New Keynesian Models: Not Yet Useful for Policy Analysis [report]

V.V. Chari, Patrick Kehoe, Ellen McGrattan
2008 unpublished
Macroeconomists have largely converged on method, model design, reduced-form shocks, and principles of policy advice. Our main disagreements today are about implementing the methodology. Some think New Keynesian models are ready to be used for quarter-to-quarter quantitative policy advice; we do not. Focusing on the state-of-the-art version of these models, we argue that some of its shocks and other features are not structural or consistent with microeconomic evidence. Since an accurate
more » ... an accurate structural model is essential to reliably evaluate the effects of policies, we conclude that New Keynesian models are not yet useful for policy analysis. Viewed from a distance, modern macroeconomists, whether New Keynesian or neoclassical, are all alike, at least in the sense that we use the same methodology, work with similar models, agree on which reduced-form shocks are needed for models to fit the data, and agree on broad principles for policy. Viewed up close, however, we disagree considerably. This disagreement revolves around a set of shocks and other features that have recently been introduced into New Keynesian models. Here we argue that the new shocks are dubiously structural and that the other new features are inconsistent with microeconomic evidence. Until these issues are resolved, we conclude, New Keynesian models are not useful for policy analysis. This critique should not diminish the fact that the areas of agreement among macroeconomists are now significant. In terms of methodology, we agree that in order to do serious policy analysis, we need a structural model with primitive, interpretable shocks which are invariant to the class of policy interventions being considered. In terms of the models themselves, most macroeconomists now analyze policy using some sort of dynamic stochastic general equilibrium (DSGE) model. This type of model can be so generally defined that it incorporates all types of frictions, such as various ways of learning, incomplete markets, imperfections in markets, and spatial frictions. The model's only practical restriction is that it specify an agreed-upon language by which we can communicate, a restriction hard to argue with. An aphorism among macroeconomists today is that if you have a coherent story to propose, you can do it in a suitably elaborate DSGE model. Macroeconomists are also beginning to agree on the nature of the reduced-form shocks needed to be included in a model in order for it to fit the data. In our 2007 work (V. V. Chari, Patrick J. Kehoe, and Ellen R. McGrattan, henceforth CKM ), we have argued that two particular reduced-form shocks play a central role in generating U.S. business cycle fluctuations. The efficiency wedge, at face value, looks like time-varying productivity. The labor wedge distorts the static relationship between the marginal rate of substitution of consumption for labor and the marginal product of labor. A consensus appears to be emerging on the importance of these two reduced-form shocks over the business cycle. This emerging consensus implies that we need to develop structural models which generate these wedges from primitive, interpretable shocks.
doi:10.3386/w14313 fatcat:win7v2k4mjhm3bxjzfrzok5ru4