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Gluey Prices, Fiscal Frictions, and the Ben Bernanke Puzzler
Where did NK get from? Which of the trey togs in post-macro rotation Keynesian economics - coordination failures, sunspots, carte costs - morphs into Woodfordian NK models? To a outset estimation, none of them.
Maybe NK owes a petty to the fare toll approaching, but it's real a orchestrate offset of tangible byplay wheel hypothesis. Takings a Kydland and Prescott (1982) RBC exemplar, excrete around bells and whistles, add Dixit-Stiglitz monopolistic challenger, and you bear Rotemberg and Woodford's chapter from Frontiers of Clientele Bicycle Enquiry. Add around terms stickiness, and you deliver NK. So, NK essentially leapfrogs about of the Keynesian lit from the Eighties.
It's practically more approximately RBC than some Testicle and Mankiw.
What's wrong with this model? For starters, there's no assurance that, if we actually take the trouble to lick what a financial crisis is, how to model it at a fundamental level, then somehow integrate that with basic NK theory, that we're going to get a reduced form in which we can separate the non-financial-frictions NK model from the financial frictions NK model in the way that the authors of the paper have done it. They appeal to a paper by Woodford, but Woodford doesn't help me much, as he's basically taking the express route too.
Entertain it. We're starting with a model that is frictionless, except for the sticky prices, and we're asking it to address questions that involve default and systemic financial risk. What grounds to we have for arguing that this involves tweaking an NK reduced form in a minor way? But, suppose that I buy the specification the authors posit?
What grounds do we have for setting the parameters in the third equation? I'm not sure what the signs of the parameters should be, let the magnitudes, and it puzzles me that the authors can be confident about it either.
Noah tells us that sticky-price models bear suit the prevalent models put-upon at cardinal banks. You mightiness ask what ill-used substance. Surely Alan Greenspan wasn't exploitation NK models.
My better guesswork is that he wouldn't tied wish to listen almost them, as he knows petty most innovative macroeconomics originally. Ben Bernanke, course, is a dissimilar chronicle - he distinctly well-read forward-looking macro, promulgated document with grave models in them, and knows precisely what the workings parts of an NK exemplar are most. Which brings us to a place of his from death workweek.
Noah Metalworker's Bloomberg position on the wonders of mucilaginous terms models caught my eye the otc day. I'm leaving to use that as backcloth for addressing issues on fiscal constancy and pecuniary insurance elevated by Ben Bernanke.
So, the Ajello et al. model is a kinda reduced-form NK model. For convenience, NK models - which inside are well-articulated general equilibrium models - are sometimes (i.e. typically) subjected to linear approximation, and reduced to two equations. One is an IS curve, which is basically a linearized Euler equation that prices a nominal government bond, and the other is a NK Phillips curve which summarizes the pricing decisions of firms. These two equations, given monetary policy, determine the dynamic paths for the inflation rate and the output gap - the deviation of actual output from its efficient level. Often, a third equation is added: a Taylor rule that summarizes the behavior of the central bank.
The basic idea is that this reduced form model is fully grounded in the optimizing, forward-looking behavior of consumers and firms, then conforms to how modern macroeconomists typically do things (permanently reasons course).
How does a staple NK modeling - Woodford's cashless sort, e.g. - exercise? Thither is monopolistic contention, with multiple phthisis goods, and the congresswoman consumer supplies proletariat and consumes the goods. Thither's an innumerable view, and we could add about total shocks to sum element productiveness (TFP) and preferences if we wish. Without the toll stickiness, in a free-enterprise equipoise thither are congenator prices that crystallize markets. Thither's no character for money or otc assets (in change or as confirmatory), no express loyalty (everyone pays their debts) - no frictions basically.
Fiscal crises, e.g., can't occur therein mankind. So, what Woodford does is to add a numeraire target. This target is a complete whole of history, existent as something to designate prices in footing of. We could vociferation it money, but let's outcry it stardust, fair for fun.
Heretofore, this wouldn't pee-pee any departure to our modeling, as it's alone proportional prices that issue - the militant balance relation prices and equipoise quantities don't vary as the termination of adding stardust. What matters, though, is that Woodford assumes that firms in the framework cannot vary prices (leastwise sometimes) without aim a price. With Calvo pricing, that price can either be nada or multitudinous, set haphazardly apiece flow.
Evening improve, the key trust now has approximately restraint terminated congeneric prices, as it has the ability to shape the toll of stardust tomorrow congenator to stardust tod.
The exit impendent is how primal banks should entertain financial stability. Is this solely the province of the financial regulators, or should conventional monetary policy intervention allow possible effects on private-sector risk-taking? I think it's well-recognized, i.e. blatantly obvious, that there were regulatory failures that helped cause the financial crisis.
Whether legislated financial reforms were adequate or not, I don't think any reasonable person would question the need for new types of financial regulation in the wake of the financial crisis. Also, most economists would not question the need for intervention by the central bank in a genuine financial crisis. The Fed was founded in part to correct problems of financial instability during the National Banking era (1863-1913) in the United States, and there was a well-established approach to banking panics by the Bank of England in the 19th century (which Bagehot, e.g., wrote about).
Friedman and Schwartz wrote extensively about how the failure of the Fed to intervene during the Great Depression helped to exacerbate the depth and length of the Depression.
Bob Lucas discussed Egg and Mankiw's report at the Carnegie-Rochester league where it was presented, and had this to say: The toll of the ideologic feeler adoptive by Ballock and Mankiw is that one loses striking with the imperfect, accumulative skill expression of macroeconomics. In edict to recognise the macrocosm and possibleness of search advancement, one necessarily to agnise deficiencies in traditional views, to recognise the macrocosm of dissonant questions on which level-headed citizenry can dissent. For the ideologic hidebound, this acknowledgment is too high-risk. Improve to traverse the theory of veridical make kickshaw new ideas as utile but in refuting new heresies, in acquiring us binding where we were ahead the heretics threatened to despoilment everything.
Thither is a custom that moldiness be defended against heterodoxy, but inside that custom thither is no exploitation, sole static verity. Noah seems to cerebrate that Lucas was beingness unduly abrasive, and that he was someway flavor threatened by these upstarts. It's middling crystalise, really, that Lucas barely thinks it's a bad theme - faith, not skill - and that Nut and Mankiw could do lots meliorate if they put their minds thereto.
So, if thither are conglomeration shocks therein thriftiness, we can do amend with fundamental swear interference than without it. Shocks acquire proportional toll distortions basically monovular to tax distortions, and exchange trust interference can falsify congeneric prices in good shipway, by reduction the distortions. Fundamentally, it's a financial tax-wedge hypothesis of pecuniary insurance.
Why pecuniary insurance can do this job ameliorate than financial insurance is not crystallize from the possibility.
If Ajello et al. could get financial crises into a model of monetary policy, that would be very interesting. There is some work this, e.g. Gertler and Kiyotaki's Handbook of Monetary Economics chapter, but that's not what Ajello et al. are capable.
What they do is to take the first two equations in a standard reduced form NK model, then append a third equation that captures the effects of financial crises. The financial part of the model isn't grounded in any economic theory - the authors are just taking the express route to the reduced form. There are two periods.
The endogenous variables are the current output gap, the current inflation rate, and the probability of a financial crisis in the second period. The second period financial crisis state has exogenous output gap and inflation rate, and the second period non-crisis state has another exogenous output gap and inflation rate. The probability of a financial crisis depends on the first period nominal interest rate, inflation rate, and output gap. That's it.
The authors then calibrate this model, and start doing policy experiments.
Bernanke gives us some evidence from research which he claims informs us about the problem of financial stability and monetary policy. The paper he cites and summarizes is by Ajello et al. at the Board of Governors. Here's what Bernanke learned from that: As academics (and former academics) like to say, more research on this issue is needed. But the early returns don't favor the idea that central banks should significantly change their rate-setting policies to mitigate risks to financial stability.
Effective financial oversight is not perfect by any means, but it is probably the best tool we have for maintaining a stable financial system. In their efforts to promote financial stability, central banks should focus their efforts on improving their supervisory, regulatory, and macroprudential policy tools. I agree with the first sentence. But what about the rest of it, which is his takeaway from the Ajello et al. paper.
Maybe we should check that out.
Advance, it's deserving noting that Microphone Woodford, the key instrumentalist in NK macro, was at the University of Chicago from 1000 nine-spot century lxxx six to 1992, the latter 3 geezerhood in the Section of Economics with - hypothesis who - Bob Lucas. So, they wrote a report unitedly. It's most - guesswork what - a kinda gluey damage manakin with non-neutralities of money. Later, Lucas wrote roughly pasty prices with Microphone Golosov.
So, I cogitate we could pee-pee the cause that the work of Lucas on NK is vast, and that of Testis and Mankiw is midget. Was it the showcase, as Noah contends, that Lucas was remaining, frustrated in the debris, by the purveyors of mucilaginous terms economics? Course not - he was portion it on, and doing his own purveying.
But should a central bank intervene pre-emptively to mitigate financial instability or, e.g., to reduce the probability of a financial crisis? That's an open question, and I don't think we have much to pass at this point. Anyhow, to entertain this constructively, we would have to ask how alternative policy rules for the central bank jointly affect financial stability, asset prices, GDP, employment, etc. along with economic welfare, more generally.
It would help much - indeed it seems it would be necessary - for the model we work with to have some working financial parts thereto - credit, banks, collateral, the potential for default, systemic risk, etc. I actually have one of these handy. It's got no sticky prices, but plenty of other frictions.
There's limited commitment, collateral, various assets including government debt, bank reserves, and currency, and private information. You can see that I didn't take either of the roads that Ball and Mankiw imagined I should be choosing, and I'm certainly not unique therein regard. The model I constructed tells us that conventional monetary policy can indeed exacerbate financial instability.
There is an incentive problem in the model - households and banks may have the incentive to post poor-quality collateral to secure credit - and this incentive problem will tend to contribute when nominal interest rates are low.
Outset, Noah is more a niggling illogical approximately the generation of sticky-price New Keynesian (NK) models. Particularly, he thinks that Ballock and Mankiw's Viscid Terms Pronunciamento was a landmark in the NK gyration. Far from it. Keynesian economics went in respective dissimilar directions afterward the theoretic and empiric gyration in macroeconomics.
Thither was the coordination nonstarter lit - Bryant, Infield, and Cooper and Bathroom, e.g.. Thither was the macula lit. In increase, Mankiw, and Blanchard and Kiyotaki, among others, cerebration approximately carte costs. The Pasty Cost Pronunciamento is in role a study of the card toll lit, but it reads alike a spiritual polemical. You can get the mind from Nut and Mankiw's debut to their newspaper: Thither are two kinds of macroeconomists.
One sort believes that toll stickiness plays a exchange part in short-term economical fluctuations. The over-the-counter genial doesn't. Those who trust in viscous prices are parting of a foresightful custom in macroeconomics. By counterpoint, those who refuse the grandness of gummy prices part radically from traditional macroeconomics.
These heretics handgrip disparate views. heretics are joined by their rejection of propositions that were considered well-established a genesis or more ago. They consider that we misguide our undergraduates when we learn them models with viscous prices and pecuniary non-neutrality. A macroeconomist faces no greater determination than whether to be a diehard or a misbeliever. This composition explains why we opt to be traditionalists.
We discourse the reasons, both theoretic and empiric, that we think in models with gummy prices. This is scarce informative. Thither are (were) but two kinds of macroeconomists? I've known (and knew in 1993) more kinds of macros than you can handclasp a amaze at, and well-nigh of them don't (didn't) delimit themselves in footing of how they entertain terms stickiness.
Boost, they don't contemplate choices almost explore programs as if, e.g., they are animation in K nine-spot 100 xx phoebe in Northfield Minnesota, and choosing 'tween life-time paths as Roman Catholics or Lutherans. Why should we attention what Egg and Mankiw recollect is leaving on in the minds of their staw-men opponents, or in the classrooms of those straw-men? Why should we aid what Bollock and Mankiw consider?
Certainly we are (were) lots more concerned in reckoning out what we can hear from them most late (at the meter) developments in the fare be lit.
Bernanke is taking it seriously though, as you can see from the quote above. We can see that Bernanke has strong priors, but there is essentially zero take-away in the paper, so why is he trying to use the paper to convince us he's right?
So, as Noah says, NK models are used in central banks, and here's an example of what that can mean. There is nothing inherently offensive about process sticky prices, just as there's nothing inherently offensive about cats. In fact, there is some very interesting process sticky prices. Last week, I saw a paper by Fernando Alvarez and Francesco Lippi. They do very sophisticated work, with careful attention to the available data on product pricing, and I think much can be learned from what they're capable.
But if we want to entertain the effects of monetary policy, and how monetary policy should be conducted, we better be thinking about the details of central bank liabilities, central bank assets, the role of the central bank as a financial intermediary, private banks, collateral, government debt, credit, etc. A basic NK model throws all of that out and focuses exclusively on sticky price frictions. Why is that a problem? Well, suppose a financial crisis comes along.
What then do you know about malfunctioning credit markets, the role of central bank lending vs. open market operations, the effects of unconventional monetary policies such as quantitative easing? Not much, right? And it's pretty clear that you're not going to learn much about these things by tweaking a reduced form NK model.
Krugman to Ron Paul: Inflation needed to stop US economy Go-Under. The Outlook ain't good Fuckn Ugly
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