Evening Must-Read: Olivier Blanchard (2008): The State of Macro

Olivier Blanchard (2008): The State of Macro: “The so-called new-Keynesian (or NK) model…

…has emerged and become a workhorse.… The model starts from the RBC model without capital, and… introduces monopolistic competition in the goods market…. If the economy is going to have price setters, they better have some monopoly power. It then introduces discrete nominal price setting, using a formulation introduced by Calvo… which turns out to be the most analytically convenient…. [It] has largely replaced the IS-LM model as the basic model of fluctuations in graduate courses…. 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…. The costs are that… the first two equations of the model are patently false.… The aggregate demand equation ignores the existence of investment, and relies on an intertemporal substitution effect… hard to detect in the data on consumers. The inflation equation implies a purely forward looking behavior of inflation, which again appears strongly at odds with the data…. One striking (and unpleasant) characteristic… is that there is no unemployment! Movements take place along a labor supply curve…. One has a sense… that this may give a misleading description of fluctuations, in positive terms, and, even more so, in normative terms…

February 11, 2015

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