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?
