Do Novel Keynesians Assume Total Employment?

I’ve tried to write this every bit jargon gratis every bit I can, but it is mainly for economists

Nick Rowe claims that the New Keynesian model assumes total employment. I intend he is onto something, but spell he treats it every bit a job amongst the model, I intend it is a job amongst the existent world.

Nick sets upwards a uncomplicated consumption alone economic scheme amongst infinitely lived self employed workers, where nosotros are at the steady state (=long run) marking of consumption C(t)= output Y(t)=100. Then something bad happens (what macroeconomists telephone squall upwards a shock):

“every agent has a bad illustration of brute spirits. There's a sunspot. Or someone forgets to sacrifice a goat. So each agent expects every other agent to eat at C(t)=50 from instantly on. ... So each agent expects his income to live on 50 per menstruum from instantly on. So each agent realises that he must cutting his consumption to 50 per menstruum from instantly on too, otherwise he volition receive got to borrow to finance his negative saving as well as volition larn deeper as well as deeper into debt, till he hits his borrowing restrain as well as is forced to cutting his consumption below 50 thus he tin pay at to the lowest degree the involvement on his debt.”

To set it to a greater extent than formally: each agent believes the steady state marking of output has fallen. That inward plough has to imply that everyone makes a error almost the desired labour render of everyone else. I assume this is a false belief. If the belief was correct, thus at that spot is no problem: the steady state marking of output should fall, because people wishing to a greater extent than leisure as well as less work.

Nick says that at that spot is cypher a monetary authorization that controls the existent involvement charge per unit of measurement tin exercise almost this false belief almost the steady state, because changing existent rates alone changes the profile of consumption (shifting consumption from the futurity to the present) as well as non its overall level. That is correct. Furthermore if each private only assumes what they intend is true, as well as does non fifty-fifty bother to offering his pre-shock marking of labour to others, thus this is indeed a novel equilibrium which the monetary authorization tin exercise cypher about.

But people as well as economies are non similar that. Each agent wants to operate at the pre-shock level, as well as volition dot that inward some way. They volition run into that the economic scheme had widespread underemployment, as well as every bit a lawsuit they volition revise their expectations almost the steady state. I intend Nick knows that, because he writes that the NK model needs “to just assume the economic scheme ever approaches total work inward the restrain every bit fourth dimension goes to infinity, otherwise our Phiilips Curve tells us nosotros volition eventually larn hyperinflation or hyperdeflation, as well as nosotros can't receive got our model predicting that, tin we.”

He treats that every bit if it were a problem, but I exercise non run into that it is. After all, nosotros receive got no job amongst the sentiment that consumers volition revise downward their expectations of their futurity income if they unexpectedly notice they are ever inward debt. Equally I receive got no job amongst the sentiment that inward Nick’s economic scheme amongst widespread as well as visible involuntary underemployment consumers powerfulness intend they had made a error almost others desired labour supply.

Let me set it some other way. In a unmarried individual economic scheme nosotros never larn underemployment. The job arises because inward a existent economic scheme nosotros bespeak to cast expectations almost what others volition do. But if at that spot be signals which help us larn our expectations right, that should shift us out of a false belief equilibrium.

Which gets us to why I intend Nick is on to something almost the existent world. Suppose at that spot is a daze similar a financial crisis, which for the sake of declaration exactly temporarily reduces demand yesteryear a lot as well as creates unemployment. Central banks cannot cutting existent involvement rates plenty to larn rid of the unemployment because of the null lower bound. Inflation falls, but because everyone initially thinks this is all temporary, as well as mayhap also because of an aversion to nominal wage cuts, nosotros larn a small-scale autumn inward inflation.

Now suppose people erroneously revise downward their beliefs almost steady state output, to live on to a greater extent than similar electrical current output. Suppose also that visible unemployment goes away, because firms substitute labour for working capital alphabetic quality (UK) or workers larn discouraged (US). We larn to what looks similar Nick’s bad equilibrium. Even inflation moves dorsum to target, because the electrical current output gap appears to disappear. We no longer receive got whatever signals that at that spot is an alternative, improve for everyone, inflation at target equilibrium amongst higher output.

Now nosotros could travel out of this bad equilibrium, if some positive daze or monetary/fiscal policy raised demand ‘temporarily’ as well as people saw that, because firms substituted working capital alphabetic quality for labour, or discouraged workers came dorsum into the labour force, inflation did non ascension good higher upwards target. But suppose policymakers also commencement to concord these erroneous beliefs, as well as thus exercise non endeavour as well as larn us out of the bad equilibrium. Could that pull the secular stagnation nosotros are in?