Saturday, January 21, 2012

New Keynesian Stimulus

One piece of interesting economics did come up while I was looking through the stimulus blogwars.

Paul Krugman pointed to New Keynesian stimulus models in a recent post, When Some Rigor Helps.
But take an NK [New-Keynesian] model like Mike Woodford’s (pdf) — a model in which everyone maximizes given a budget constraint, in which by construction all the accounting identities are honored, and in which it is assumed that everyone perfectly anticipates future taxes and all that— and you find immediately that a temporary rise in G produces a rise in Y"...

So I guess I’d urge all the people now engaging in contorted debates about what S=I does and does not imply to read Mike first, and see whether you have any point left. 
As it happens, I've spent a lot of time reading and teaching New Keynesian models.

I  wrote a paper about New Keynesian models, published in the Journal of Political Economy (appendix, html on JSTOR).  I haven't totally digested the NK stimulus literature --  In addition to Mike's paper, Christiano, Eichenbaum and Rebelo; Gauti Eggertsson; Leeper Traum and Walker; Cogan, Cwik, Taylor, and Wieland are on my reading list -- but I've gotten far enough to have some sharp questions worth passing on in a blog post.

Krugman continues,
That doesn’t mean that you have to use Mike’s model or something like it every time you think about policy; by and large, ad hoc models like IS-LM are actually more useful, in my judgment

One thing I know for sure: This is wrong. (It's an understandable mistake, and many people make it.) The New Keynesian models are radically different from Old-Keynesian ISLM models. They are not a magic wand that lets you silence Lucas and Sargent and go back to the good old days.

New-Keynesian models have multiple equilibria. The model's responses -- such as the response of output to government spending or to monetary policy shocks -- are not controlled by demand and  supply.  They occur by cajoling the economy to jump to a different one of many possible equilibria. If you're going to write an honest op-ed about New Keynesian models, you really have to say "government spending will make the economy jump from one equilibrium to another."  Good luck! 

New Keynesian models offer a fundamentally different mechanism from the IS-LM or standard stories that Krugman -- and Bernanke, and lots of sensible people who think about policy -- find "actually more useful."

For example, 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). Good luck explaining that honestly!

In the context of the zero bound and multipliers, not even this mechanism can work, because the interest rate is stuck at zero. There are "multiple locally-bounded equilibria."  Some stimulus models select equilbria by supposing that for any but the chosen one, people expect that the Fed will l hyperinflate many years in the future once the zero bound is lifted. Hmmm.

These problems can be fixed, and my paper shows how. Alas, the fix completely changes the model dynamics and predictions for the economy's reaction to shocks. 

Or maybe not. I know the simple New Keynesian models suffer these problems. (That's what the JPE paper is about.)  Do they apply to the stimulus models? I don't know yet. I certainly have some sharp questions to ask, and I don't see anything in the models I've looked at with a hope of solving these problems.

Moreover, even taken at face value, the predictions of New Keynesian models are a lot different from Krugman's advertisement that more G gives more Y.

Every NK stimulus model that I have read is "Ricardian." Government spending has very large effects, even if it is financed by current taxes. Good luck writing an op-ed that says, "The government should grab a trillion of new taxes this year and spend it. We'll all be a trillion and a half better off by Christmas."  The popular appeal of stimulus comes from the idea that borrowed money doesn't transparently reduce demand as much as taxed money.  But that's the iron discipline of models -- you can't take one prediction without the other. If you don't believe in taxed stimulus, you can't use a Ricardian New Keynesian model to defend borrowed stimulus. (Or you have to construct one in which there is a big difference, which I have not found so far.)

More weird stuff, from Gauti Eggertsson's introduction
Cutting taxes on labor or capital is contractionary under the special circumstances the United States is experiencing today. Meanwhile, the effect of temporarily increasing government spending is large, much larger than under normal circumstances. Similarly, some other forms of tax cuts, such as a reduction in sales taxes and investment tax credits, as suggested, for example, by Feldstein (2002) in the context of Japan’s “Great Recession,” are extremely effective....

At positive interest rates, a labor tax cut is expansionary, as the literature has emphasized in the past. But at zero interest rates, it flips signs and tax cuts become contractionary. Similarly while capital tax cuts are almost irrelevant in the model at a positive interest rate (up to the second decimal point) they become strongly negative at zero. Meanwhile, the multiplier of government spending not only stays positive at zero interest rates but becomes almost five times larger.
Tax cuts are contractionary? The stimulus failed because the large tax cut component dragged output down? That's new, and I didn't hear Krugman complaining! Maybe it's right, but you can see we're a long long way from simple ISLM logic. Also, it's clear that these models make a sharp distinction between zero and nonzero rates, that stimulus advocates certainly do not make.

I also notice that "deflationary spirals" are a big part of the analysis. For example, in Christiano et al.,
But, in contrast to the textbook scenario, the zero-bound scenario studied in the modern literature involves a deflationary spiral which contributes to and accompanies the large fall in output.
OK, but we have near zero short-term government rates, a 3% positive rate of inflation and far from zero corporate and long term rates. Does the analysis apply?

Back to reading. I'll post again if I get more NK stimulus insights. It may take a while. I still think it's yesterday's news. Sovereign default seems more important for the future.


  1. Hello,

    Thanks for the article, I have a quick question though: what did you meant when you said "Ricardian" ?

    At this point in the blogodebates I have really lost sight of the fundamental definitions.

  2. This comment has been removed by the author.

  3. Here you go, LAL:

    Ricardian equivalence states that it doesn't matter if government spending is financed by taxes now or by deficits because taxpayers will respond to deficits by reducing consumption in anticipation of future taxes.

    Those who use Ricardian models to argue in favor of deficit spending to achieve stimulus, but who would not support a tax increase to finance that same stimulus, are treating their Ricardian models as though they are not Ricardian at all.

    That's my understanding, anyway. Hope it helps.

  4. I am a microeconomist with a very basic question for the New Keynsian folks. The model of Christiano et al. and others in this lterature assume that prices are sticky. If I am reading correctly, a numerical example in Christiano et al. assumes that the price of every input supplier in the economy is fixed at last period's value with probability .85. That is, each period there is only a 15 percent chance that an input supplier will re-optimize it's price. In the example, it appears that one period is one year. So in the face of a large negative shock, there is an 85 percent chance that each input supplier will stand and watch its demand tank for a full year without being able to respond by adjusting its price! Is this correct?

    Commodity prices plumetted in the middle of 2008. If the model requires this degree of stickiness to fit the data, the model is not wildly unrelistic. What am I missing?

    A problem I've always had with these models is that they usually make the ad hoc assumption that the speed of price adjustment is exogenous and independent of the size of the shock. However, is there any doubt that a firm's incentive to adjust price depends on the size of the shock (and probably many other factors)? "Menu costs" (or pick your favorite friction) will not cause an oil producer to hold its price 20% above market for a year as its demand plummets. What am I missing?

    Dan O'Brien

  5. On that last post: change "not wildly unrealistic" to "not realistic" or "wildly unrealistic," take your pick. I believe the latter is a better characterization, but I don't know this literature very well, so maybe someone will convince me that this view is wrong.


  6. The impression I had gotten from Steve Williamson was that most of the focus in NK had gone to sticky wage/price models, with multiple-equilibrium models being (in his opinion) unfairly neglected.

  7. Here is the criticism:

    With all due respect, you don't fully understand the rationale behind the fiscal stimuli.

    People (the NK people) who advocate them have rather the short-term effect in mind (about the long-term effect later). Economy is in crisis, and it is not a regular cyclical crisis. Probably, the proper solution would require big structural and systemic changes (and perhaps even a paradigm change). So, financial stimuli alleviate short-term difficulties while the economy and politico-economic leaders are contemplating the proper response based on the scientific and political considerations.

    There is also a long-term effect though it is probably rather of theoretical than of a practical matter, which I don't want to discuss here -- since it is still rather a work in progress and this blog is not a proper platform for that.


  8. Prof. Cochrane, I am not at your level and am just an interested dummie when we talk about economics. But there things that are not clear to me in your post:

    1. You say that inflation targeting shifts the economies's equilibrium. Ok, that's obviously true. But if I understood it correctly, they do based in the first and second wellfare theorems. So, in short, you are questioning the validity of those theorems. Is there any studies on this issue? Could it give this discussion an end? I mean, if market automatically converges to equilibrium, perhaps Krugamn's argument makes complete sense for me ....

    2. When you talk about Ricardian Equivalence, you are supposing that with a rise in government expenditures means a intertemporal decrease in consumption because the agents knows for a fact they are the ones to pay it in the future. Correct? What I don't understand is that it actually means that the impact of the government expediture will be diluted in time, so that there is an actual increase in DA in the short run. Where am I wrong?


    1. I have just found a note in a periodic that shows the obvious fact that that no price system can support as a competitive equilibrium an allocation that is not Pareto efficient by means of contraposition reasoning for the demonstration look at( At least theoreticaly, it forces us to conclude that in the absence of externalities, markets tend to converge to Pareto eficient positions.
      You can argue by saying that the very existence of regulation already means an externality and that even the most efficient market in the world is doomed to turn into a monopoly of a supereficient player. You can also argue that markets are in constant change due to facts like creative destruction and that it means that any kind of intervention is destructive due non-systematic risk. But I believe you cannot say that changing regulation hasn't got the very same problems with the adiction of political prolems such as Lobbies and interpretational distortions.
      I mean. in my ignorance, it seems to me you are offering a medicine which is by definition incapable of healing the patient. That's the reason I would love to hear your opinion on the issue ....

  9. @Mr.Cochrane
    I know I am going a bit OT, sorry for this, but today I read the following mentioning multiple equilibria:
    "Mispricing of sovereign risk and multiple equilibria in the Eurozone",
    The more general theoretical stuff about stimulus is interesting, and thank you very much for continuing to develop the argument! Nevertheless if you have time and you wish to do that, I would like to know your opinion on the euro situation.

  10. Dear John;

    I have written a blog post that discusses some aspects of your JPE paper mentioned in this blog post:

    I don't quite agree with your exposition of New Keynesian models, or lack thereof, but you will see that I generally like the paper very much.

    I hope I am not misrepresenting anything; if it's the case, feel free to comment.


    Henrik Jensen
    University of Copenhagen

  11. Mr Cochrane,
    In regards to your comments about your alleged "Iron Discipline" of models, let me give you the words of Mr Paul Krugman (,

    "Here’s what we agree on: if consumers have perfect foresight, live forever, have perfect access to capital markets, etc., then they will take into account the expected future burden of taxes to pay for government spending. If the government introduces a new program that will spend $100 billion a year forever, then taxes must ultimately go up by the present-value equivalent of $100 billion forever. Assume that consumers want to reduce consumption by the same amount every year to offset this tax burden; then consumer spending will fall by $100 billion per year to compensate, wiping out any expansionary effect of the government spending.

    But suppose that the increase in government spending is temporary, not permanent — that it will increase spending by $100 billion per year for only 1 or 2 years, not forever. This clearly implies a lower future tax burden than $100 billion a year forever, and therefore implies a fall in consumer spending of less than $100 billion per year. So the spending program IS expansionary in this case, EVEN IF you have full Ricardian equivalence."

    Understood? This is one of the talking points of the Chicago school that doesn't seem to go away. PLEASE be a part of the solution.

    1. How can you suggest that the federal government will cut spending, and that people can plan around that action, when the federal government has never cut spending? The debt under Clinton expanded by almost three trillion dollars and spending was expanded.

  12. Hi,
    just a quick heads-up: I went through the latest Werning paper on liquidity traps (admittedly not the same as any run-of-the-mill recession), and I did not notice the multiple equilibria problem or the reliance on future hyperinflation (some inflation, yes, but importantly, a boom, as he emphasizes). But he admittedly builds on a Woodford-Eggertson-type model. So what's the weakness here?

    I hope future posts will clarify the subtleties.


  13. argh! who ever said anything about hyperinflation?!? we're tailing about tolerating 4-5% inflation for a couple of years, to encourage businesses (and people) to sit on less cash and spend a bit more. (And to bring prices back up to trend.) And we're talking about the government spending a bit more (and adding to public debt) to compensate for all the people who are busy paying off their private debt.

    which part of this is hard to understand?!?


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