Second-Generation New Keynesian Modelling
The mid-1990s saw a decline in real business cycle modelling and the concomitant emergence of a new type of models. This move should be seen as an endogenous change rather than a revolution.
Ending their methodological fight, new Keynesians and real business cycle theorists came to agree upon adopting a workhorse model that both considered apposite - hence the “new neoclassical synthesis” label (Goodfriend and King 1997). Keynesians’ contribution to the wedding was imperfect competition and sluggishness, as well as a focus on the role of the central bank. In exchange they accepted the basic components of real business cycle modelling (that is, exogenous shocks, the dynamic stochastic perspective, the equilibrium discipline, intertemporal substitution and rational expectations).Monopolistic competition was integrated into DSGE modelling by borrowing the Dixit-Stiglitz aggregator from Dixit and Stiglitz’s (1977) model of product differentiation. In the canonical version of this model, the economy comprises four types of goods: labour, a final all-purpose good, a continuum of intermediary goods, and money. The final good is a homogenous good produced using the intermediary goods. It is exchanged competitively. Intermediary goods are each produced by a monopolistic firm using Leontief technology based only on labour. These monopolistic firms are price-makers applying a mark-up on their marginal costs. If, for any reason, they are willing but unable to change their prices, it is in their interest to increase the quantity sold, until demand is fully satisfied.
As for sluggishness, at last, a satisfactory theoretical translation (that is, menu costs and staggering contracts) of its fact-of-life evidence seemed to have been found. It eventually became fixed in Calvo’s (1983) price formation theory, a formulation close to the staggered contracts insight.
It is assumed that at each period of exchange, firms are authorised to change their prices as soon as they receive a signal, occurring with a given probability. If, for instance, this probability is one in three, then on average, firms will reset their prices every three periods. While this price formation assumption can be criticised for being ad hoc, it has been more widely used than the earlier versions of sluggishness, as a result of its tractability.Another development that emerged in the last decade of the twentieth century concerned monetary policy, in particular the rules that central banks should follow. Here a radical shift away from Friedman’s vision took place as the rate of interest came to substitute the quantity of money as the leading control variable. Two economists, John Taylor and Michael Woodford played a prominent role in this development. Taylor devised a rule that became popular enough to be named the “Taylor rule”. It originated in an article (Taylor 1993), which tried to provide an empirical assessment of the Federal Reserve System’s (FED’s) policy. The rule consists of fixing the rate of interest taking into account three objectives: (1) price stability, measured by the difference between the observed and the targeted rate of inflation; (2) the output gap, the deviation of effective from potential output (that is, the output level that would have occurred had the economy been competitive) and (3) an economic policy shock, a purely residual shock uncorrelated with either inflation or output. Woodford pursued the same idea in several contributions, ranging from a 1977 article (Rotemberg and Woodford 1997) to his 2003 book, Interest and Prices: Foundations of a Theory of Monetary Policy. This book quickly became a standard reference in the monetary policy literature. Woodford’s approach was to address the problem at the level of principles by attempting to make a full link between macroeconomic stabilisation and economic welfare. Taking the stabilisation of inflation as the prominent aim of monetary policy, he nonetheless found ways to couple it with the Keynesian objective of a stabilisation of the output gap (Rotemberg and Woodford 1997). He also paid considerable attention to the credibility dimension:
When choosing a policy to best serve the goal of stabilization, it is crucial to take account of the effects of the policy’s systematic component on people’s expectations of future policy.
For this reason, my work has focused largely on the study of policy rules: this forces one to think about the systematic patterns that one can expect to be anticipated by sufficiently sophisticated market participants. (Woodford 2006: 2, original emphasis)This perspective, Woodford further argues, has some counter-intuitive implications. For example, it makes policy inertia desirable or, in other words, purely forward-looking policy is seen to be harmful.
The end result of all these developments is that now economists holding opposite policy views have come to agree about the conceptual apparatus upon which to base their theoretical work. This state of affairs seems to be agreeable to both camps. Macroeconomists from the real business cycle tradition are happy because new Keynesians have yielded by adopting their language and toolbox. New Keynesians are content because they have been able to bring to the merger the concepts they were insisting upon in their more static days. Moreover, the admission that monetary policy can have real effects marks a reversal of the Friedman-Lucas view that had previously held the high ground. In other words, when it comes to policy, new Keynesians seem to be the winners.
Another milestone in the recent evolution of macroeconomics has been Christiano et al.’s (2005) article. This enriched the standard DSGE model, based on staggered wage and price contracts, with four additional ingredients: (1) habit formation in preferences for consumers; (2) adjustment costs in investment; (3) variable capital utilisation; and (4) the need for firms to borrow working capital in order to finance their wage bill. The ensuing (complex) model allows the authors to account for the inertia of inflation and persistence in output, two important features supporting the Keynesian standpoint on the real effects of monetary shocks.
The next step occurred when Smets and Wouters (2003) took up Christiano et al.’s model and estimated it for the euro zone viewed as a closed economy.
Before this, central banks were still using models which, for all their sophistication, remained based on the Kleinian tradition. In contrast, the Smets-Wouters model was microfounded, specifying the preferences of households and the central bank. Smets and Wouters estimated seven variables (gross domestic product, consumption, investment, prices, real wages, employment and the nominal interest rate) under ten structural shocks (including productivity, labour supply, investment preferences, cost-push and monetary policy shocks). Having more shocks certainly gives a better fit. The flip side, however, is that none of them comes out as dominant. The model also embedded friction, which had the effect of slowing down the adjustment to shocks. Smets and Wouters’s main contribution is technical, consisting of using Bayesian estimation methods in a DSGE setting for the first time. In a very short time, central banks around the world adopted the Smets-Wouters model for their policy analysis and forecasting, thus replacing “old” with “new” Keynesian modelling. However, one aspect of the old way of modelling remains: the distinctive trait of real business cycle models was their attempt to be as simple as possible. In effect, they comprised a limited number of equations. This parsimony is a feature no longer to be found in new models a la Smets-Wouters.