The history of ‘New Keynesianism’

from Lars Syll

Stage 0. Late 1960’s. The Phelps volume, and Milton Friedman’s paper (pdf), both thinking about the microfoundations of the Phillips Curve, the difference between actual and expected inflation, and the role of monetary policy. This was the ancestral homeland of both New Keynesian and New Classical macroeconomics, which could not be distinguished at this stage …

Stage 1. Mid 1970’s. Now we see the difference. A distinct New Keynesian approach emerges. New Keynesians assume that prices (and/or wages) are set in advance, at expected market-clearing levels, before the shocks are known. This means that monetary policy can respond to those shocks, and help prevent undesirable fluctuations in output and employment. Even under rational expectations …

Stage 2. Late 1980’s. New Keynesians introduce monopolistic competition. This has two big advantages. First, you can now easily model price-setting firms as choosing a price to maximize profit… Second, because if a positive demand shock hits a perfectly competitive market, where prices are fixed at what was the expected market-clearing level, firms would ration sales, and you get a drop in output and employment, rather than a boom. And the world doesn’t seem to look like that.

Stage 3. Early 2000’s. New Keynesians introduce monetary policy without money. They become Neo-Wicksellians … There were two advantages to doing this. First, it let them model households’ and firms’ choices without needing to model the demand for money and the supply of money. Second, it made it easier to talk to central bankers who already thought of central banks as setting interest rates.

Which brings us to the End of History.

What about microfoundations? Well, it was an underlying theme, but there is nothing distinctively New Keynesian about that theme …

Likewise with rational expectations. New Keynesians just went with the flow.

Nick Rowe

Although I find Rowe’s macro history interesting — and to a large extent in line with the one I give in my own history of economics books — I also think the fact that on microfoundations “there is nothing distinctively New Keynesian” and that “New Keynesians just went with the flow” on that theme, deserves a comment.

Where ‘New Keynesian’ economists think that they can rigorously deduce the aggregate effects of (representative) actors with their reductionist microfoundational methodology, they have to put a blind eye on the emergent properties that characterize all open social systems – including the economic system. The interaction between animal spirits, trust, confidence, institutions etc., cannot be deduced or reduced to a question answerable on the individual level. Macroeconomic structures and phenomena have to be analyzed also on their own terms. And although one may easily agree with e.g. Paul Krugman’s emphasis on simple models, the simplifications used may have to be simplifications adequate for macroeconomics and not those adequate for microeconomics.

In microeconomics we know that aggregation really presupposes homothetic and identical preferences, something that almost never exists in real economies. The results given by these assumptions are therefore not robust and do not capture the underlying mechanisms at work in any real economy. And models that are critically based on particular and odd assumptions – and are neither robust nor congruent to real world economies – are of questionable value.

Even if economies naturally presuppose individuals, it does not follow that we can infer or explain macroeconomic phenomena solely from knowledge of these individuals. Macroeconomics is to a large extent emergent and cannot be reduced to a simple summation of micro-phenomena. Moreover, even these microfoundations aren’t immutable. The ‘deep parameters’ of ‘New Keynesian’ DSGE models– ‘tastes’ and ‘technology’ – are not really the bedrock of constancy that they believe (pretend) them to be.

So — I cannot concur with Paul Krugman, Mike Woodford, Greg Mankiw and other sorta-kinda ‘New Keynesians’ when they more or less try to reduce Keynesian economics to “intertemporal maximization modified with sticky prices and a few other deviations”. And I’m certainly not the only one thinking in these terms:

In a world that is importantly indeterminate — a world in which even some central things, such as the ‘rate and direction’ of innovation, and thus of productivity advances, are not predetermined — some models are better than others in outlining the structure of relationships. But even our models cannot offer forecasts of the future levels of the real price … and the real wage … in relation to present levels … As Keynes, when writing on this point, put it, ‘we simply do not know’ …

Does this finding mean that the ‘natural’ level of (un)employment no longer exists? That depends on what we mean by ‘natural.’ If we mean some immutable central tendency, then it never existed … It is ironic that the originators of models of the natural rate, whose formulations did not explicitly exclude that background expectations of future capital goods prices and future wages might be quite wrong, stand accused of not appreciating that any sort of economic equilibrium is to some extent a social phenomenon—a creature of beliefs, optimism, the policy climate, and so forth—while today’s crude Keynesians, despite their mechanical deterministic approach, wrap themselves in the mantle of Keynes, who, with his profound sense of indeterminacy and, consequently, radical uncertainty, was worlds away from their thinking.

Edmund Phelps