the new consensus from a post-keynesian perspectivethe new consensus from a post-keynesian...

The New Consensus from a Post-KeynesianPerspective

Progress by the Mainstream or a Trojan Horse for New ClassicalEconomics?

Sebastian Dullien1

1FHTW Berlin - University of Applied Sciences

July 2008

Sebastian Dullien (FHTW Berlin) The New Consensus from a Post-Keynesian Perspective July 2008 1 / 25

Outline

1 Why talk about DSGE?

2 Main elements of DSGE modeling

3 Why does DSGE appeal to (some) (Post-)Keynesians?

4 Problems with DSGE from a (Post-)Keynesian perspective

5 DSGE for policy evaluation


Why talk about DSGE?DSGE in the Academics

DSGE has become the predominant approach in academicmacroeconomics

A large share of papers in the”top 5“ journals are now about

DSGE

The American Economics Association wants to put a specialemphasis on DSGE modeling in its new American EconomicJournal: Macroeoconomics

DSGE is now dubbed”the new consensus“

Woodford(2003, 2007), Galı/Gertler(2007), Goodfriend(2007)


Why talk about DSGE?DSGE in the Central Banks

DSGE increasingly becomes tool of choice for monetary policyanalysis

DSGE is the theoretical foundation for inflation targetingAny central bank that wants to be accepted in the internationaldebate now has its own DSGE model

ECB: Smets/Wouter (2003) Bundesbank: see monthly bulletin July 2008 Finnish central bank Banco de Espana: Andres/Burriel/Estrada (2006) ...


Main elements of DSGEWhat is DSGE?

The acronymDSGE = Dynamic Stochastic General Equilibrium model

Dynamic: Individual actors optimize over infinite horizon

Stochastic: We look what happens if there are stochastic shocks

General Equilibrium: Microeconomic foundations with a numberof markets which are in equilibrium


Main elements of DSGETypical approach of DSGE modeling

Modern DSGE modeling for policy evaluation is a multi-stage process:

Appropriate (microeconomic) optimization conditions are chosen

Model is”log-linerized“ around steady-state

”Deep“ parameters (i.e. for the utility function) are chosen so that

impulse response fits well with empirical data (”calibration“ of the

model)

Model is then used to simulate the response to an exogenousshock


Main elements of DSGEIntellectual roots of DSGE modeling

Household optimization stems from real business cycle models Infinite horizon Rational expectations Variation of labour supply to intertemporal changes in real wages (representative agent)

Some”Keynesian“ elements are added

Price-stickiness Monopolistic competition


Main elements of DSGEEquations in a simple Baseline DSGE model

I. Household optimization

One utility function:

Et

∞∑

t=0

βt[u (Ct) + v

(Mn

t

P

)− γ (Nt)

]⇒ max (1)

under the budget constraint

YtPt + Mnt−1 + Bn

t−1 (1 + it−1) = CtPt + Mnt + Bn

t (2)

YtPt = NtWt + Πt (3)

t ∈ [0,∞) (4)

and under the non-Ponzi condition

limT→∞

Bn

TT∏

s=0(1 + is)

≥ 0 (5)



II. Firms’ price setting I

Consumption is modeled as a consumption bundle with households preferringvariety in consumption (often with a CES utility function).

Hence, firms act as monopolistically competitive similar to Dixit/Stiglitz (1977)

Firms produce given a simple neo-classical production function

Yt = AtN(1−σ)t (6)

In addition, following Calvo(1983), a given share of firms θ will not change pricesin any given period

Given this framework, firms act as profit-maximisers by minimizing expecteddeviation from their optimum price

Solving yields us a mark-up pricing over unit labour costs (now written in logterms)

p∗

t = µ + mqt (7)



III. The results: Three macroeconomic equations

The individual firms’ price setting gives us for the whole economy”New

Keynesian Phillips curve“ (NKPC):

πt = βEtπt+1 + Ω1yt (8)

Log-linearizing the optimality conditions from the utility function around thesteady-state and assuming equilibrium in the goods and labour market, we getsomething which looks slightly similar to the standard IS-curve

yt = Et yt+1 −1σ

(it − Etπt+1) (9)

For the system to be stable, we now need a central bank reaction function,mostly written as an interest rate function following something like:

it = ρ + φππt + ρy yt + vt (10)



IV. Where is the money

Many DSGE models neglect money altoghether

However, it can be introduced as endogenous to the central bank’s interest rateequation

mst = −

1ν

(it − Et πt+1) (11)


DSGE’s appeal to KeynesiansFamiliar elements

For some traditional Keynesians, a lot of elements now seem familiar:

Monopolistic competition has a long tradition in Keynesianism

The new IS-curve looks at first sight similar to traditional IS-curve

yt = Et yt+1 −1σ

(it − Etπt+1

)(12)

Monetary policy is conducted by changing interest rates

Money supply is now endogenous - no Friedman’s helicopter


DSGE’s appeal to KeynesiansFamiliar policy conclusions

For some traditional Keynesians, some policy conclusions also seemfamiliar:

No real balance effects (Pigou or Keynes), hence deflation is notstabilizing any more

DSGE system is not self-stabilizing without the central bank,active monetary policy is necessary to stabilize system

Central bank reaction to output gap is usually part of an optimalreaction function


Problems with DSGEUnemployment and the Output Gap I

Problem: DSGE is not what it seems to be:Even if there is an output gap and fluctuations in employment in aDSGE model, this is completely different from the Keynesianbusiness cycle

Remember that the labour market is always in equilibrium All unemployment is voluntary

”Output gap“ is not a lack of aggregate demand over aggregate

supply, but an optimal reaction of households to slowly adjustingprices


Problems with DSGEUnemployment and the Output Gap II

If central bank cuts interest rates, the result is the following Demand increases because current consumption becomes

cheaper relative to future consumption Higher demand pushes up nominal wages in a situation of

(partially) fixed nominal prices Real wages increase Households offer a larger labour supply because of the

intertemporal substitution of labour and leisure (leisure todaybecomes more expensive relative to leisure tomorrow)

Are all Keynesians really happy with this story?


Problems with DSGEEndogenous Money I

Post-Keynesians use endogenous money to show thecomplexeties of the interaction of commercial banks, borrowersand the central bank for the money supply process

Central bank cannot always expand money supply at will Monetary policy is powerless in certain situations (if firms are so

pessimistic about the future that they refrain from borrowing orbanks refrain from lending)

Money is created in the credit process Money temporarily transfers purchasing power from surplus units to

deficit units


Problems with DSGEEndogenous Money II

Endogenous money in DSGE is completely different

Endogenous money in DSGE endogenously fulfills the wish ofhouseholds to hold liquidity - not that of borrowers to borrowmoney

No purchasing power is transferred between units

In the basic DSGE model, as all households are identical inpreferences and endowments, no one is in surplus and no one isin deficit, Ct = Yt for all households

No role for financial sector


Problems with DSGEThe IS curve and fiscal policy

The New Keynesian IS curve is not what it seems!

Consumption demand is not a function of current income, but onlyof future incomeThere are strange effects of fiscal policy

An increase in government spending leads to an increase in output,but a fall of private consumption

This effect is independent from question of tax/debt finance(Ricardian equivalence)

Higher government spending leads to higher present or futuretaxation

This is a negative wealth effect Households cut back on consumption as well as leisure time ⇒

labour supply increases As labour market is always in equilibrium, higher labour supply

leads to more output


Problems with DSGECan problems be mitigated by more elaborated formulations? (I)

A number of approaches now try to come up with more realisticreactions to fiscal policyMost common approach: Galı/Valles/Lopez-Salido (2007)

A share of households has no access to financial markets These

”rule-of-thumb“ consumers consume always all their income

for the period given Rule-of-Thumb households do not react to future taxes Higher present government expenditure increases nominal wages

today With sticky prices, real wages increase Rule-of-Thumb households offer more labour and consume more As labour market is always in equilibrium, this leads to higher

employment If share is large enough, output and private consumption increases


Problems with DSGEPreliminary conclusions

Even in the more elaborate versions, output in DSGE models isdetermined from the supply side and especially the labour market

There is no possibility for involuntary unemployment

Deviations from steady state output are always due to thedecisions of households to work less due to (relative) low realwages (intertemporal substitution of labour and leisure)

Fiscal policy works in ways which are completely Non-Keynesian


DSGE for policy evaluationThe question

But might DSGE models not be useful for policy evaluation?

After all, the impulse responses to an external shock seem tosome variables (not fiscal policy) fit time series of the real worldquite well...


DSGE for policy evaluationLessons from computer science

This debate reminds of the debate in Computer Science in the1970sTuring test for artificial intelligence

Proposed ba Alan Turing in 1950 as a test to demonstrate amachine’s intelligence

Software tries to appear human in communication with the user If user cannot determine whether she is communicating with a

computer or a human being the computer has passed the touringtest

ELIZA (programmed in the 1960) did not pass strict Turing test,but did quite wellNowadays, there exist software which routinely passes TuringtestsHowever, in the theory of AI, no one would still call the software

”intelligent“

Turing test is now seen as”distraction from useful lines of

research“ (Economist)Sebastian Dullien (FHTW Berlin) The New Consensus from a Post-Keynesian Perspective July 2008 22 / 25

Would you use”Eliza“ to find out how another person

reacts to your actions?

Figure: Output from software”Eliza“

ConclusionsDSGE for policy evaluation

DSGE is trying what Eliza has been trying for Artificial Intelligence

Eliza tries to give an output which looks like a human reaction, yetwe know it does not work like a human brain

DSGE tries to give an output which looks like data from a realeconomy, yet we know it does not work like a real economy

It is hard to believe that this approach is very helpful forunderstanding policy options!


Conclusion: New Consensus: Progress or TrojanHorse for New Classical Economics?

Figure: How does it look like?

the new consensus from a post-keynesian perspectivethe new consensus from a post-keynesian...

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