How Seriously Should We Take the New Keynesian Model?

Calvo pricing Google Search

Nick Rowe continues his long twilight struggle to try to take the New Keynesian-DSGE seriously, to understand what the model says, and to explain what is really going on in the New Keynesian DSGE model to the world. I said that I think this is a Sisyphean task. Let me expand on that here:

Now there is a long–and very successful–tradition in the natural sciences of taking the model that produces the right numbers seriously. Max Planck introduced a mathematical fudge in order to fit the cavity-radiation spectrum. Taking that fudge seriously produced quantum mechanics. Maxwell’s equations produced equivalent effects via two very different physical processes from moving a wire near a magnet and moving a magnet near a wire. Taking that equivalence seriously produced relativity theory.

And economists think they ought to be engaged in the same business of taking what their models say seriously. They shouldn’t. For one thing, their models don’t capture what is going on in the real world with any precision. For another, their models’ fudge factors lack hooks into possible underlying processes.

Now to business:

In the basic New Keynesian model, you see, the central bank “sets the nominal interest rate” and that, combined with the inflation rate, produces the real interest rate that people face when they use their Euler equation to decide how much less (or more) than their income they should spend. When the interest rate high, saving to spend later is expensive and so people do less of it and spend more now. When the interest rate is low, saving to spend later is cheap and so people do more of it and spend less now.

But how does the central bank “set the nominal interest rate” in practice? What does it physically (or, rather, financially) do?


In a normal IS-LM model, there are three commodities:

  1. currently-produced goods and services,
  2. bonds, and
  3. money.

In a normal IS-LM model, the central bank raises the interest rate by selling some of the bonds it has in its portfolio for cash and burns the cash it thus collects (for cash is, remember, nothing but a nominal liability of the central bank). It thus creates an excess supply (at the previous interest rate) for bonds and an excess demand (at the previous interest rate) for cash. Those wanting to hold more cash slow down their purchases of currently-produced goods and services (thus creating an excess supply of currently produced goods and services) and sell some of their bonds (thus decreasing the excess supply of bonds). Those wanting to hold fewer bonds sell bonds for cash. Thus the interest rate rises, the flow quantity of currently-produced goods and services falls, and the sticky price of currently-produced goods and services stays where it is. Adjustment continues until supply equals demand for both money and bonds at the new equilibrium interest rate and at a new flow quantity of currently produced goods and services.

In the New Keynesian model?…

Nick Rowe: Cheshire Cats and New Keynesian Central Banks:

How can money disappear from a New Keynesian model, but the Central Bank still set a nominal rate of interest and create a recession by setting it too high?…

Ignore what New Keynesians say about their own New Keynesian models and listen to me instead. I will tell you how it is possible…. The Cheshire Cat has disappeared, but its smile remains. And its smile (or frown) has real effects. The New Keynesian model is a model of a monetary exchange economy, not a barter economy. The rate of interest is the rate of interest paid on central bank money, not on bonds. Raising the interest rate paid on money creates an excess demand for money which creates a recession. Or it makes no sense at all.

I will take “it makes no sense at all” for $2000, Alex…

Either there is a normal money-supply money-demand sector behind the model, which is brought out whenever it is wanted but suppressed whenever it raises issues that the model builders want ignored, or it makes no sense at all…

October 2, 2016


Brad DeLong
Connect with us!

Explore the Equitable Growth network of experts around the country and get answers to today's most pressing questions!

Get in Touch