Home > Uncategorized > Are New-Keynesians accidentally discovering Keynes?

Are New-Keynesians accidentally discovering Keynes?

Are ‘New-Keynesians’ discovering Keynes? Paul Krugman links on his blog to an Eggertsson/Merohtra paper which allows the ‘natural rate of interest’ to fluctuate. Which actually sounds somewhat Keynesian. In new/neo/old classical thinking the natural rate of interest equilibrates, in the unspecified run, supply and demand in all markets, including the labour market. An idea which, according to Keynes, was not so much wrong but useless. David Glasner, on his ‘Uneasy Money’ blog, states about Keynes this (emphasis added):

Keynes did not conclude, as had Sraffa, that there is no natural rate of interest. Rather, he made a very different argument: that the natural rate of interest is a useless concept, because there are many natural rates each corresponding to a different the level of income and employment, a consideration that Hayek, and presumably Fisher, had avoided by assuming full intertemporal equilibrium.

This last assumption is, according to Eggersson and Merohtra, still crucial for ‘microfounded’ models (which are not founded upon micro-relations at all, but that’s another discussion, see the end). But adding even a little realism to the model leads the model away from equilibrium, even in the long run…

In Summers’ words, we may have found ourselves in a situation in which the natural rate of interest – the short-term real interest rate consistent with full employment – is permanently negative … It may seem somewhat surprising that the idea of secular stagnation has not already been studied in detail in the recent literature on the liquidity trap, which does indeed already invite the possibility that the zero bound on the nominal interest rate is binding for some period of time due to a drop in the natural rate of interest. The reason for this, we suspect, is that secular stagnation does not emerge naturally from the current vintage of models in use in the literature. This, however – and perhaps unfortunately – has less to do with economic reality than the limitations of these models. Most analyses of the current crisis takes place within representative agent models … In these models, the long run real interest rate is directly determined by the discount factor of the representative agent, which is fixed. The natural rate of interest can then only temporarily deviate from this fixed state of affairs due to preference shocks … We show that … any combination of a permanent collateral (deleveraging) shock, slowdown in population growth, or an increase in inequality can lead to a permanent output shortfall by lowering the natural rate of interest below zero on a sustained basis. Absent a higher inflation target, the zero lower bound on nominal rates will bind, real wages will exceed their market clearing rate, and, output will fall below the full employment level.

Which starts, in my opinion, to sound at least a little like Keynes, in chapter 17 of the General Theory:

In my Treatise on Money I defined what purported to be a unique rate of interest, which I called the natural rate of interest — namely, the rate of interest which, in the terminology of my Treatise, preserved equality between the rate of saving (as there defined) and the rate of investment. I believed this to be a development and clarification of Wicksell’s “natural rate of interest”, which was, according to him, the rate which would preserve the stability if some, not quite clearly specified, price-level.

I had, however, overlooked the fact that in any given society there is, on this definition, a different natural rate of interest for each hypothetical level of employment. And, similarly, for every rate of interest there is a level of employment for which that rate is the “natural” rate, in the sense that the system will be in equilibrium with that rate of interest and that level of employment. Thus it was a mistake to speak of the natural rate of interest or to suggest that the above definition would yield a unique value for the rate of interest irrespective of the level of employment. I had not then understood that, in certain conditions, the system could be in equilibrium with less than full employment.

I am now no longer of the opinion that the concept of a “natural” rate of interest, which previously seemed to me a most promising idea, has anything very useful or significant to contribute to our analysis. It is merely the rate of interest which will preserve the status quo; and, in general, we have no predominant interest in the status quo as such.

In my opinion, interest rates are, though very important, not as important as economists assume, but that’s another discussion, too. The interesting thing is why this idea (forcefully stated 80 years ago) has not been incorporated in these models many decades ago.

And yes, I do know that many economists actually mean ‘based upon ‘social indifference curves” when they use the phrase ‘micro-founded’ but statisticians really mean ‘founded upon micro data’ when they talk about ‘micro-founded’, so lets use the proper, scientific meaning of the phrase and lets not talk about micro-founded models anymore when these models are not based upon micro data or relationships.

  1. F. Beard
    April 9, 2014 at 5:06 pm

    When I hear the word “interest”, I am disgusted that we live in a usury-soaked world and there’s no excuse since common stock is an endogenous money form that requires no borrowing, much less at interest – that shares rather than concentrates wealth and power.

    But what’s worse is the glaring, stinks-to-High-Heaven, hypocrisy of government backing for what should be 100% private businesses, the banks. For Heaven’s sake, if an endogenous money form REQUIRES government privileges, isn’t that a dead giveaway that it is morally bogus?

    Do I even have the stomach to jump down in the sewer and consider the “natural rate of interest?” No I don’t, not today, since usury is PERMITTED (Deuteronomy 23:19-20) from foreigners but what isn’t permitted, even from foreigners, is government-backed, systematic THEFT, especially from the poor.

  2. April 10, 2014 at 2:09 pm

    The key thing about this paper is that it uses an OLG structure rather than the infinite horizon or perpetual youth structures that are common in New Keynesian models. This completely changes the dynamics and tends to result in much more traditional Keynesian results, (such as with the balanced budget multiplier http://monetaryreflections.blogspot.co.uk/2014/02/preference-functions-and-balanced.html). It also means that, to the extent that there is a natural rate of interest, it has a very different role to that in an infinite horizon model (http://monetaryreflections.blogspot.co.uk/2013/11/more-on-natural-rate-of-interest-in-olg.html).

    • merijnknibbe
      April 10, 2014 at 3:29 pm

      Clarification: OLG = ‘overlapping generations’, i.e. a young generation, an overburdened generation and an old generation and not just one eternal representative consumer.

      • merijnknibbe
        April 10, 2014 at 3:39 pm

        I took a quick glance at your links and you indeed pointed out comparable dynamics.

  3. J M
    April 12, 2014 at 12:12 am

    Not sure they are rediscovering the essence if Keynes. They keep repeating the claim that Keynes thought sticky wages were the cause of unemployment in the depression. Nothing could be further from the truth. He pointed out that even with falling money wages, the labour market wasn’t clearing, it was the shortfall in aggregate demand that matter. I’m pretty sure I also saw something that looked like a loanable funds diagram in their paper, not sure Keynes would have bought it that.

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