This Best Paper Is Not So Good

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The editors of the American Economic Journal: Macroeconomics (AJE:M) have selected “Deconstructing Monetary Policy Surprises – The Role of Information Shocks” by Marek Jarocinski and Peter Karadi (hereafter J&K) as the best article appearing in their journal in 2020. The authors’ first paragraph summarizes their paper:

“The extent of monetary policy nonneutrality is a classic question in macroeconomics (Christiano, Eichenbaum, and  Evans 2005). To measure the causal effect of policy, one needs to control for the variation in economic fundamentals that the policy endogenously responds to. Central bank announcements can help overcome this identification challenge. They provide an opportunity to isolate unexpected variation in policy and, hence, can be used to assess the impact of monetary policy on real activity and prices (Gertler and  Karadi 2015; Nakamura and  Steinsson 2018). However, these announcements reveal information not just about policy but also about the central bank’s assessment of the economic outlook. In this paper, we ask whether the surprises in these assessments, “central bank information shocks,” have a sizable macroeconomic impact. If they do, this provides evidence on the relevance of central bank communication and implies that disregarding these shocks can lead to biased measurements of monetary nonneutrality.”

The J&K paper takes on an important subject, claiming to improve our understanding of “the impact of monetary policy on real activity and prices”. It is not so good because it fails in that mission. It provides instead a badly misleading picture of macro instability and what to do about it  The reason is familiar to readers of this Blog. The J&K analysis is rooted in the New Keynesian go-to friction-augmented general-market-equilibrium modeling.

The GEM Project has demonstrated that market-centric framework cannot accommodate rational meaningful wage rigidity (MWR) and therefore cannot accommodate involuntary job loss. It cannot accommodate evidence-sized business cycles and the criticality of aggregate-demand management. Excluding the most important characteristics of macro instability renders FGME-based J&K analysis useless in making sense out of macro instability. Stabilization policymakers know that FGME modeling badly misleads, a fact that they made clear in the immediate aftermath of the 2008-09 extreme instability. It reflects some kind of moral bankruptcy that AJE:M editors, leaders in the macro academy, continue to promote the big lie that FGME analysis adequately describes macro instability.

The particular FGME error that trips up J&K is their assumption that central bank announcements substantially and independently influence investment and consumption spending. The evidence strongly demonstrates that pure profit and household income are the primary respective drivers of each. FGME modeling, unable to accommodate those facts, instead defaults to interest rates as the critical determinate of both. J&K motivate aggregate spending with interest-rate expectations, positing that central-bank announcements are central to total spending. (For more on the macro academy’s tortured role for interest rates, see next week’s post.)

The Project microfounds the criticality of pure profit and income as the most important drivers of investment and consumption, relegating interest rates to their proper evidence-consistent secondary status. Central-bank announcements are further diminished by issues of accuracy and credulity. J&K assign great importance to an artifact of deeply misleading FGME modeling. It is unsurprising that their paper is unimportant.

In closing, there is a much larger point to be made. The AEJ:M failure to publish important papers is a direct result of the NK fiction that friction-augmented general-market-equilibrium modeling is a finished product. There is no longer any need for fundamental microfoundations research. That fiction of convenience provides damaging incentives for theorists engaged in research and sharply limits the usefulness of the AEA’s macro journal.

Blog Type: New Keynesians Saint Joseph, Michigan

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