New Keynesian Models In Addition To The Labour Market

Do all those using New Keynesian models receive got to believe everything inwards those models? To respond this question, you lot receive got to know the history of macroeconomic thought. I squall upward the respond is also relevant to some other oft asked question, which is what the difference is betwixt a ‘New Keynesian’ as well as an ‘Old Keynesian’?

You cannot empathize macro today without going dorsum to the New Classical revolution of the 1970s/80s. I often tell that the state of war betwixt traditional macro (Keynesian or Monetarist) as well as New Classical macro was won as well as lost on the battlefield of rational expectations. This was non merely because rational expectations was such an innovative as well as refreshing idea, but also because the primary weapon inwards the traditionalists armoury was therefore vulnerable to it. Take Friedman’s version of the Phillips curve, as well as supercede adaptive expectations past times rational expectations, as well as the traditional mainstream Keynesian story merely barbarous apart. It actually was no contest. (See Roger Farmer here, for example.)

I believe that revolution, as well as the microfoundations programme that lay behind it, brought huge improvements to macro. But it also led to a close kicking the bucket experience for Keynesian economics. I squall upward it is fairly clear that this was i of the objectives of the revolution, as well as the winners of wars instruct to rewrite the rules. So getting Keynesian ideas dorsum into macro was a tiresome procedure of attrition. The New Classical sentiment was non overthrown but amended. New Keynesian models were RBC models plus pasty prices (and occasionally pasty wages), where stickiness was at in i lawsuit microfounded (sort of). Yet from the New Classical signal of view, New Keynesian analysis was non a key threat to the revolution. It built upon their analysis, as well as could endure easily dismissed amongst an assertion nigh toll flexibility. Specifically NK models retained the labour leisure choice, which was at the center of RBC analysis. Monetary policymakers were doing the Keynesian thing anyway, therefore lilliputian was beingness conceded inwards terms of policy. [1]

So labour furnish pick as well as labour marketplace seat clearing became component of the heart as well as soul New Keynesian model. Is this because all those who utilisation New Keynesian models believe it is a skillful approximation to what happens inwards trouble organisation cycles? I dubiety it really much. However for many purposes allowing perfect labour markets does non thing likewise much. Sticky prices plough over you lot a distortion that monetary policy tin forcefulness out endeavor to negate past times stabilising the trouble organisation cycle. The seat you lot are trying to stabilise towards is the outcome of an RBC model (natural levels), but inwards many cases that involves the same variety of stabilisation that would endure familiar to to a greater extent than traditional Keynesians.

This is non to propose that New Keynesians are cupboard traditionalists. Speaking for myself, I am much here.) Now in that location is inwards fact an asymmetry implicit inwards the NK model: although imperfect challenger way that firms may honor it profitable to enhance production as well as continue prices unchanged next ‘small’ increases inwards demand, at some signal additional production is probable to move unprofitable. There is no equivalent signal amongst falling demand. However that potential asymmetry is unremarkably ignored. I suspect that a model of unemployment based on rationing volition arrive at asymmetries which cannot endure ignored.

The other surface area where modelling unemployment matters concerns welfare. As I receive got noted happier using rational expectations than anything adaptive, as well as I honor it really hard to squall upward nigh consumption decisions without starting amongst an intertemporally optimising consumer. I also squall upward Old Keynesians could endure really confused nigh the human relationship betwixt aggregate furnish as well as demand, whereas I here.) Now in that location is inwards fact an asymmetry implicit inwards the NK model: although imperfect challenger way that firms may honor it profitable to enhance production as well as continue prices unchanged next ‘small’ increases inwards demand, at some signal additional production is probable to move unprofitable. There is no equivalent signal amongst falling demand. However that potential asymmetry is unremarkably ignored. I suspect that a model of unemployment based on rationing volition arrive at asymmetries which cannot endure ignored.

The other surface area where modelling unemployment matters concerns welfare. As I receive got noted find the New Keynesian approach both coherent as well as intuitive. However, the thought that labour markets clear inwards a recession is some other matter. It is therefore evidently incorrect (again, see Roger Farmer). So why did New Keynesian analysis non apace abandon the labour marketplace seat clearing assumption?

Part of the respond is the measure one: it is a useful simplifying supposition which does non plough over us misleading answers for some questions. However the ground for my initial excursion into macro history is because I squall upward in that location was, as well as even therefore is, some other answer. If you lot desire to remain inside the mainstream, the less you lot enhance the hackles of those who won the bully macro war, the to a greater extent than adventure you lot receive got of getting your newspaper published.

There are of course of written report a number of measure ways of complicating the labour marketplace seat inwards the baseline New Keynesian model. We tin forcefulness out brand the labour marketplace seat imperfectly competitive, which allows involuntary unemployment to exist. We tin forcefulness out assume reward are sticky, of course. We tin forcefulness out add matching. But I would debate that none of these on its own gets roughly realistically modelling unemployment inwards trouble organisation cycles. In a recession, I dubiety really much if unemployment would disappear if the unemployed spent an interplanetary space amount of fourth dimension searching. (I receive got ever seen programmes designed to plough over project search assistance to the unemployed every bit trying to cut down the scaring effects of long term unemployment, rather than every bit a way of reducing aggregate unemployment inwards a recession.) To capture unemployment inwards the trouble organisation cycle, nosotros demand rationing, every bit Pascal Michaillat argues here (AER article here). This is non an choice to these other imperfections: to ‘support’ rationing nosotros demand some existent wage rigidity, as well as Michaillat’s model incorporates matching. [2]

I squall upward a rationing model of this type is what many ‘Old Keynesians’ had inwards remove heed when thinking nigh unemployment during a trouble organisation cycle. If this is true, as well as then in this detail sense I am much to a greater extent than of an Old Keynesian than a New Keynesian. The interesting query as well as then becomes when this matters. When does a rationed labour marketplace seat brand a pregnant difference? I receive got ii suggestions, i tentative as well as i less so. I am certain in that location are others.

The tentative proposition concerns asymmetries. In the baseline NK model, booms are merely the reverse of downturns - in that location is no key asymmetry. Yet traditional mensuration of trouble organisation cycles, amongst verbalize of ‘productive potential’ as well as ‘capacity’, are implicitly based on a rather dissimilar project design of the cycle. H5N1 recent newspaper (Vox) past times Antonio Fatás as well as Ilian Mihov takes a similar approach. (See also Paul Krugman here.) Now in that location is inwards fact an asymmetry implicit inwards the NK model: although imperfect challenger way that firms may honor it profitable to enhance production as well as continue prices unchanged next ‘small’ increases inwards demand, at some signal additional production is probable to move unprofitable. There is no equivalent signal amongst falling demand. However that potential asymmetry is unremarkably ignored. I suspect that a model of unemployment based on rationing volition arrive at asymmetries which cannot endure ignored.

The other surface area where modelling unemployment matters concerns welfare. As I receive got noted before, Woodford type derivations of social welfare plough over a depression weight to the output gap relative to inflation. This is because the costs of working a fight less than the efficient floor are small: what nosotros lose inwards output nosotros almost gain dorsum inwards additional leisure. If nosotros receive got unemployment because of rationing, those costs volition rising merely because of convexity. [3]

However I squall upward in that location is a to a greater extent than subtle ground why models that process cyclical unemployment every bit rationing should endure to a greater extent than prevalent. It volition let New Keynesian economists to tell that this is what they would ideally model, fifty-fifty when for reasons of tractability they tin forcefulness out instruct away amongst simpler models where the labour marketplace seat clears. Once you lot recognise that periods of rationing inwards the labour marketplace seat are fairly mutual because economical downturns are common, as well as that to endure on the incorrect destination of that rationing is really costly, you lot tin forcefulness out come across to a greater extent than clearly why the labour contract betwixt a worker as well as a theater itself involves of import asymmetries - asymmetries that firms would endure tempted to exploit during a recession. 

Yet you lot receive got to ask, if I am correct that this way of modelling unemployment is both to a greater extent than realistic as well as implicit inwards quite traditional ways of thinking, why is it therefore rare inwards the literature? Are nosotros even therefore inwards a province of affairs where departures from the RBC image receive got to endure express as well as non-threatening to the victors of the New Classical revolution?

[1] When, inwards a liquidity trap, macroeconomists started using these really same models to present that financial policy mightiness endure effective every bit a replacement for monetary policy, the response was really here.) Now in that location is inwards fact an asymmetry implicit inwards the NK model: although imperfect challenger way that firms may honor it profitable to enhance production as well as continue prices unchanged next ‘small’ increases inwards demand, at some signal additional production is probable to move unprofitable. There is no equivalent signal amongst falling demand. However that potential asymmetry is unremarkably ignored. I suspect that a model of unemployment based on rationing volition arrive at asymmetries which cannot endure ignored.

The other surface area where modelling unemployment matters concerns welfare. As I receive got noted different. Countercyclical financial policy was something that New Classical economists had thought they had killed off for good.

[2] Some technical remarks.

(a) Indivisibility of labour, reflecting the observation (e.g. Shimer, 2010) that hours per worker are quite acyclical, has been used inwards RBC models: early on examples include Hansen (1985) as well as Hansen as well as Wright (1992). Michaillat also assumes constant labour forcefulness participation, therefore the labour furnish bend is vertical, as well as critically some existent wage rigidity as well as diminishing returns.

(b) Consider a deterioration inwards technology. With flexible wages, nosotros would instruct no rationing, because existent reward would autumn until all labour was employed. What if existent reward were fixed? If nosotros receive got constant returns to labour, as well as then if anyone is employed, everyone would endure employed, because hiring to a greater extent than workers is ever profitable (mpl>w always). What Michaillat does is to let diminishing returns (and a floor of wage flexibility): some workers volition endure employed, but afterward a signal hiring becomes unprofitable, therefore rationing tin forcefulness out occur.  

(c) Michaillat adds matching frictions to the model, therefore every bit productivity improves, rationing unemployment declines but frictional unemployment increases (as matches move to a greater extent than difficult). Michaillat’s model is non New Keynesian, every bit in that location is no toll rigidity, but in that location is no ground why toll rigidity could non endure added. Blanchard as well as Gali (2010) is a NK model amongst matching frictions, but constant returns rules out rationing.

[3] I exercise non squall upward they volition rising enough, because inwards the measure formulation the unemployed are even therefore ‘enjoying’ their additional leisure. One solar daytime macroeconomists volition experience able to banknote that inwards reality most sentiment the cost of beingness unemployed every bit far greater than its pecuniary cost less whatever exercise goodness they instruct from their additional leisure time. This may endure a outcome of a rational anticipation of time to come personal costs (e.g. here.) Now in that location is inwards fact an asymmetry implicit inwards the NK model: although imperfect challenger way that firms may honor it profitable to enhance production as well as continue prices unchanged next ‘small’ increases inwards demand, at some signal additional production is probable to move unprofitable. There is no equivalent signal amongst falling demand. However that potential asymmetry is unremarkably ignored. I suspect that a model of unemployment based on rationing volition arrive at asymmetries which cannot endure ignored.

The other surface area where modelling unemployment matters concerns welfare. As I receive got noted here or here), or a to a greater extent than ‘behavioural’ condition issue, but the evidence that it is in that location is here.) Now in that location is inwards fact an asymmetry implicit inwards the NK model: although imperfect challenger way that firms may honor it profitable to enhance production as well as continue prices unchanged next ‘small’ increases inwards demand, at some signal additional production is probable to move unprofitable. There is no equivalent signal amongst falling demand. However that potential asymmetry is unremarkably ignored. I suspect that a model of unemployment based on rationing volition arrive at asymmetries which cannot endure ignored.

The other surface area where modelling unemployment matters concerns welfare. As I receive got noted undeniable. And delight exercise non tell me that microfounding this unhappiness is hard - why should macro endure the exclusively house where behavioural economic science is non allowed to enter!? (There is a literature on using wellbeing information to brand valuations.) Once nosotros receive got got this fight of reality (back?) into macro, it should endure much to a greater extent than hard for policymakers to give up on the unemployed.

References (some amongst links inwards the primary text)

Olivier Blanchard & Jordi Galí (2010), Labor Markets as well as Monetary Policy: H5N1 New Keynesian Model amongst Unemployment,  American Economic Journal: Macroeconomics, vol. 2(2), pages 1-30

Hansen, Gary D (1985) “Indivisible Labour as well as the Business Cycle” Journal of Monetary Economics 16, 309-327

Hansen, Gary D as well as Wright, Randall (1992) “The Labour Market inwards Real Business Cycle Theory” Federal Reserve Bank of Minneapolis Quarterly Review 16, 2-12.

Pascal Michaillat (2012), Do Matching Frictions Explain Unemployment? Not inwards Bad Times, American Economic Review, vol. 102(4), pages 1721-50.

Shimer, R. ‘Labor Markets as well as Business Cycles’, Princeton, NJ: Princeton University Press, 2010.