Blog Post

Blogs review: Understanding New-Keynesian models

What’s at stake: Many academics and policymakers have felt uncomfortable with the bold and often paradoxical predictions of New-Keynesian models at the zero lower bound. But few have managed to provide a satisfying criticism, as the mechanics of these models often remain mysterious. A recent tractable formulation of the New-Keynesian liquidity trap by Ivan Werming has helped streamline the model to its essence and has generated important contributions that help clarify its mechanics.

By: Date: January 8, 2014 Topic: Global Economics & Governance

What’s at stake: Many academics and policymakers have felt uncomfortable with the bold and often paradoxical predictions of New-Keynesian models at the zero lower bound. But few have managed to provide a satisfying criticism, as the mechanics of these models often remain mysterious. A recent tractable formulation of the New-Keynesian liquidity trap by Ivan Werming has helped streamline the model to its essence and has generated important contributions that help clarify its mechanics.

Every law of economics changes sign at the zero bound

Johannes Wieland writes that New-Keynesian models, originally designed and estimated to match normal times, robustly make two predictions at the ZLB: First, demand-side policies are very stimulative and, second, negative supply shocks are expansionary. While many are skeptical whether these models describe the ZLB accurately enough to justify such bold policy choices, actual policy decisions in the U.S. and other countries have been based on these propositions.

Paul Krugman writes the liquidity trap is puts us in a world of topsy-turvy, in which many of the usual rules of economics cease to hold. John Cochrane writes that New-Keynesian models predict that fully expected future inflation is a good thing. Growth is bad. Deliberate destruction of output, capital, and productivity raise GDP. "Forward guidance," and commitments to keep interest rates low for long periods, with no current action, stimulate the current level of consumption. Government spending, even if financed by current taxation, and even if completely wasted, of the digging ditches and filling them up type can have huge output multipliers.

Understanding New Keynesian multipliers

Arnold Kling writes that advocates of Keynesian stimulus use the old Keynesian model to persuade laymen and policymakers and use the new Keynesian model to fend off other economists. You tell the simplistic “spending creates jobs, and jobs create spending” story to the public, and you tell a mathematically elegant but quite different intertemporal substitution story in academic work.

John Cochrane writes that the heart of the New-Keynesian model is a completely different view of consumption than that of Old Keynesian models. People in this model think about the future when deciding how much to consume and allocate consumption today vs. tomorrow looking at the real interest rate. In its simplest form, the FOC Euler equation is given by:

In this model, totally wasted government spending can raise consumption and output, but by a radically different mechanism. Government spending raises inflation π (as it pushes output closer to potential and there is a New-Keynesian Phillips curve). Holding nominal interest rates i fixed, either at the zero bound or with Fed cooperation, more inflation π means lower real interest rates. It induces consumers to spend their money today rather than in the future. The old-Keynesian model is driven completely by an income effect with no substitution effect. Consumers don’t think about today vs. the future at all. The new-Keynesian model based on the intertemporal substitution effect with no income effect at all.

John Cochrane writes that you might think that if you have to pay taxes to the government, which buys output to throw it away, you’ll have to consume less. But the logical structure of the models is, roughly, that you first decide how much you want to consume, then you’ll work hard enough to make the required income. If consumption is determined first by the Euler equation, then you just work harder to pay taxes and make the stuff the government wants to throw away. That gives us a multiplier of one, not zero, and then inflation kicks in to raise desired consumption and give us a larger multiplier.

Paul Krugman writes that the reason the classic Keynesian multiplier isn’t in NK models is not because it has been disproved, but because such models deliberately give hostages — they show that Keynesian outcomes can emerge even if you assume rational expectations and intertemporal blah blah. Many people who do such models consider this a useful strategy, but remain open to the possibility that given real-world imperfections the classic story also has explanatory power.

Are negative supply shocks expansionary at the ZLB?

Johannes Wieland writes that solving the Euler equation forward illustrates that today’s consumption depends on the sum of expected real interest rates and expected consumption in the far future. Thus, consumption today is high relative to the long-run consumption level if the expected path of real interest rates is relatively low, and vice-versa (p is a discount rate, v is a demand shifter).

Standard sticky-price models predict that temporary, negative supply shocks are expansionary at the ZLB because they lower expected real interest rates, which stimulates consumption. After demonstrating that negative supply shocks are contractionary in the data, Wieland writes that a less restrictive Euler equation is needed to match the contraction of consumption. In particular, the demand shifter has to respond to the negative supply shock (denoted below by u) in a way that offsets the effects of the decline in real interest rates from higher expected inflation.

There are several mechanisms that can generate this dependency. For example, if nominal wages are sticky and a large fraction of consumers are hand-to-mouth, then a negative supply shock can be contractionary because it lowers real income for these consumers. Another possibility is that negative supply shocks endogenously raise uncertainty in the economy, which will raise precautionary savings for a given real interest rate.

Johannes Wieland focuses on another mechanism where a negative supply shock lowers firm profits and asset values, which reduces net worth at banks. These banks then reduce loan supply, which raises borrowing costs so that borrowers’ consumption contracts. Because a negative supply shock reduces profits and share values, the net worth of financial intermediaries falls, tightening their balance sheet constraints. In turn, banks contract loan supply, the borrowing spread rises, and borrowers reduce consumption such that negative supply shocks are contractionary at the ZLB. In the calibrated model with credit frictions, demand-side policies are up to 50% less effective than in a standard new Keynesian model.

Determinacy and inflation

John Cochrane writes that New Keynesian models offer a fundamentally different mechanism for determinacy of inflation than the Taylor-rule. The common-sense story for inflation control via the Taylor rule is this: Inflation rises 1%, the Fed raises rates 1.5% so real rates rise 0.5%, "demand" falls, and inflation subsides. In a new-Keynesian model, by contrast, if inflation rises 1%, the Fed engineers a hyperinflation where inflation will rise more and more! Not liking this threat, the private sector jumps to an alternative equilibrium in which inflation doesn’t rise in the first place. New Keynesian models try to attain "determinacy" — choose one of many equilibria — by supposing that the Fed deliberately introduces "instability" (eigenvalues greater than one in system dynamics).

John Cochrane shows that the equilibrium with paradoxical implication depends on the level of inflation agents expect after the trap ends. If people think we must have exactly zero inflation (deviation from long run trend) as soon as the trap ends, then we will experience the new-Keynesian recession and its paradoxical policy implications. If people expect that we can retain a mild inflation and then a smoothly declining inflation, then we will experience a benign period during the liquidity trap and magical policies will not work.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

View comments
Read article More on this topic More by this author

Blog Post

Economy of Intangibles

Economists have been discussing the implications of the rise of the intangible economy in relation to the secular stagnation hypothesis, and looking more generally into the policy implications it has for taxation. We review some recent contributions.

By: Silvia Merler Topic: Finance & Financial Regulation Date: July 16, 2018
Read article More on this topic More by this author

Blog Post

World Cup Economics

As we approach the final rounds of the tournament, here are some recent contributions about the economics and economic impact of the World Cup.

By: Silvia Merler Topic: Global Economics & Governance Date: July 9, 2018
Read article More on this topic More by this author

Blog Post

US tariffs and China's holding of Treasuries

China has the biggest bilateral trade surplus vis-à-vis the US but is also a top holder of US government bonds. While China has started to counteract US trade tariffs, economists have been discussing the case of China acting on its holdings of US Treasuries. We review recent contributions.

By: Silvia Merler Topic: Global Economics & Governance Date: July 2, 2018
Read article More on this topic More by this author

Blog Post

The Meseberg declaration and euro-zone reform

The recent Franco-German Meseberg declaration will set the scene for next week’s summit. We review opinions on this important agreement.

By: Silvia Merler Topic: European Macroeconomics & Governance Date: June 25, 2018
Read article More on this topic More by this author

Blog Post

Demographics and Long Run Growth

Scholars have been investigating the relationship between demographics and long term growth, in the context of the secular stagnation hypothesis. We review recent contributions.

By: Silvia Merler Topic: Global Economics & Governance Date: June 18, 2018
Read article More on this topic More by this author

Blog Post

The Italian mini-BOT debate

Talks of parallel currency are not new in Italy. But one of the proposals – the so called mini-BOT – has made it into the government contract that underpins the current League-M5S coalition. We review what has been said about these proposals.

By: Silvia Merler Topic: Finance & Financial Regulation Date: June 11, 2018
Read article More on this topic More by this author

Blog Post

The Italian Crisis

While Italy has been through one of the gravest institutional crises in its history, we review recent opinions on the topic.

By: Silvia Merler Topic: European Macroeconomics & Governance Date: June 4, 2018
Read article More on this topic More by this author

Blog Post

China’s new role in the global economy

The changing role of China in the world economy has recently been highlighted by its registering of a first current account deficit in 17 years. We review the economists’ analyses of this new role and associated challenges.

By: Nicolas Moës Topic: Global Economics & Governance Date: May 28, 2018
Read article More on this topic More by this author

Blog Post

Argentina’s troubles

Argentina has abruptly called on the International Monetary Fund for financial help, amid currency pressures. We review recent economists’ position on this.

By: Silvia Merler Topic: Global Economics & Governance Date: May 22, 2018
Read article More on this topic More by this author

Blog Post

200 Years of Karl Marx

May 5th 2018 marked the 200th anniversary of the birth of Karl Marx. We review some economists’ takes on the controversial philosopher’s legacy.

By: Silvia Merler Topic: Global Economics & Governance Date: May 14, 2018
Read article More on this topic More by this author

Blog Post

Did Economics Fail?

The debate about rethinking economics keeps rambling. We summarise newest contributions to this important discussion.

By: Silvia Merler Topic: Global Economics & Governance Date: May 7, 2018
Read article More on this topic More by this author

Blog Post

The cost of remittances

Remittances flows are very important for developing countries. In 2009 the G8 pledged to reduce the cost of remittances to 5%, a commitment that was endorsed by the G20 in 2011 and 2014, and included in the UN’s Sustainable Development Goals in 2015. What is the cost today, and what are economists’ suggestions to reduce it?

By: Silvia Merler Topic: Global Economics & Governance Date: April 30, 2018
Load more posts