Ptolemaic Woes: New Keynesian 3-Equation Model

The severely compacted New Keynesian (NK) 3-Equation macro model has long been the  mainstream workhorse for stabilization analysis. From Blanchard (2013, pp.214-15): “The model is simple, analytically convenient, and has largely replaced the IS-LM model as the basic model of fluctuations in graduate courses (although not yet in undergraduate textbooks). Similar to the IS-LM model, it reduces a complex reality to a few simple equations. Unlike the IS-LM model, it is formally, rather than informally, derived from optimization by firms and consumers.”

This post is much less sanguine than Blanchard. It argues that the NK model is a poster child for the debilitating role of Ptolemaic thinking in modern macroeconomics. It has earned a central place in the GEM Blog’s on-going series on the modern dominance of the Ptolemaic approach, in which the defense of consensus market-centric general-equilibrium theory is the primary objective of research. In today’s academy, explaining important evidence or effectively advising policymakers has become secondary, to be sacrificed whenever they conflict with the application and dissemination of the established model class.

Blanchard (p.214) provides thumbnail descriptions of the three NK equations:

• “First, the aggregate demand equation is derived from the first-order conditions of rational consumer behavior, which make consumption a function of the real interest rate and future expected consumption. As there is no other source of demand in the basic model, consumption outlays is equivalent to total spending. Given the assumption that, so long as the marginal cost is less than the price, price setters satisfy demand at existing prices; and thus, aggregate demand is equal to output. Putting the assumptions together, the first relation gives us output as a function of the real interest rate and future expected output.
• “Second, under the Calvo specification, the Phillips equation makes inflation a function of expected future inflation and an “output gap,” defined as actual output minus what it would be absent nominal rigidities.
• “Third, the monetary policy rule is formalized as a Taylor rule, a reaction function giving the real interest rate chosen by the central bank as a function of inflation and the output gap. (Nominal money does not explicitly appear in the model: The assumption is that the central bank can adjust the nominal money stock so as to achieve any real interest rate it wants. What matters for activity is the real interest rate, not nominal money per se.)”

What follows compares the market-centric NK framework to the generalized-exchange modeling featured in the GEM Project. Consider first the aggregate-demand equation, in which consumption is a function of the real interest rate and future expected income. By contrast, the fully microfounded GEM theory makes income the predominate determinant of consumption, with interest rates playing a very minor role. The centrality of income is the overwhelming message of the evidence and intuition. Moreover, in the GEM Project, income-dominance  is derived from optimizing firms and households whenever meaningful wage rigidity (MWR) and market disequilibrium exist. Barro and Grossman (1971, 1974) first demonstrated that rational MWR microfounds income primacy in consumption. Rational NK interest-rate significance is restricted to the imaginary case of general market equilibrium. Here’s a bit of a secret. NK theorists know that such equilibrium does not exist in the real world. At the heart of their Ptolemaic behavior is the pretense that it does.

The second equation is a much modified Phillips curve, attempting to motivate the real-nominal nexus at the core of stabilization-relevant macroeconomics. It is the unsurprising wellspring of the most debilitating problems for market-centric general-equilibrium theorists, forcing this post to confine itself a few highlights of really bad analysis. The Calvo specification, used wholly because of its analytic convenience, imposes restrictions on pricing that force behavior to be irrational. The disconnect is so fundamental with respect to labor-price recontracting that NK macrodynamics pushes wages aside. The only “nominal rigidities” permissible are rooted in frictions that are consistent with market-centric general equilibrium, inherently excluding MWR. The omission  renders the 3-Equation model incapable of accommodating involuntary job loss as well as recognizably-sized fluctuations in output, employment, and income that demonstrably result from disturbances in nominal demand.

Rational MWR, derived in the GEM Project, uniquely suppresses wage recontracting, making it the keystone of the nominal-real nexus that enables macroeconomics to be simultaneously stabilization-relevant and micro-coherent. Its absence produces metastasizing deficiencies in the 3-Equation model. Consider one consequential example, chosen because it is always ignored. MWR is central to the existence and optimizing time-path of pure profit, enabling its dominance in the rational management of production capability in modern, highly specialized economies. Recognizable profits cannot exist in the consensus market-centric general-equilibrium model and are inadequately replaced by interest rates. Unsurprisingly, investment is also omitted in the 3-Equation model. Who decided that it is OK to suppress the most volatile spending category? Early Keynesians emphasized investment and its determinants in their workhorse Neoclassical Synthesis, analysis that remains useful but is snubbed in today’s Ptolemaic mainstream.

The third equation reaps the practical irrelevance of the first two, reducing NK stabilization policymaking to an obviously deficient Taylor rule. Suffice it to say that nobody (except perhaps John Taylor) would have wanted, during the 2007-09 Great Recession, Ben Bernanke and other stabilization authorities to have confined their attention to a mechanical rule focused on interest rates, price inflation, and the output gap, thereby effectively ignoring what was actually happening. A much more useful policymaking roadmap is provided by the GEM model of extreme instability, constructed on generalized rational exchange, that emphasizes asset-market disruptions rooted in shifts in investor-lender confidence. That model identifies the criticality of using the Fed balance sheet to directly intervene in collapsing asset markets. Nobody who understands macro instability was shocked that the 3-Equation NK model was generally ignored during the Great Recession. Apparently, crisis greatly reduces tolerance for Ptolemaic silliness.

The NK 3-Equation model goes beyond badly misleading graduate students. NK scholars, drawing on what remains of the reputational capital built up by the original Keynesians, have been using the model as part of an extraordinary Ptolemaic campaign that misleads policymakers and the public and damages our capacity to manage future episodes of acute instability.

Blog Type: New Keynesians Chicago, Illinois