New Keynesian Models: Not Yet Useful for Policy Analysis

This 2009 American Economic Journal: Macroeconomics paper by V. V. Chari, Patrick Kehoe, and Ellen McGrattan is a theoretical and methodological critique rather than an empirical study: it asks whether state-of-the-art New Keynesian DSGE models, as typified by Smets and Wouters (2007), are yet reliable enough for quantitative policy analysis, and argues they are not. Building on the “business cycle accounting” framework of Chari, Kehoe, and McGrattan (2007) – which decomposes aggregate fluctuations into an efficiency wedge, a labor wedge, an investment wedge, and a government-consumption wedge that together capture essentially all the movement in US output – the authors first show that the same labor wedge can be generated by two observationally equivalent structural models with opposite policy implications: one in which the wedge reflects fluctuating union monopoly power over wages (a “bad” shock the government should offset, so that “relentless union busting is optimal”), and one in which it reflects fluctuating utility of leisure (a “good,” efficient shock, so that laissez-faire is optimal). They argue a model is useful for policy only if its shocks are both invariant to the policy interventions being evaluated and interpretable as “good” or “bad” in this sense, and that four of the seven shocks in the Smets-Wouters model – the wage markup, price markup, exogenous spending, and risk premium shocks – fail this test and are therefore “dubiously structural.” These four shocks are far from a side issue: per the paper’s own forecast-error variance decomposition (their Table 1), they account for 39.6/53.9/86.9 percent of the variance of output/hours/inflation at a 4-quarter horizon, rising to 60.3/86.0/88.0 percent at a 1,000-quarter horizon. Taken at face value, the wage markup shock implies a standard deviation of the wage markup of 2,587 percent – “several orders of magnitude outside of a reasonable range” if interpreted literally as variation in workers’ elasticity of substitution; the exogenous spending shock, defined residually from the national income identity and including net exports, has 3.5 times the variance of measured US government spending; and the risk premium shock has more than six times the variance of short-term nominal rates, which the authors argue is best read as a flight-to-quality shock – and therefore plainly not invariant to monetary policy. The paper separately criticizes the model’s backward price-indexation assumption, used to generate inflation persistence, as inconsistent with microeconomic price-duration evidence (Bils and Klenow 2004 report about 4 months between price changes; Nakamura and Steinsson 2008 report about 11 months; backward indexation instead implies every price changes every period), and questions the standard Taylor-rule specification as hard to reconcile with the smooth, trending behavior of long-term interest rates implied by the expectations hypothesis. The authors are explicit that the critique targets the Smets-Wouters (2007) implementation specifically and does not claim New Keynesian models are wrong – only that they are “not yet useful” for the kind of quarter-to-quarter policy counterfactual exercises for which they are increasingly used – and they note that, despite the critique, New Keynesian and neoclassical economists have in practice converged on similar broad policy recommendations (commitment to rules, low average inflation).

Sticky Price Models of the Business Cycle: Can the Contract Multiplier Solve the Persistence Problem?

Since the early 1970s macroeconomists have known how to build general equilibrium models in which monetary shocks move output contemporaneously; the harder problem, as the authors frame it, is generating the defining feature of business cycles – persistent output movements – without simply assuming prices are fixed for long stretches. Staggered price-setting has long been the promising candidate, following Taylor’s argument that because contracts are written relative to one another, shocks are “passed on from one contract to another – a sort of ‘contract multiplier’.” This paper asks quantitatively whether that mechanism delivers, in a general equilibrium model with a continuum of monopolistically competitive firms producing differentiated goods from capital and labour, real balances in the utility function, and prices set for a fixed number of periods in staggered cohorts. The authors define the contract multiplier as the ratio of the half-life of output after a monetary shock under staggering to one-half the length of exogenous price stickiness (the half-life under synchronized setting, since shocks arrive randomly between adjustments), and note it is approximately invariant to that length in their models. Fitting an ARMA to quadratically detrended log real GDP gives an output half-life of 10 quarters, so with one quarter of exogenous stickiness the required multiplier is 20 (60 with one month, 5 with one year). Under a benchmark calibration – money demand parameters estimated from a regression of log consumption velocity on the interest rate using 1960:1-1995:4 Citibase data, giving an interest elasticity of 0.39; an 11 percent markup and demand elasticity of 10 following Basu and co-authors; a capital-output ratio of 2.65, investment-output ratio of 0.23, one-third of time in market work, and a capital share of one-third; money growth serial correlation of 0.57 from M1 over 1959:3-1995:2 – the multiplier is roughly 1, implying exogenous stickiness would have to last 5 years to match the data. The reason is that with constant-elasticity demand prices move one-for-one with costs, and with unit elasticity of substitution between consumption and leisure costs are extremely sensitive to output, so the elasticity of the equilibrium real wage with respect to consumption exceeds one and output is not persistent. The authors then test three escapes and find each fails once intertemporal links are restored: near-perfect substitutes preferences give a multiplier of 21.97 without capital and interest-sensitive money demand but 0.50 with them (and imply labour input would rise 57 percent per day under 2 percent growth in wages and consumption); Kimball-style convex demand yields 3.79 without links and 1.55 with them, at a parameterization under which a 2.3 percent rise in relative price drives demand to zero; and specific factors give 1.82 without links and 1.33 with them, needing a demand elasticity of about 6500 to reach 20. Combining all three raises the multiplier only to 1.81, and simultaneous parameter searches over wide ranges top out at 3.05 for the benchmark, 3.20 for convex demand and 4.17 for specific factors and the combined model. Their conclusion is that “the staggered price-setting mechanism is not the long-sought solution” and that mechanisms to solve the persistence problem must be found elsewhere.

Patrick J. Kehoe | Macro Paper Warehouse

New Keynesian Models: Not Yet Useful for Policy Analysis

Sticky Price Models of the Business Cycle: Can the Contract Multiplier Solve the Persistence Problem?