New Keynesian Economics

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It is often said that in times of global macroeconomic disruption, new economic consensuses are born (Hartley, 2014). New Keynesian economics is no exception as ‘the poor performance of Keynesian wage and price adjustment equations during the ‘Great Inflation’ of the 1970s…made it imperative for Keynesians to modify their models’ (Snowdon & Vane , 2005, p. 357). Under the influence of the New Classical Counter Revolution (NCCR), New Keynesians sought to aggregate microfoundations up to the macro-level in pursuit of internal consistency. This essay will argue that such microfounded convention successfully accounts for imperfect competition and rational expectations and as such, nominal price rigidities, money non-neutrality and involuntary unemployment.

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However, as Gregory Mankiw notes, ‘a good theory has two characteristics: internal and external consistency’ and whilst the latter requires empirical substantiation, New Keynesian economics, ‘is completely at odd with the facts’ (Mankiw, 2001, p. 46) (Mankiw, 1989 , p. 88). With a primary focus on the New Keynesian Phillips Curve (NKPC), this essay will examine the model’s failure to rationalise inflation persistence and its problematic suggestion of disinflationary booms.

It will too suggest that despite its supposed ‘internal consistency’, ad hoc assumptions in relation to Calvo pricing may render the NKPC ineffective. This essay will conclude that whilst New Keynesian economics has found success within the microfoundations revolution, its failure to achieve external consistency weakens its accomplishments.

Firstly, it is important to understand how New Keynesian economics developed from traditional orthodoxy. Disagreement between the two schools’ centres around the speed at which wages and prices adjust. Orthodox Keynesian schools propose that wages and prices are flexible, suggesting that their prompt adjustments clear their respective markets.

New Keynesian economists disagree, arguing that market-clearing models and price flexibility cannot rationalise short-term economic fluctuations (Mankiw, n.d.). Led by the Lucas critique (1976), the NCCR thus proposed that microeconomic consistency was needed to authenticate macroeconomic models. Lucas argued that parameters proposed by macroeconomic models rendered misleading results as they failed to capture policy invariance. He suggested that parameters should be modelled on individual behaviour and as such, initiated the popular use of microfoundations of which Hoover contends ‘has changed the face of the discipline’ (Hoover, 2001, p. 72).

New Keynesian economics attempts to escape the Lucas critique in more ways than one. Whilst microfounded, its success also lies in its adoption of rational expectations and imperfect competition. Rational expectations supports internal consistency and are, according to both Muth and Lucas, essential for models to be built upon (Muth, 1961). Likewise, Dixon suggests that the ‘fundamental ‘new’ idea behind the new Keynesian models is that of imperfect competition’ (Dixon, 1997, p. 2). Concurred by Stigler who argues that the ‘concept of perfect competition…is unrealistic’, the introduction of an imperfect market structure allows for all further ‘innovations of the new Keynesian school’ to be developed (Stigler, 1957, p. 17) (Dixon, 1997, p. 2).

Such innovations include nominal price rigidities and the subsequent justification of money non-neutrality. Nominal price rigidities suggest that price stickiness at the micro level may be aggregated upwards such that obstinate prices have an effect on real variables such as output (money non-neutrality). Through the presence of imperfect competition, it is assumed that all firms are price takers and as such hold the power to adjust prices independently. Menu cost theory fuels price stickiness as ‘the cost of resetting prices, such as the printing of new price lists’ or communicating price changes, discourages firms from revising their prices regularly – firms will only change their prices ‘if the benefits of doing so outweigh the costs’ (Snowdon & Vane , 2005, p. 372) (Gärtner, 2016, p. 484). Yet as Snowdon and Vane contend, the ‘presence of even small costs to price adjustment can generate considerable aggregate nominal price rigidity’ thus justifying the use of monetary policy (Snowdon & Vane , 2005, p. 372). In other words, sluggish prices, and the subsequent macroeconomic disequilibrium New Keynesian models find themselves in produce aggregate demand externalities that warrant the use of monetary policy to stabilise.

Calvo’s (1983) model of staggered price adjustment suggests how these firms come to alter their pricing. Following ‘time-contingent pricing rules’ firms ‘adjust prices on a schedule’ as per the Poisson distribution with the probability that a firm is able to change its price equal to  ‘regardless of how long it has been since the last price adjustment’ (Mankiw, 2001, pp. 9-10) (Mankiw & Reis, 2002, p. 1299). Taking into account desired prices (in light of the estimated level of demand) and the probability of changing prices in both in the present and the future, Calvo’s model is able to produce a NKPC whereby  represents the ‘rate of arrival for price adjustment’ (Mankiw, 2001, p. 57).

NKPC: π_t= 〖π^e〗_(t+1)+(α^2 λ)/(1-α) (yt-ye)

This theoretically established NKPC thus possesses ‘rational expectations hypothesis microfoundations’ and as such, shields itself from the Lucas critique (Carré, 2008 , p. 5). Moreover, with inflation today (t) a function of expected future inflation (e), the NKPC differs from the classical, empirically based Phillips curve (IAPC) in the sense that it is constructed on forward-looking pricing (Babutsidze, 2012, p. 180). Gagnon and Kahan stress that such theoretical foundations produce a ‘clear structural interpretation’ with Carré concluding that it is such standard that allows New Keynesians to claim superiority over other curves (Gagnon & Khan , 2001, p. 1) (Carré, 2008 , p. 5).

However, the Calvo pricing scheme has been labelled by Wren-Lewis as a ‘short-cut’ and ‘compromise’ as he suggests that the NKPC is based on the very ad hoc assumptions that the NCCR sought to eradicate (Wren-Lewis, 2005). Its subsequent theoretical fragility puts New Keynesian success under question. There has been a wide array of literature attempting to propose alternatives to such contracts. Caplin and Spulber (1978) offer an asynchronous pricing policy which suggests that ‘the time between successive price revisions [are] endogenous’ such that ‘prices change more frequently when inflation is rapid than when it is slow’ (Caplin & Spulber, 1987, p. 709). Concluding that this renders money neutral, it is clear that varying perceptions of pricing schemes will come to have large impacts on macro-analysis and policy implementation. Despite Mankiw arguing that such proposition produces ‘implausible results’, the question over Calvo contract credibility still stands (Mankiw & Reis, 2002, p. 1319). Romer simply argues that ‘economists do not have a good understanding of the price adjustment policies of firms’ rendering ‘studies of the barriers to price adjustment…a pressing subject for research’ (Romer, 1993, p. 19).

What New Keynesians have developed however, is a new theory of unemployment whereby involuntary unemployment may be accounted for through efficiency wages. Again microfounded, efficiency wage theory suggests that ‘productivity is a positive function of the wage’ (Pernecky, 1994, p. 403).

E=E (Wj,Wr)

The efficiency function poses worker effort as a negative function of the reservation wage (Wr, i.e. benefits) and a positive function of the wage paid (Wj). New Keynesian economists use such theory to argue against Keynesian market-clearing models, suggesting that subsequent wage rigidity produces involuntary unemployment as ‘the influence of wages on worker efficiency’ results in the ‘failure of firms to cut wages despite an excess supply of labour’ (Mankiw, n.d.). Pernecky hails this theory as ‘intuitive’ and ‘empirically supported’, concluding that it has ‘re-established involuntary unemployment as a vital subject of study in macroeconomics’ (Pernecky, 1994, p. 411).

However, Mankiw stresses that New Keynesianism fails to rationalise inflation persistence. He stresses that in the data, inflation is a highly persistent variable, indicative of the variables’ slow nature to converge back to equilibrium following economic shocks. However, the NKPC fails to cater for this occurrence – due to its forward looking nature, any shock to output causes inflation to ‘jump immediately in response’ (Fuhrer, 2009, p. 6). Essentially, New Keynesian price inertia is not reflected through inertia in inflation despite empirical evidence suggesting otherwise. As Fuhrer notes, this is problematic for policy makers as their decision making is grounded in understanding ‘the sources of inflation dynamics’ (Fuhrer, 2009, p. 8). Cogley and Sbordone attempt to solve this problem, arguing that persistence in trend inflation ‘determined by the long-run target in the central bank’s policy rule’ justifies ‘most of the persistence in inflation’ we see today (Cogley & Sbordone, 2008, pp. 3-23). The subsequent inclusion of gross trend inflation in their version of the NKPC may solve such issue although they note that this rides on the assumption that ‘Calvo pricing parameters are invariant to shifts in trend inflation, which cannot literally be true’ (Cogley & Sbordone, 2008, p. 32). It appears that without the addition of further, unrealistic ad hoc assumptions, such shortfall of the NKPC is unavoidable thus inherently problematic.

Furthermore, it was Ball (1994) who found the NKPC capable of producing disinflationary booms – an almost non-existent occurrence in reality. Ball, as cited by Mankiw and Reis, found that in a study of nine countries, 27 out of 28 cases of disinflation were ‘associated with a fall in output below its trend level’ (Mankiw & Reis, 2002, p. 1306). The problem lies within the forward looking NKPC. Demonstrated by Figure-1, if disinflation is ‘announced’ and ‘credible’ then due to rational expectations, firms are able to alter inflationary expectations prior to any central banks action coming into force (Mankiw & Reis, 2002, p. 1306). Following an announcement from the central bank that the inflation target is to be lowered from A to z, expected inflation in the next period (〖π^e〗_(t+1)) immediately jumps thus shifting the NKPC0 curve out to point B (NKPC1). At point B, and until monetary policy comes into force, disinflation has an expansionary effect (yB – yE). Eventually monetary policy will take effect and the monetary rule curve (MR0) will shift inwards to equilibrium at point Z (z, yE). Such implausible phenomenon thus puts the credibility of New Keynesian economics under scrutiny.

Mankiw and Reis suggest a sticky information model which survives both the disinflationary boom and inflation persistence argument whilst providing an alternative to the Calvo pricing scheme. Suggesting that firms are able to obtain ‘new information about the state of the economy and’ compute new paths ‘of optimal prices’, its Phillips curve is forward and backward looking as ‘the relevant expectations are past expecations of current economic conditions’ (Mankiw & Reis, 2002, pp. 1299-1300). Due to firm’s information gathering and price setting occurring at a slower pace, inflation persistence prevails alongside minimal variation in output until disinflationary policies commence. Mankiw claims that it survives his third critique of the NKPC relating to impulse response functions or ‘the dynamic path of some variables in response to some shock’ (Mankiw, 2001, p. 16). Demonstrating that the NKPC ‘implies a completely implausible response function for unemployment’, he suggests that the sticky information model better suits the empirical data (Mankiw, 2001, p. 20). However, adaptively formed, such hybrid fails to achieve internal consistency due to its assumption of adaptive expectations rendering it incompatible with economic purity.

Thus, whilst others tried and failed to improve upon the shortfalls of the NKPC, one could argue, like McCallum (as cited by Mankiw), that New Keynesian economics is ‘the closest thing there is to a standard formation’ (Mankiw & Reis, 2002, p. 2). Its near survival of the Lucas critique must not be overlooked as its success in achieving internal consistency through the application of microfoundations and rational expectations has seen the model ‘inhibit’ and help clarify ‘a brave new theoretical world’ marked by imperfections and disequilibria (Snowdon & Vane , 2005, p. 365). However, emphasis on the ‘near’ – inconsistency with regards to its ad hoc assumptions and empirical substantiation leaves the model as one to be used with caution. The NKPC fails to achieve external consistency and despite apparent internal consistency, ‘microfoundations can turn to be ad hoc when not realistic’ (Carré, 2008 , p. 7). Thus, whilst New Keynesian economics has seen both success and failure in its endeavours, ultimately, ‘the methodological integrity of the microfoundations project is not as unblemished as the ‘purists’ imagined’ (Wren-Lewis, 2005).