Monetarism >>>> New Keynesianism (and Paul Krugman tells us why)

My approach to macro has always been “nominal shocks have real effects.”  As a result, I’ve never cared for the Keynesian view that inflation was caused by an overheating economy, and disinflation was caused by economic “slack.”  If that were true, then it would be the case that “real shocks have nominal effects.”  I.e. changes in real GDP affect inflation.  And that just didn’t seem right.

Milton Friedman (and Irving Fisher) interpreted the Phillips curve in the same way I do—deflation causes unemployment, not the other way around.  As I got older I modified this view slightly, now I see nominal shocks as changes in NGDP growth.  But I still believe nominal shocks have real effects.  Only now an unexpected change in NGDP would simultaneously change both prices and output.  So how does this differ from the Keynesian view?

Mankiw and Reis (2006) identify “three key facts” of modern business cycle theory: 

  1. The Acceleration Phenomenon . . . inflation tends to rise when the economy is booming and falls when economic activity is depressed.”
  2. The Smoothness of Real Wages . . . real wages do not fluctuate as much as labor productivity.”
  3. Gradual Response of Real Variables . . . The full impact of shocks is usually felt only after several quarters.”

None of these facts even comes close to fitting the economy of 1933, and the first is especially strongly rejected.  Inflation soared in 1933, when unemployment was at the highest level in history.  The monetarist model, however, can easily explain 1933.  After all, a powerful nominal shock (dollar devaluation) sharply raised output.  But I get tired of talking about 1933, unless there are other good examples then the distinction I’m trying to make might not be that important.  Fortunately, Paul Krugman has found some recent examples:

Via Mark Thoma, the Dallas Fed notes some acceleration even in its core inflation measures, although these remain below target. What should we make of this?  .  .  .

What this suggests to me, anyway, is that there’s a rate-of-change effect as well as a level effect: when the economy is growing, even from a low base, some firms gain pricing power, and some firms raise their wage offers a bit. So the acceleration of US growth and the fall in unemployment since last summer has produced an inflation uptick; if past experience is a good guide, however, this will be only temporary unless the economy continues to accelerate.

I’m sure if you add enough epicycles to the Keynesian model you can make it all work out.  For my part I’ll stick with Fisher and Friedman—nominal shocks have real effects.

PS.  Check out Krugman’s short post.  It’ll make more sense if you look at his graphs.  I don’t like to copy entire posts, if I can avoid it.

PPS.  Krugman refers to an “acceleration of US growth and the fall in unemployment since last summer”.  Did QE cause that acceleration?  Martin Feldstein says yes.  Wasn’t he one of those economists who said the Fed was out of ammo back in 2008-09?  Any help from commenters would be appreciated.


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30 Responses to “Monetarism >>>> New Keynesianism (and Paul Krugman tells us why)”

  1. Gravatar of StatsGuy StatsGuy
    2. March 2011 at 20:32

    I think this is what you’re looking for:

    http://www.nber.org/feldstein/RethinkingtheRole.pdf

    “Why then the recent revival of interest in fiscal stimulus?  By the fall of 2007 it 
    became clear to many economists that the current downturn is different from previous 
    recessions and that monetary policy would not be effective in bringing us back to full 
    employment.”

    Of course, you know my opinion – the Joe Gagnon view. :)

    BTW, in the past you’ve argued that monetary policy has a “response function” to fiscal policy, such that central bankers like Mervyn King will offset fiscal activity that the bank disagrees with. (Of course, if you don’t believe economic activity ==> inflation, then why would they do anything?)

    I’ve argued the opposite can be true (not always, but it _can_ be true). That is, fiscal policy can force central bankers to accommodate by expanding the money supply to purchase debt (or risk a failed bond auction, as has nearly been happening in several EU countries, and would have happened without ECB support). Think of it as a game of chicken, except it’s not really simultaneous since the Fed has the last move. If Congress knows the Fed’s response function, it can select it’s preferred solution along that curve, and no matter how much the Fed blusters, it will accommodate. (Of course, it’s really a much more complicated, and repeated, game, so this is an exaggeration.)

    Anyway, it seems that I’m not alone in that view. In Bernanke’s interview today, guess who said this:

    “…the Congress spends and they know there is a moral hazard involved because they know that if interest rates go up, the Fed accommodates them. So the Fed really facilitates this spending, and until we realize this I think the Fed is involved with our deficit and encourages it as well as the Congress.”

    .
    .
    .
    .

    If you guessed Ron Paul, then aces to you! I happen to agree with him here, in that it’s questionable how effective Fed policy would have been without the treasury running a 1.5 trillion dollar deficit.

    Since Ron Paul is talking, it’s unclear which way the causation is running (you might argue that the Fed was encouraging Congress to run a deficit, but I might argue that Congress was able to run a deficit knowing it could force some level of accommodation).

    So you can claim victory for monetary policy, and DeKrugman can say whatever they want about fiscal policy, but 2009 was no pure test of either theory. We do not know what QE would have done if the government was running a balanced budget.

    I doubt we’ll get a pure test soon, since the Fed and Congress are currently sparring over just how big the deficit will be and how much of it the Fed will absorb. My guess is that we’ll end up with a negotiated settlement.

  2. Gravatar of dtoh dtoh
    2. March 2011 at 20:35

    Scott,
    From a business perspective, here’s some feedback on how pricing works in some industries and in some businesses.

    Prices on individual transactions or deals (as opposed to list pricing) are usually approved by a VP of Sales. The VP of Sales usually gets compensated on whether he meets his sales quota. Consequently profitability takes a backseat. When the economy is in decline (or below expectations) the sales quota has usually been set too high so the VP will be inclined to accept worse (i.e. lower pricing) in order to get sales and meet the quota. When the market picks up or growth rates exceed expectations, it’s easier to meet the quota, so the VP heeds the admonitions of the CEO to achieve better profitability and jacks pricing up.

    Interest rates play a role as well. With declining rates, interest expense goes down, profitability goes up and there is less discipline on pricing (i.e. the company is willing to do transactions at lower pricing). Vice versa when rates are ticking up in a recovery.

    Other than commodity prices, there is zero inflation pressure on companies. Labor is plentiful… no sane business is considering the need to raise wages. Competition is intense in most industries. Ongoing productivity and automation gains allow many or most businesses to continue to push prices down.

  3. Gravatar of Benjamin Cole Benjamin Cole
    2. March 2011 at 20:45

    Another interesting post by Scott Sumner. I wonder if QE will have to become a permanent policy tool. With savings swamping capital markets, it will easy to get to zero bound. Then what, when you need a shot in the arm?

    Martin Feldstein seems to rule out more QE. But what is the harm is constant QE, albeit at lower levels? If the savings rate is too high, and we hit zero bound, then we have to deploy QE (and some other tools) no?

    Again, the spectre is Japan. Anything is better than 20+years slumps in wages, property values and equities prices.

  4. Gravatar of Doc Merlin Doc Merlin
    2. March 2011 at 21:05

    @Benjamin Cole:
    “Another interesting post by Scott Sumner. I wonder if QE will have to become a permanent policy tool. With savings swamping capital markets, it will easy to get to zero bound. Then what, when you need a shot in the arm?”

    WILD AND CRAZY NEW PREDICTION:

    We will have effectively zero interest on short term government debt from now till forever, as
    1) The only people buying government debt at this point at buying it as a dollar cash substitute or are legally obligated to, or are the fed, yet the short term rates are near zero. (Yes, I realize the fed is also legally obligated to buy treasuries, but the NY Fed doesn’t really follow the law anymore, it buys all sorts of whatever it wants and has for a while.)

    2) Spending cuts will to happen in the state and federal government, the Fed will think of that as a fiscal un-stimulus and try to lower rates more. Because of low short term rates, hey won’t be able to lower short term rates without something like negative IOR, which they won’t do because they care more about their stockholders than just about anything else.

    3) The fed instead will massively flatten the yield curve.

    @Scott:
    4) What happens if the fed massively flattens the yield curve? I know what the Austrians think would happen, but what do you?

  5. Gravatar of Mark A. Sadowski Mark A. Sadowski
    2. March 2011 at 21:26

    Scott,
    We must be on the same wavelength. (This is so freaky. I think, and then you blog.) I think the key reason is we both believe nominal=>real. (But maybe you taught me that.)

    I had just finished digesting the idea that core inflation has steadied and am interpreting it in a fashion I suspect that is very similar to you.

    P.S. 1933 is key.

  6. Gravatar of Morgan Warstler Morgan Warstler
    2. March 2011 at 21:50

    Scott, I think DeKrugman is wrong. I think as prices went up on inputs, businesses made every productivity improvement they could find, cut payroll to the bone… mergers are all the rage… and it’s all about how to finally raise prices to survive.

    Doc,

    1 has to happen to keep interest on debt from consuming all our tax revenue.

    2 has to happen to to make productivity gains – I don’t think Republicans (even ones at the Fed) EVER really think of teachers making less money as “un-stimulus.”

    —–

    Hey a friend of mine was positing as theory that the banks are keeping cash in reserves – based upon the mark down on assets they know is eventually coming. Meaning each bank’s reserves should give you an indication of how screwed they are.

    Does this make any sense?

  7. Gravatar of david david
    3. March 2011 at 00:22

    But the Mankiw and Reis 2006 paper that you are citing, isn’t canonically New Keynesian :P

    (it seems like a paper that might appeal to Arnold Kling, though)

    Atop that, you may be misinterpreting #1, where Mankiw and Reis are describing an empirical correlation rather than a causation. Like all good New Keynesians, Mankiw does believe that nominal shocks have real effects; that is why we have #3, where it is real effects that are following nominal shocks.

    What part of the canonical NK Phillips curve doesn’t suggest that nominal shocks have real effects?!

    New Keynesians do believe that real shocks can have nominal effects; if you disagree, I direct you to observe any earthquake. But there can be nominal and real shocks in the world, of course.

  8. Gravatar of JTapp JTapp
    3. March 2011 at 04:51

    Scott, a little off-topic but did you see this bit in Bernanke’s testimony before Congress the other day?

    “I think that many of the monetary or nominal indicators that somebody like Milton Friedman would look at did suggest the need for a monetary stimulus. For example, nominal GDP has grown very slowly. Growth in the money supply is in fact — I’m not talking about the reserves held by banks which are basically idle — but if you look at M1 and M2, those have grown pretty slowly. ”

    Source: WSJ. The topic of the article is Taylor’s beef with Bernanke’s interpretations of his rule.

  9. Gravatar of Scott Sumner Scott Sumner
    3. March 2011 at 06:12

    Statsguy, Thanks for the Feldstein quotation. Do others see a contradiction with his current position, or am I reading to much into it?

    Regarding the rest of your comment; hmm . . . would someone rather side with Sumner and Bernanke, or Statsguy and Ron Paul?

    :)

    dtoh, First of all, if I wanted to know why businesses set prices where they do, a businessman would be about the last person I’d ask. As Milton Friedman pointed out, an expert billiard player doesn’t have to know the laws of trigonometry, but those laws may predict his shots. Businessman often explain their actions in ways that have nothing to do with the actual motivation. When sales are low it often makes sense to have price cuts, as MC may be low, or sunk costs may be involved. Businessman behave as if they are maximizing profits, even if they think they are not maximizing profits.

    You said;

    “Labor is plentiful… no sane business is considering the need to raise wages.”

    Then there must be lots of insane companies, as wages (on average) are rising.

    Benjamin, Yes, it’s odd that he thinks QE2 worked, but opposes QE3.

    Doc merlin, I think there is a 20% risk that we end up stuck at zero rates.

    You said;

    “4) What happens if the fed massively flattens the yield curve? I know what the Austrians think would happen, but what do you?”

    I suppose we end up like Japan, with falling asset prices. But I thought the Austrians said low rates produced bubbles?

    Morgan, I don’t know enough about reserves to answer that. I suppose it’s possible.

    I agree that costs have been cut, but I’d say stronger final sales in Q4 are part of the story.

    David; You said;

    “Atop that, you may be misinterpreting #1, where Mankiw and Reis are describing an empirical correlation rather than a causation.”

    Maybe, but I think the clear implication is that the causation goes from a weak economy to falling inflation. If inflation were the exogenous variable, that could not be true unless an increase in prices instantly moved one from 25% unemployment to full employment. Surely no Keynesian would claim that to be true.

    I agree with your point three.

    Thanks JTapp, I’ll use that in a post.

  10. Gravatar of David Pearson David Pearson
    3. March 2011 at 06:28

    “As a result, I’ve never cared for the Keynesian view that inflation was caused by an overheating economy, and disinflation was caused by economic “slack.” ”

    Do you believe that economic slack contains inflation? Or that inflation cannot accelerate beyond some “speed limit” in the presence of economic slack?

  11. Gravatar of david glasner david glasner
    3. March 2011 at 07:30

    Obviously, there is a contradiction. For more evidence, see Feldstein’s piece in the Financial Times of November 3, bashing QE2. Maybe this had something to do with his seeing the light.

    http://www.ft.com/cms/s/0/dea38722-eadf-11df-b28d-00144feab49a.html#axzz1FYApHfj3

    But I doubt it

  12. Gravatar of Richard Allan Richard Allan
    3. March 2011 at 08:08

    I have rather an open-ended question… what’s “artificial” about price/wage stickiness? I’m defining “artificial” as “contrary to the wishes of the market participants”. Menu costs? Certainly, but are they really so important? Pre-arranged contracts? But if the workers wanted to take a pay cut, surely they could… if they don’t, does it mean they don’t want to?

    I don’t know how to phrase this correctly, but what I’m driving at is a suggestion that a fall in Real GDP might be utility-maximising. If everyone’s reservation wage shoots up in a “non-artificial” manner, then of course Real GDP will fall, and that’s a good thing, because it’s what market participants want. Collective bargaining might make people unemployed, but in the absence of laws protecting it, I think workers have the right to make that mistake without the State suppressing their wages to boost output.

    Of course my definition of “artificial” is in itself question-begging. If everyone tries to increase currency balances, the resulting fall in Nominal GDP isn’t artificial in my book. If workers freely choose to resist wage cuts, the resulting fall in Real GDP isn’t artificial. I would call it “artificial” if Kim Jong-Il came out and stated that 30% of the US currency in circulation was counterfeit, and the counterfeit notes would become obvious in a month’s time. In that case, the Fed should commit to honouring the counterfeit notes at face value (as long as the supply could be choked off).

    Anyway let me know if this is making any sense.

  13. Gravatar of Brian Brian
    3. March 2011 at 08:41

    I’m currently working my way through Jordi Gali’s textbook, “Monetary Policy, Inflation, and the Business Cycle: An Introduction to the New Keynesian Framework.”

    It is not making me any more fond of New Keyensianism. But I suppose I should properly learn what all the fuss is about.

  14. Gravatar of Mark A. Sadowski Mark A. Sadowski
    3. March 2011 at 08:43

    Scott,
    What do New Keynesians think about inflation? Your post reminded me of this post by John C. Williams of the FRBSF:

    http://www.frbsf.org/publications/economics/letter/2009/el2009-12.html

    He argues that the type of expectations play a key role in determining the behavior of inflation. During the Depression people had “price level” expectations. Since the mid 1990s people have had “inflation rate” expectations. Thus he argues away the discrepancy between the behavior of inflation in the 1930s and standard New Keynesian explanations. (And, I should mention also, that in the 1970s, he notes we had unanchored expectations, which gave rise to that “Oh God, we’re all going to die” feeling.)

    Just thought I’d throw that out there.

  15. Gravatar of Silas Barta Silas Barta
    3. March 2011 at 08:52

    The monetarist model, however, can easily explain 1933. After all, a powerful nominal shock (dollar devaluation) sharply raised output.

    This example always bothers me. The “dollar devlauation of ’33″ is just a roundabout way of saying “looting holders of (what they thought was) gold (equivalents)”.

    Yes, seizing the assets of the relatively wealthy can show up as an increase in “economic activity”, but you need to correct for how much of that is due to consumption of expropriated savings. Do any analyses of this situation (and its parallels in other countries) actually account for this?

    If you’re not careful, this kind of sanguine reasoning will lead you to say that when revolutionaries seized rich people’s plantations and gobbled up the seed corn, consumption went up, therefore a general policy of looting the wealthy must be good policy.

  16. Gravatar of Morgan Warstler Morgan Warstler
    3. March 2011 at 09:51

    http://www.ny.frb.org/research/epr/02v08n1/0205benn/0205benn.html

  17. Gravatar of david david
    3. March 2011 at 11:03

    “If inflation were the exogenous variable, that could not be true unless an increase in prices instantly moved one from 25% unemployment to full employment. Surely no Keynesian would claim that to be true.”

    Not instantly, but with a lag, as per Mankiw and Reis’ #3. But there would indeed be increased employment, provided the inflation shock is unexpected, and the economy is not at full employment. At least, that is what the NK model predicts!

  18. Gravatar of StatsGuy StatsGuy
    3. March 2011 at 11:12

    ssumner:

    “Regarding the rest of your comment; hmm . . . would someone rather side with Sumner and Bernanke, or Statsguy and Ron Paul?”

    We have more guns!

    http://www.flickr.com/photos/9977278@N04/2249564736/

    (But then again, you and Bernanke have more black helicopters…)

    On Feldstein, oh yes, there’s some inconsistency. Likewise with Krugman. The Krugman fallback, really, is that the “Fed was out of ammo” because QE was politically not feasible. Except that, in the end, it was.

    To Feldstein’s credit, even in the early article he seems aware of some of the inconsistency.

    “Some of the past problems in using fiscal policy to stimulate demand may be less of
    an impediment in the current circumstances. Government borrowing to finance fiscal
    deficits will not be offset by higher interest rates since the current environment is
    characterized by very easy money and a dysfunctional credit market. The delays in starting
    infrastructure projects and the long tail in that spending are not likely to be as much of a
    problem now because the current downturn is likely to last much longer than previous
    ones. In the past, the average recession lasted only 12 months from peak to trough. This
    recession has already lasted 12 months and probably will last a good deal longer. I believe
    we will be lucky if we see the recession end in 2009. Once the recovery begins, the upturn
    will be very slow because households need to increase their saving – i.e., to consume less ‐‐
    to rebuild their wealth for retirement and other purposes. So fiscal policy is likely to be
    useful even if it is not strongly effective in 2009. It is not likely to overheat the economy if it
    continues to add significantly to demand in 2010 and 2011.”

    However, he’s saying “this time is different”. More or less the zero bound thing. In his 3 ways out at the end, he includes one as a fall in the value of the dollar sufficient to erase the trade deficit, but actually we didn’t need nearly this much – all we needed was the expectation of enough of a drop to reflate commodity and asset (corporate exporter stocks) prices.

    His view was very crude – expectations virtually vanished. The impact of dollar devaluation was measured directly in the yearly trade deficit, not the net present value of export-generating/impost-substituting assets. Even in his discussion of the tax credit, he recanted earlier views that temporary cuts don’t matter much.

    He does mention one thing about fiscal – which is that in a zero bound condition with “dysfunctional credit markets”, fiscal stimulus might be more likely to work than in a standard recession where the zero bound is not pegged. At some level, there seems some truth to this – if credit markets are truly dysfunctional, then ricardian equivalence should not hold in the short (and perhaps medium) term. Interest rates will _not_ rise substantially due to deficit spending until deficit spending is enough to escape the zero bound.

    The odd thing is that the primary cause of the shock seems to be (in his description) a drop in nominal asset values that leads to a wealth effect causing a loss of 400 billion/annum in household exp. But in the fixes, there’s no mention of reflating asset values to undo the negative wealth effect.

    Head scratcher.

  19. Gravatar of Philo Philo
    3. March 2011 at 11:16

    I think I understand the difference between real effects and nominal effects. Suppose we have an economy, with activities, prices, etc., the qualitative description of which we call “(situation) A”; and let “(situation) B” be the qualitative description of a very similar economy, with very similar activities but with all prices (wages, etc.; but not interest rates) *double* those in situation A. Then whatever caused an A economy to change into a B economy would have produced a *purely nominal effect*, since nothing would have changed but the price level.

    But I am less clear about the distinction between real shocks and nominal shocks. Is a “nominal shock” a *mere change in the price level* (relative prices, including interest rates, remaining the same, at least initially)? (If such a “shock” had an effect, E–real or otherwise–I suspect we would be inclined to identify as the true, underlying cause of effect E *the cause of the shock*, rather than the shock itself.) Or does the term ‘nominal shock’ cover other things–for example, a major discovery of gold (under a gold standard), or a change in the peg (for a pegged currency), or a suddenly changed desire of people to hold money? If so, exactly what range of other things?

  20. Gravatar of Richard Allan Richard Allan
    3. March 2011 at 13:05

    Philo, I would guess that a nominal shock would be any unanticipated change in Nominal GDP, that is, (Money supply * Velocity). So a change in either or both of those latter two values.

  21. Gravatar of Greg Ransom Greg Ransom
    3. March 2011 at 13:58

    So according to Mr. Krugman the economy is a rocket ship that follows Newton’s laws of motion …

    I love how economists think in terms of physical processes that have nothing to do with market processes.

  22. Gravatar of Dtoh Dtoh
    4. March 2011 at 01:25

    Scott,
    You said, “dtoh, First of all, if I wanted to know why businesses set prices where they do, a businessman would be about the last person I’d ask.”

    The comment was from a business perspective not a businessman’s perspective. There’s a difference. And if there is not a realistic underlying micro mechanism for macro theory, it’s like the earth is perched on the back of a giant turtle theory of cosmology…perhaps predictively accurate occasionally but not robust.

    As for wage rates, I would guess the small uptick is mostly a result of increased overtime (which btw would be consistent with higher average hours also being seen. )

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    [...] コアの上昇 (オタク風) by Paul Krugman  // クルーグマンのブログから、”Core Uptick (Wonkish)” (March 1, 2011)を翻訳紹介。 「いつも言っていることと因果関係が逆?」とおっしゃる向きもありますね。実は本当に紹介したいのはこれに対する、サムナーの勝利宣言(^^)の方です。 そちらは週末にでも。 [...]

  24. Gravatar of マネタリズム>>>>ニューケインジアニズム(その理由はクルーグマンが) by Scott Sumner  マネタリズム>>>>ニューケインジアニズム(その理由はクルーグマンが) by Scott Sumner 
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  25. Gravatar of Scott Sumner Scott Sumner
    5. March 2011 at 10:43

    David, You said;

    “Do you believe that economic slack contains inflation? Or that inflation cannot accelerate beyond some “speed limit” in the presence of economic slack?”

    I suppose it partly depends on how one defines “slack.” I wouldn’t say it contains inflation, rather it may reflect disinflation. Inflation can rise dramatically during periods of slack, but in general inflation is less likely to rise when there is slack, as compared to when there is no slack.

    David Glasner, Thanks–as you know I have a new post on you and Feldstein.

    Richard, You asked;

    “I have rather an open-ended question… what’s “artificial” about price/wage stickiness? I’m defining “artificial” as “contrary to the wishes of the market participants”. Menu costs? Certainly, but are they really so important? Pre-arranged contracts? But if the workers wanted to take a pay cut, surely they could… if they don’t, does it mean they don’t want to?”

    This is a good example of the fallacy of composition. If all workers took pay cuts, they’d all be better off. But if any one group of workers did, but others didn’t, they would not be better off.

    You asked;

    “Anyway let me know if this is making any sense.”

    Concepts like “artificial” rarely do more good than harm in economics.

    Brian, Let me know if you find anything of interest.

    Mark, So he’s saying the new Keynesian model doesn’t apply to the 1930s? (I agree.) Or did I misinterpret your point.

    Silas, The rich T-bond holders did very well. Even in dollar terms the real value of their bonds soared in the 1930s–even after devaluation. You need not worry about money being taken from rich coupon clippers–didn’t happen.

    David; You said;

    “Not instantly, but with a lag, as per Mankiw and Reis’ #3. But there would indeed be increased employment, provided the inflation shock is unexpected, and the economy is not at full employment. At least, that is what the NK model predicts!”

    I thought the NK model said you wouldn’t get much higher inflation if the economy had lots of slack.
    But we did, in 1933.

    Statsguy, Yeah, I’m not impressed with that argument. BTW, he predicts:

    “I believe
    we will be lucky if we see the recession end in 2009.”

    Didn’t the recession end in June, shortly after he made that prediction?

    Philo, Nominal shocks can be defined in various ways—I prefer an unexpected change in NGDP growth.

    Greg, That’s especially a problem with Keynesian economists, although I’m not sure it applies in this case.

    Dtoh, You might be right about overtime.

  26. Gravatar of Mark A. Sadowski Mark A. Sadowski
    5. March 2011 at 12:43

    Scott,
    You wrote:
    “Mark, So he’s saying the new Keynesian model doesn’t apply to the 1930s? (I agree.) Or did I misinterpret your point.”

    Well I suppose, what he’s saying is that the New Keynesians have a different model depending on which time period you’re looking at. The 1930s were characterized by a well anchored expectations of the price level, the period since the 1990s by a well anchored expectations of the inflation rate, and the 1970s by unanchored expectations that is best explained by some form of the accelerationist hypothesis. At least that is my understanding.

  27. Gravatar of Duncan Van Limbergen Duncan Van Limbergen
    5. March 2011 at 13:43

    Some interesting points, but I really miss a further explanation on expectations (such as expectations about inflation and future monetary policy). In the above mentioned view, nominal shocks (i.e. monetary base and money supply increases) did not cause siginificant changes in real variables in contractionary environments (see Japan’s ‘liquidity trap’). This opens up room for the introduction of certain (New Keynesian-modeled) expectation formations. One of the most interesting features of New Keynesian monetary theory is the dualist way expectations are formed. This can, in fact, explain how certain nominal shocks eventually will induce real effects. (however, of course, prone to improvement)

    I agree, however, completely that nominal variables are widely overlooked in modern macro.

  28. Gravatar of Scott Sumner Scott Sumner
    6. March 2011 at 09:08

    Mark, There ought to be some way to nest all these models into one meta-model.

    Duncan, A permanent nominal shock has the same impact in a liquidity trap as it does when rates are positive.

  29. Gravatar of Philo Philo
    7. March 2011 at 22:09

    Your definition of ‘nominal shock’ is “an unexpected change in NGDP growth.” Such a change would, of course, have a cause (or causes–but let’s just roll them all into one, and call it ‘the cause’–’C’ for short). And this cause certainly would have other effects, , besides the unexpected change in NGDP growth. Inevitably some of these effects would be “real”; that is, they would be other than a mere change in prices that left relative prices unchanged (a “nominal effect,” on my definition, which you did not reject). Let Ei be one such real effect.
    So we have C causing NS (nominal shock), and C causing Ei. But–here’s the metaphysical fine point–do we want to say that NS caused Ei? If in general we do not, then we don’t after all want to say that nominal shocks have real effects. Yes, it’s a metaphysical fine point; but why not be accurate, and say that *what causes a nominal shock* will (inevitably) also have real effects? That sounds less profound, but I don’t think what you’re saying really *is* profound.

  30. Gravatar of ssumner ssumner
    8. March 2011 at 09:07

    Philo, You asked:

    “do we want to say that NS caused Ei?”

    Yes.

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