation. Is that how you are reading him?

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  2. Also is this: " In a single person economy we never get underemployment. The problem arises because in a real economy we need to form expectations about what others will do." really how you think about the real world? It gives the impression that you think expectation formation is the root of unemployment and without it unemployment would not arise.

    In the real world production is organized into firms and we can't all just switch to home production and start producing and bartering, so if we get fired, we become unproductive. I think even if nobody ever formed any expectations about anything and firms just took decisions after observing sales of whatever it is that they produce each day, you could get unemployment. You need a reason for demand to fall in the first place, but once that's happen, firms observe demand fall, they fire workers, there is a negative demand multiplier. No role for expectations needed.

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  3. There seems to be a link missing in the argument at the moment. What happens when people see the underemployment and revise their expectations about the steady state? What do they do next? And how does it lead back to full employment?

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    1. any chance of an answer?

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  4. This is an old Keynesian unemployment equilibrium as promoted by Falmer, not an NK one surely?

    Nothing érronious 'about fall in AD

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  5. I'm not an economist, so perhaps I should have heeded our warning. Consider that a clumsy apology for a dumb question. Nick's example assumed someone with diminished expectations might want to consider borrowing, but rules this out because it implies a future inability to borrow. So here's my dumb question. If someone borrows to finance current consumption, doesn't that imply that he or she has to borrow from someone with surplus income that can be lent at interest? And doesn't the stream of interest payments represent income for the creditor that is above what the creditor would have had prior to the shock? In order for Nick's story to work you have to assume that the creditor will just stuff the interest payments under the mattress, which assumes a lower MPC. In other words, for every IOU there's a corresponding wealth asset owned by a creditor. Doesn't Nick's story require an additional story about how the income stream from the creditor's wealth leaks from the overall income flow?

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    1. You know more about real world problems then if you were an economist and so you ask a right question which an economist would not dare to: "to finance current consumption, doesn't that imply that he or she has to borrow from someone with surplus income that can be lent at interest?"

      That is the right question since it cosiders the problem of interest payments on agregate demand.

      But the real answer is: No. It is a trick answer because false assumptions that people borrow from other people's savings. The reason is that nobody borrows from anybody else except within mafia system. People borrow from banks that print money for that purpose, and then destroy money as payment is received. Printed amount of money has to equal destroyed money in time of a loan. There lies the cause of deflation.

      Where the saved money goes? Into saving account at a bank, and then sent to reserve account at Central Bank or lent to other bank. No person or corporation can borrow saved money. Only states and other banks. So, to replace savings that leaked from cirkulation, a state has to borrow it by deficit spending and return it back into economy.

      By definition, savings are not spent, and since state pay interest on it, it produces more savings which enables a state to borrow more, indefinetly. So states do not pay back their debt nor they should, ever, since it would decrease savings of people.

      When you as a person, borrow money from a bank, they print that money (throughout history it was found that it was too risky for a bank to lend someone else's money so they print it by governments permission) and then destroy it as you pay it back and only interest payments are left as bank profits.

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    2. Anonymous, 11 November 06:01. Your comment reminds of a tale I was told at university about how the government once used an economy simulated as a water container with outputs for leakages and inputs from overseas trade, etc. - a circular flow of income, I think is the concept. I, like you, have wondered how the financial services sector 'feeds' into the national economy. One person's income is another's salary. This leads savings, external investments and trade imbalances as the main variables. I'm no economist and so have missed aspects of Mr. Lowe's argument and Simon's too, but it is a weakness in my knowledge, perhaps. Though, perhaps with one reading it will all fall into place!

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    3. A comment below alludes to the answer here - banks create the credit rather than waiting for a surplus unit with deposits. There are routes for the interest back into the economy, and some, such as building excess CB reserves that are leakages from circulation.

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  6. It sounds like you and Nick are in agreement that what underpins the NK model is expectations about future steady-state employment levels. You think that in "run-of-the-mill" recessions there is no reason why these expectations for this steady state should not be compatible with full-employment - which is why standard NK interest rate policy works.

    You then conjecture that if people's views about the steady fall and they no longer expect it to be the old full employment level then (just as Nick describes) we may end up in a recession where interest rate policy will be ineffective.

    The punch-line to Nick post was that this could be avoided if money is introduced into the model and a nominal anchor used as a policy tool. You don't fully address this in your post. Would you agree that a NK-like model with the addition of money and the introduction (as an example) of an NGDP-target would avoid the kind of low-expectations equilibrium that you discuss ?


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  7. Thanks Simon!

    Your thought-experiment is slightly different from mine. But I like your thought-experiment too.

    I was assuming it is common knowledge that "full employment" output (natural rate of output Y*) is always 100. And then considering a sunspot equilibrium where people expect that actual output will always be (say) 50. If agents could cut their own hair, we get straight back to full employment. If two agents could do a barter deal to cut each other's hair, we get straight back to full employment [and that is true regardless of the interest rate set by the central bank]. But if we have a monetary exchange economy, where barter is impossible, an underemployment equilibrium of 50 forever is possible, [even if the central bank sets the right real rate of interest r=r* forever].

    When I wrote ...'that the NK model needs “to just assume the economy always approaches full employment in the limit as time goes to infinity, otherwise our Phiilips Curve tells us we will eventually get hyperinflation or hyperdeflation, and we can't have our model predicting that, can we.” I was paraphrasing Gali, ironically. That's where Gali slips in the illicit assumption about the limit as t approaches infinity of Y(t) approaching Y*(t).

    Your thought-experiment has a slightly different conclusion than mine, because in mine the agents know there's an output gap, and in yours they falsely think there isn't an output gap. So (given rational expectations and any standard expectations-augmented Phillips Curve), my agents will expect lower inflation than yours, so actual inflation will be lower in mine too. Which means your thought-experiment can explain why inflation didn't fall much.

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    1. I think you can rewrite what I wrote on that basis too, unless your sunspot is impervious to observation and rational thought. Otherwise you come close to assuming what you want to show is possible. (I don't like sunspots much!) But the crucial insight you exploit, the insight at the heart of Keynesian economics, is that as my income is your spending the economy is vulnerable to an unemployment equilibrium.

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  8. I do not find nothing Keynesian in this explanation, it is more anti-keynesianism then neo.

    "idea that consumers will revise down their expectations of their future income if they unexpectedly find they are always in debt."

    "in a real economy we need to form expectations about what others will do."

    "But if there exist signals which help us get our expectations right,"

    "but because everyone initially thinks this is all temporary, and maybe also because of an aversion to nominal wage cuts"

    "Now suppose people erroneously revise down their beliefs about steady state output, to be more like current output."

    "if some positive shock or monetary/fiscal policy raised demand ‘temporarily’ and people saw that,"

    Did Keynes write like this? This has nothing to do with the real world.

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  9. "Could that describe the secular stagnation we are in?"

    No

    Spreadsheet recession describes secular stagnation, or in other linque: Old debts place burden overwhelmingly on incomes that stagnate, and banks will not offer nor allow reduction of such burden because they do not offer refinancing at official interest rates. Nor will offer new loans at close to official rate as they did before the crisis.

    Burden of debt is still unresolved and getting worse in deflation. Inflation from wage increase is the only thing that can resolve it.

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  10. Bullshit.

    You doesn't ask the fundamental question, Where does the money come from; hence he does not understand monetary economics and sectoral balances, or the difference in policy space between sound finance and functional finance.

    So this is not in the model and therefore the model can't explain actual events other than by assuming that the labor market is based on the ratio between preference for work (income) and leisure (reduced income).

    Work is just leisure you get paid to do that others find of value.

    It is a politician’s trick to talk about one definition of a term, knowing that only those in their little clique will get the ‘correct’ meaning and everybody else will think they are talking about something else.

    So it is with full employment. To everybody in the world outside economics, full employment means that everybody who wants a job at a living wage has one.

    The Oxford English Dictionary defines it as “The condition in which virtually all who are able and willing to work are employed”.

    I guess this is what happens when one spends one's life on campus rather than in the actual world. It's also pretty astounding since this is a principal issue that Keynes addressed.

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  11. Here is a fantastic new paper by Prof Andrea Terzi

    Macroeconomics is shifting what's the new direction.

    http://moslereconomics.com/wp-content/uploads/2016/11/Berlin-2016-TERZI.pdf

    Covers the history of where most of the economic profession got it wrong.

    I loved the way she uses Rip Van Winkle.

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  12. The Quantity Theory of Money which in symbols is MV = PQ but means that the money stock times the turnover per period (V) is equal to the price level (P) times real output (Q). The mainstream assume that V is fixed (despite empirically it moving all over the place) and Q is always at full employment as a result of market adjustments.



    In applying this theory the mainstream deny the existence of unemployment. The more reasonable mainstream economists admit that short-run deviations in the predictions of the Quantity Theory of Money can occur but in the long-run all the frictions causing unemployment will disappear and the theory will apply.


    In general, the Monetarists (the most recent group to revive the Quantity Theory of Money) claim that with V and Q fixed, then changes in M cause changes in P – which is the basic Monetarist claim that expanding the money supply is inflationary. They say that excess monetary growth creates a situation where too much money is chasing too few goods and the only adjustment that is possible is nominal (that is, inflation).

    One of the contributions of Keynes was to show the Quantity Theory of Money could not be correct. He observed price level changes independent of monetary supply movements (and vice versa) which changed his own perception of the way the monetary system operated.

    Further, with high rates of capacity and labour underutilisation at various times (including now) one can hardly seriously maintain the view that Q is fixed. There is always scope for real adjustments (that is, increasing output) to match nominal growth in aggregate demand. So if increased credit became available and borrowers used the deposits that were created by the loans to purchase goods and services, it is likely that firms with excess capacity will react to the increased nominal demand by increasing output.

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  13. The unfortunate thing is that, to tell if this is a good description of what happens, you need at least one brave who will wait "for too long." But CB set their policy path months in advance and many of them have explicit targets.

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  14. Fun stuff! You'll know this already, but other readers might want to see the similarities of the thesis here to Diamond's coconut model: https://en.wikipedia.org/wiki/Diamond_coconut_model

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    1. «the similarities of the thesis here to Diamond's coconut model»

      There are very many different models and approaches that are not properly "New Keynesian", there is certainly no lack of supply. The question is whether there is market demand for them, that is whether those models and approaches are validated by being publishable in top journals or are validated by acceptance by policy influencers and deciders.

      The discussion here does not seem to me about yet another model, but a different approach to packaging models: whether market demand for models that look New Keynesian outside but have some aspects of different approaches inside is better than market demand for models that just have different approaches.

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  15. How to end the futile economics zombie ping-pong
    Comment on Simon Wren-Lewis on ‘Do New Keynesians assume full employment?’

    It is impossible for Nick Rowe and Simon Wren-Lewis to get their heads around the fact that Walrasianism, Keynesianism, Marxianism, Austrianism is axiomatically false, that is, beyond repair. So ― not to get them out from behind the curve ― just for the record: it is pointless to pick one aspect, e.g. employment, and to discuss the respective faults or merits of some model variants. The iron methodological rule says: when the axioms are false the whole analytical superstructure is false.

    Already Keynes knew this: “For if orthodox economics is at fault, the error is to be found not in the superstructure, which has been erected with great care for logical consistency, but in a lack of clearness and of generality in the premises.”

    Standard economics is built upon false premises. Therefore, the way forward is to bury all variants for good and to fully replace the false Walrasian micro axioms and the false Keynesian macro axioms by true macro axioms.#1

    This is the correct set of premises: (0) The objectively given and most elementary configuration of the (world-) economy consists of the household and the business sector which in turn consists initially of one giant fully integrated firm. (i) Yw=WL wage income Yw is equal to wage rate W times working hours. L, (ii) O=RL output O is equal to productivity R times working hours L, (iii) C=PX consumption expenditure C is equal to price P times quantity bought/sold X.

    A1/A3 defines the pure consumption economy.#2 Note that the set of foundational equations is ENTIRELY FREE of behavioral assumptions like constrained/intertemporal optimization or equilibrium, that is, the axiom set is OBJECTIVE SYSTEMIC. This new analytical workhorse fully replaces Nick Rowe’s hallucinatory behavioral construct.

    In the pure consumption economy, this is what happens if, for example, the productivity falls, due to some shock, by 50 percent: the price doubles because the correct Law of Supply and Demand says for the most elementary case that P=W/R, i.e., the market clearing price is equal to unit wage costs or, in other words, the real wage is equal to the productivity at any employment level, i.e. W/P=R. This is the objective-systemic configuration to start with. The usual guessing ping-pong about what agents might maximize or expect or do has always been futile, is futile with Nick and Simon, and will be futile in all eternity.

    From the minimalist formal core A1/A3 follows in consistent logical steps the investment economy with the systemic employment equation, a.k.a. Phillips curve. #3, #4

    The systemic employment equation says that employment increases if productivity falls and all other variables are held constant. Secular stagnation results from productivity and price rising faster than the wage rate, with all other variables held constant.

    To paraphrase a summary of Blaug: ‘At long last, it can be said that the history of general theory from Walras to Arrow-Debreu and on to DSGE and New Keynesianism has been a journey down a blind alley, and it is the set A1/A3 to have finally hammered down the nails in the coffin.’

    Egmont Kakarot-Handtke

    #1 See ‘How to restart economics’
    http://axecorg.blogspot.de/2016/01/how-to-restart-economics.html

    and ‘From microfoundations to macrofoundations’
    http://axecorg.blogspot.de/2016/04/from-microfoundations-to.html

    #2 For a detailed description see ‘The future of economics: why you will probably not be admitted to it, and why this is a good thing’
    http://axecorg.blogspot.de/2016/01/the-future-or-economics-why-you-will.html

    #3 See ‘Keynes’ Employment Function and the Gratuitous Phillips Curve Disaster’
    https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2130421

    #4 Equation on Wikimedia
    https://commons.wikimedia.org/wiki/File:AXEC62.png

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  16. in keynes y=I+C

    consumption is spending from current income only

    like, you know, the marginal propensity to consume, consume out of what?

    current income

    in the equation y=i+c spending from preexisting wealth has to actually count as investment

    point is, you cant have a consumption only economy

    in other words, lets say current sales are paid for totally by current income, and current income is produced totally by current sales

    the only way the economy is viable is if people spend 100 percent of their income, therefore producing enough income to pay for the sales that gives them that income

    in other words, the MPC is 1

    thats the only way you have a consumption only economy

    in the real world we need investment added to the consumption to produce total income

    income has to EXCEED current sales

    in order to have a viable economy

    and it is investment that allows the income to exceed the sales

    whether it be income added by investors or or consumption paid for by preexisting wealth, this is what makes the economy viable

    involuntary unemployment , according keynes multiplier concept, requires investment, addition of preexisting wealth to the economy, this investment is acted on by the multiplier to create total income greater than the investment

    addition of preexisting wealth to peoples income, that is investment and that is how to get out of secular stagnation

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  17. "But suppose policymakers also start to hold these erroneous beliefs, and so do not try and get us out of the bad equilibrium. Could that describe the secular stagnation we are in?"

    It might if this is was the case.

    While consumers/business men have decided that output will be lower (owing to the shock of 2008), policymakers at large have decided the response should be fiscal consolidation. That added to the retraction of general expectations has led to stagnation. (Not to forget income distribution trends and the technology cycle.)


    "....each agent believes the steady state level of output has fallen. That in turn has to imply that everyone makes a mistake about the desired labour supply of everyone else."

    Why does this necessarily follow?
    Then you go on to say:

    "If the belief was correct, then there is no problem: the steady state level of output should fall, because people want more leisure and less work. "

    Just because everyone has decided there will less work does not mean they want more leisure.


    Henry

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  18. Trouble with all models - New Keynesian - or otherwise is that they will never fully reflect the real world. It is only when their declared or undeclared (but implicit) assumptions became so clearly out of kilter as to what is actually empirically happening (usually when a major shock such as the 2008-2009 crisis, or the earlier the 1973 oil price hike, exposes the empirical change and/or forces a critical reappraisal of the assumptions employed, that the model either is discredited or changes or adapts.

    I would venture the following: in the real world, certainly in the UK and the US, the problem is that the level of aggregate demand consistent with full employment (but see below) has become over dependent on debt-assisted private consumption and levels of housing wealth that risks retrenchment in the event of any change in confidence or actual/anticipated external shock.

    What is required, therefore, is a permanent - not a temporaty pump-priming - increase to a steady state level of productive and efficient public infrastructual investment, consistent with full employment (see below) and a lower level of debt-assisted private consumption.

    Full employment, of course, is a matter of definition. In the Keynesian past it was defined at around 2%; nowadays is seems that 5% is deemed full employment. In that regard, it needs to be recognised that full employment in the social democratic heyday of the 50's and 60's meant male full employment, and today the employment participation rate is higher; but wage levels and working conditions have retrenched, and, it is likely that even if we accept that 5% claimant unemployment means full employment, that figure has only been achieved by the expansion of zero hours, part-time, and self employment at the expense of well paid full time jobs. In short, there has been an empirical institutional change in the labour market that can be assumed away in the model, as it allows a return to full employment.

    A shift back to conditions of full employment more consistent with the interests of low to middle income workers and the public finances requires the shift in favour of infrastructural investment advocated above. Otherwise recorded claimant unemployment will rise.

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  19. Anonymous

    You say: “in keynes y=I+C consumption is spending from current income only like, you know, the marginal propensity to consume, consume out of what?”

    Yes, I know what Keynes said. And I know also (i) what Keynes said is false, (ii) After-Keynesians have not realized it until this day.

    This is what Keynes said in the General Theory “Income = value of output = consumption + investment. Saving = income - consumption. Therefore saving = investment.” (p. 63)

    This two-liner is conceptually and logically defective because Keynes did not come to grips with profit.

    “His Collected Writings show that he wrestled to solve the Profit Puzzle up till the semi-final versions of his GT but in the end he gave up and discarded the draft chapter dealing with it.” (Tómasson et al.)

    Because profit ― the pivotal magnitude of economics ― is ill-defined the whole theoretical superstructure of Keynesianism is false, in particular all I=S and IS-LM models.#1

    Neither pro-Keynesians nor anti-Keynesians detected Keynes foundational error/mistake in the last 80 years. It was Allais who got the elementary mathematics of national accounting right.#2

    Keynes was not a great thinker but what came after him is abysmal. Anonymous is a case in point.

    Egmont Kakarot-Handtke

    #1 For the formal proof see ‘Why Post Keynesianism Is Not Yet a Science’
    https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1966438

    #2 See ‘How Keynes got macro wrong and Allais got it right’
    http://axecorg.blogspot.de/2016/09/how-keynes-got-macro-wrong-and-allais.html

    ReplyDelete

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