Should-Read: David Vines and Samuel Wills: rebuilding macroeconomic theory project: an analytical assessment
Should-Read: Once again: I believe this fundamentally misconceives the origins and the utility of New Keynesian models. There are things that they are good for. But there are things that they are not good for. Getting a sensitivity of aggregate demand to the real interest rate via an Euler equation is not a good thing. Calvo pricing is not a good thing. Technology shocks as putting the residual from a production function on the right hand side and claiming it as a primitive shock is not a good thing. And what else is there in a New Keynesian model? A money demand function (or an interest rate rule). That is not very much that is useful. The things that make New Keynesian models different from VARs are, pretty much, things that make them less accurate and valuable. Do a VAR. And then argue about what the underlying shocks behind the VAR shocks really are, and how the VAR impulse response coefficients constrain the underlying structural shock ones: David Vines and Samuel Wills: rebuilding macroeconomic theory project: an analytical assessment: “We asked a number of leading macroeconomists to describe how the benchmark New Keynesian model might be rebuilt…
…The need to change macroeconomic theory is similar to the situation in the 1930s, at the time of the Great Depression, and in the 1970s, when inflationary pressures were unsustainable. Four main changes to the core model are recommended: to emphasize financial frictions, to place a limit on the operation of rational expectations, to include heterogeneous agents, and to devise more appropriate microfoundations. Achieving these objectives requires changes to all of the behavioural equations in the model governing consumption, investment, and price setting, and also the insertion of a wedge between the interest rate set by policy-makers and that facing consumers and investors. In our view, the result will not be a paradigm shift, but an evolution towards a more pluralist discipline…