Blogs review: The Lucas critique and New Keynesian Models

What’s at stake: there has been a new round of discussions on the blogosphere about micro foundations in macroeconomics following a recent speech by Charles Plosser – President of the Philadelphia Fed and one of the founders of the Real Business Cycle theory – where he argued that the Lucas critique has become more as policy actions have become more discretionary. Plosser also pointed that by ruling out that the structure of the real and nominal frictions – which transmit changes in monetary policy to the real economy – is affected by changes in monetary policy, the New Keynesian framework, that is now the workhorse for macroeconomic policy analysis in central banks around the world, fails to satisfy the Lucas critique.

A Lucas critique refresher

Noah Opinion summarizes what the Lucas critique was about. In the 1970s, Robert Lucas perceived that there was a big problem in macroeconomics. Models that didn't allow for human beings to adjust their behavior couldn't be used for policy, because if you tried to use them, people would alter their behavior until the models no longer worked. This is known as the "Lucas Critique". The solution, Lucas said, was to explicitly model the behavior of human beings, and to only use macro models that took this behavior into account. This is called the "microfoundations" approach. The first research program that came along and tried to answer the Lucas Critique was the "Real Business Cycle" program. This program, spearheaded by researchers such as Ed Prescott, made use of a new modeling approach called "DSGE". It also incorporated Robert Lucas' "Rational Expectations Hypothesis".

Stephen Williamson points out that the Lucas critique was as much a problem for the money demand function as for the Phillips curve. But the perception that Lucas critique arguments are more often used against arguments favoring government intervention than against those which do not is probably correct. Economic arguments that justify no government intervention are often easy to construct and understand. Justifying intervention is hard. Try to actually define what an externality is, or to construct a Keynesian model with all the proper working parts. Those things are difficult.

Charles Plosser writes that during the 1980s and 1990s, it was quite common to hear in workshops and seminars the criticism that a model didn’t satisfy the Lucas critique. This was often a cheap shot because almost no model satisfactorily dealt with the issue. And during a period when the policy regime was apparently fairly stable, the failure to satisfy the Lucas critique seemed somewhat less troublesome. However, throughout the crisis of the last few years and its aftermath, the Lucas critique has become decidedly more relevant as policy actions have become increasingly discretionary.

The rules of the game of New Keynesian models

Charles Plosser writes that the current generation of macro models, referred to as New Keynesian DSGE models, rely on real and nominal frictions to transmit not only unanticipated but also systematic changes in monetary policy to the economy. A shortcoming many see in the simple real business cycle model is its difficulty in internally generating persistent changes in output and employment from a transitory or temporary external shock to, say, productivity. The recognition of this problem has inspired variations on the simple model, of which the New Keynesian revival is an example. The approach taken in these models is to incorporate a structure of real and nominal frictions into the real business cycle framework.

An assumption of these models is that the structure of these real and nominal frictions are not affected by changes in monetary policy. This assumption implies that the frictions faced by consumers, workers, employers, and investors cannot be eliminated at any price they might be willing to pay. Although the actors in actual economies probably recognize the incentives they have to innovate — think of the strategy to use continuous pricing on line for many goods and services — or to seek insurance to minimize the costs of the frictions, these actions and markets are ruled out by the “rules of the game” of New Keynesian DSGE modeling. When the real and nominal frictions of New Keynesian models do not reflect the incentives faced by economic actors in actual economies, these models violate the Lucas critique’s policy invariance dictum, and thus, the policy advice these models offer must be interpreted with caution.

V. V. Chari, Patrick J. Kehoe, and Ellen R. McGrattan argue that the shocks added to help New Keynesian models fit the data are dubiously structural. They make this concern concrete by critiquing the recent New Keynesian literature, as typified by the model in Smets and Wouters (2007) – a model widely considered the state-of-the-art New Keynesian model and used at the European Central Bank to help inform policymaking. Proponents of the New Keynesian model argue that it is promising for two reasons. It represents a detailed economy that can generate the type of wedges we see in the data from interpretable primitive shocks; and second, it has enough microfoundations that both their shocks and parameters are structural, in that they can reasonably be argued to be invariant to monetary policy shocks. The Smets-Wouters model has seven exogenous random variables. The authors divide these into two groups. The potentially structural shocks group includes shocks to total factor productivity, investment-specific technology, and monetary policy. The dubiously structural shocks group includes shocks to wage markups, price markups, exogenous spending, and risk premia. The wage-markup and the price-markup shocks are just reduced form shocks in the sense that they are subject to multiple interpretations with very different policy implications, while it is doubtful that the remaining two shocks are invariant with respect to policy.

Time dependent vs. State-dependent pricing and the Lucas critique

Charles Plosser points that a nominal friction often assumed in Keynesian DSGE models is that firms and households have to wait a fixed interval of time before they can reset their prices and wages in a forward-looking, optimal manner. Noah Opinion agrees with Plosser: Calvo pricing, which is one feature of New Keynesian models, seems not to satisfy the Lucas Critique. And as Plosser points out elsewhere, it also looks to be simply false. Models in which firms choose when to change their prices are much more desirable. Of course, people are working on these. But they are really hard to do, since the decision to change prices can depend on all sorts of weird, hard-to-aggregate stuff, like coordination with other price-setters. This kind of realistic behavior is very hard to shoehorn into the kludgey modeling framework of DSGE, which is why the New Keynesians have been forced to adopt Calvo Pricing as a modeling convenience.

Calvo pricing is convenient for aggregation since all firms that adjust their prices choose the same new price (as the possibility of adjustment is random, the price distribution of firms that do not adjust is just the price distribution from the previous period). State-dependent pricing (SDP) models are more attractive as they allow:

·         Time variation in the size of price changes, conditional on the firm changing its price (intensive margin);

·         Variation in the numbers of firms that change their price in a given period (the extensive margin)

·         And variation in the composition of firms that adjust (the selection effect).

But they are usually very untractable since the entire price distribution in the inaction band becomes a state variable of the problem. A recent development in this literature, exemplified by this paper by Mark Gertler and John Leahy is to simplify these problems by imposing particular restrictions and technical assumptions that allows obtaining an analytical solution for a local approximation of the problem.

Mark Gertler and John Leahy develop an analytically tractable Phillips curve based on state–dependent pricing. The resulting Phillips curve is a simple variant of the conventional time-dependent Calvo formulation with important differences. First, the model is able to match the micro evidence on the magnitude and timing of price adjustments. Second, the state-dependent model exhibits greater flexibility in the aggregate price level than the time-dependent model. With real rigidities present, however, their model can exhibit nominal stickiness similar to a conventional time-dependent model – contrary to some recent papers using SDP.

Behavioral economics and the Lucas critique

Stephen Gordon writes that a key insight of behavioral economics is that people don't always and everywhere re-optimize whenever their environments change. Instead, they will often - or even usually - make use of various rules of thumb and/or passively accept the default option. The costs of re-optimizing every time you face something new don't always offset the benefits from making what may be only a slightly better choice. This the idea behind 'nudges': you can alter people's behavior by making minor changes to the frames in which people operate: if people have the habit of choosing the default option, then you can change choices by changing the default option. But this only works if the change is subtle enough to not attract the full, direct attention of the decision-maker. If the change is big enough, people will haul out the full artillery of their rational selves in order to try figure out what optimal decision is. This means that behavioral economics is unlikely to be of much use in policy-making.