Comments On Lavatory Cochrane's Critique Of Novel Keynesian Models

I am in ane lawsuit once to a greater extent than looking at ane of John Cochrane's papers. He has written a novel working paper, "The New Keynesian Liquidity Trap", inward which he explains the rather foreign properties of the New Keynesian models when they hitting the Zero Lower Bound for involvement rates. He likewise wrote an op-ed for the Wall Street Journal inward which he questions the instance for financial activism which is based on those models. I recall this is a adept illustration of the dysfunctional nature of mainstream economic science - I grip amongst his analysis of the 'New Keynesian' models, just I recall his policy views brand really piffling sense.

Disconnect Between Theory And Policy Discussion

There were a number of responses to this article, including Paul Krugman, Noah Smith and Paul Krugman, Nick Rowe. They largely verbalize over the arguably to a greater extent than interesting theme of whether the lack of "demand" is the crusade for the concluding recession as well as subsequent deadening increment (Paul Krugman objected to how Cochrane stuck demand inward scare quotes) versus an alternative explanation of doubtfulness (presumably caused past times President Obama). I did non encounter whatever give-and-take of the observations of the problems inside the New Keynesian methodology, which was the actual theoretical content of the newspaper that allegedly triggered this latest circular of arguments over financial policy.

This fence is a demonstration of the weaknesses of the approved methods of discussing economic science inside the mainstream. Mathematical models, amongst highly complex soundless wildly unrealistic properties are postulated, just are non properly solved. Some observations are made well-nigh what a solution powerfulness await like, as well as so these observations are stretched into categorical commandments well-nigh economical policy inward the existent world. Other researchers so follow almost just the same procedure, just they produce out to produce a organisation for which the contrary of the given belongings holds, as well as they therefore tin sack dispute those policy prescriptions..

Why bother amongst the mathematical formalism if all nosotros halt upwards amongst is the equivalent of a belatedly nighttime dorm room declaration well-nigh topics that volition never hold upwards resolved?

Problems With New Keynesian Models

If nosotros strip out the never-ending declaration well-nigh the role of the authorities inward the economy, John Cochrane's working newspaper offers an understandable explanation of New Keynesian modelling methodology (understandable assuming that you lot convey a mathematical background...), as well as what the "Zero Lower Bound" enquiry is all about.

I cannot endeavour to comprehend all the details of the working paper. But to summarise the New Keynesian methodology:

1. The New Keynesian modellers write downwards a complicated nonlinear optimsation problem, which is "microfounded".
2. A linear model is generated from this nonlinear model. Incidentally, this stride breaks the stock-flow consistency of the model, assuming that the nonlinear model was inward fact stock-flow consistent.
3. Solutions to this linear model are generated; as well as since the linear model is under-determined, some way of selecting the "correct" solution has to decided upon. (These solutions are called "equilibria", which is a meaningless term mathematically inward this context.)

John Cochrane follows "the rules of the game" (the touchstone ways of finding solutions inward the literature) inward discussing these model solutions. In gild to larn large financial multipliers at the Zero Lower Bound, a exceptional ready of solutions had to hold upwards chosen. But it is possible to pick out some other ready of solutions, which truly await to a greater extent than sensible, where financial policy is in ane lawsuit to a greater extent than largely ineffective. The belief is that key banking concern policy forces the choice of ane solution or another. That is, key banking concern policy is non truly aimed at affecting the path of the economic scheme past times setting the marking of involvement rate, rather it forces the electrical current dry ground of the economic scheme to snap to a electrical current marking past times somehow making it known that it volition hold upwards next a exceptional dominion for all eternity. (Yes, that does audio similar third-rate mysticism.)

(By way of background, financial policy appears ineffective inside DSGE models for iii primary reasons:

1. monetary policy rules would cancel out whatever final result of financial policy; 
2. fiscal policy has to passively adjust to monetary policy equally a final result of the Inter-temporal Governmental Budget Constraint (IGBC);
3. Ricardian Equivalence - households volition salve for higher time to come taxes if at that spot is a loosening of financial policy inward the present.

Correspondingly, the "multiplier" on financial spending is usually much lower than 1 inside these models.)


He points out that the solution ("equilibrium") would hold upwards pinned downwards past times the Fiscal Theory of the Price Level (Paul Krugman, explained farther here). But the Fiscal Theory of the Price Level is based upon the IGBC, as well as that constraint disappears when the organisation is linearised, as well as so it does non appear when nosotros follow the "rules" ready downwards past times New Keynesian economists to determine which solution to choose.

I am inward understanding that financial policy would drive the choice of the solution. More generally, all of the global properties of the master nonlinear organisation are needed to determine the beingness as well as uniqueness of solutions. This decision needs to hold upwards addressed before the linearisation step.

As I discussed inward my previous article, Paul Krugman, I recall the mathematical foundation of the IGBC is flawed. But fifty-fifty if nosotros overlook that major issue, the problems that John Cochrane identifies appear to hold upwards the final result of a piteous specification of financial policy. Most of the solutions to the New Keynesian models exhibit runaway inflation (which is solely tamed past times key banking concern policy rules). But rising nominal gross domestic product typically causes unforeseen financial tightening (more income as well as sales taxes, indexation of authorities benefits lags inflation past times a year), which acts equally a brake on inflation. Fiscal policy needs to hold upwards actively loosened to overcome these effects to let the inflation to continue.

(c) Brian Romanchuk 2014