Woodford’s Unanswered Questions

Print/Save PDF


Last week’s post cited Michael Woodford. He has long exercised outsized influence on New Keynesian macroeconomics. His status was captured in a conversation I had at a Fed dinner a few years after the publication of Woodford’s Interest and Prices: Foundations of a Theory of Monetary Policy (2003). A high-ranking macroeconomist at the Board of Governors, conceding that  young economists in the Research Division often seem dispirited, cheerfully explained to me why: “How can it not be discouraging when Woodford has answered all the important stabilization questions?”

Interest and Prices is obviously a product of a fine intellect with a great command of the mainstream macro literature. Unlike many modern theorists, Woodford worries about practical policymaking. That said, the proper question, provided weight by the 2007-09 Great Recession, about his substantial book is opposite from that offered by the senior Fed staffer: Why does Woodford fail to answer, or even address, the most important stabilization questions? Given the context provided by the GEM Project’s generalization of rational, price-mediated exchange, the answer does not surprise. Ambitions for stabilization relevancy were doomed by his decision to construct Interest and Prices within the framework of the consensus micro-coherent, general-market-equilibrium model. Deprived of microfounded nominal wage rigidity capable of suppressing labor-price recontracting, much of his analysis is pushed outside the usable macro core. Woodford’s playbook for monetary policymaking is, to be kind, unhelpful. It properly remained on the shelf, unconsulted, when the Fed leadership confronted the virulent demand contraction and associated huge forced job loss that began in late 2008.

Much of Woodford’s book is best understood as a Ptolemaic dance choreographed to avoid confronting the micro-coherent macro necessity of suppressing wage recontracting, repeatedly and cumulatively giving ground on the need to actively manage total spending and real-side instability. In Interest and Prices, the central stabilization problem is rooted in the Fed’s capacity to distinguish between (i) adverse demand disturbances that, in combination with relevant market frictions, induce short-lived market inefficiency and (ii) spending slowdowns associated with market-efficient reallocations of resources. The focus on distinguishing between slight deviations in the longer-term growth path that are inefficient or efficient follows from the mainstream model class that inherently restricts cyclical contractions in employment to be voluntary and therefore very small.

That peculiar identification of the central stabilization problem leads to peculiar stabilization-policy advice. From Woodford’s book: “… because of the difficulty involved in measuring the efficient level of economic activity in real time – depending as this does on variations in production costs, consumption needs, and investment opportunities – it may well be more convenient for a central bank to concern itself with monitoring the stability of prices.” (That is what young Fed macroeconomists were to understand to be the final word on monetary policymaking?) The wimpish, incorrect advice focusing on policymaker convenience  does little more than call attention to the analytical corner Woodford has been backed into by his inability to microfound MWR. Endogenous MWR would uniquely enable involuntary job loss to exist, lifting the micro-coherence restriction that recessions exclude involuntary job loss and must, therefore, be exceptionally mild. Woodford cannot play by mainstream New Keynesian market-centric rules and still generate recognizable employment cyclicality.

Actively avoiding wage recontracting, Interest and Prices ducks crucial stabilization questions. Woodford simply asserts his preference for introducing nominal stickiness via product prices, pushing aside meaningful consideration of wage rigidity. The damage to his capacity to deal effectively with job fluctuations is acknowledged by his elimination of employment from Interest and Prices models and simulation exercises. (Has a book claiming to be a comprehensive, stabilization-relevant treatment of macroeconomics ever before not included “employment” in its index? “Inflation” entries occupy an entire page.) Interest and Prices ultimately stands or falls on Woodford’s fundamental bet that downward labor-price rigidity and employment do not much matter to policymakers’ adequate understanding of macro stabilization. (Woodford’s “New” Keynesians would be better named “Very Much Not” Keynesians.)  In the decade-plus after his book’s publication, his anti-Keynesian wager looks foolish in the context provided by the 2007-09 Great Recession. The new generation of macro scholars can cheer up; they still have a great deal to accomplish, especially at central banks. A close look at the GEM Project website would jump start efforts to clean up the damage produced by Woodford and the New Keynesians.

Blog Type: New Keynesians Saint Joseph, Michigan



Write a Comment

Your email address will not be published.