Today I wrote about "New Keynesian" models of the recession:
- I clearly defined New Keynesian models as "… built on the assumption that employers charge too much for the products that their employees make and are too slow to cut their prices when demand falls" in which the recession originated with a surge in "the demand for safe assets."
"Debt overhang" was absent from my definition.
- I claimed that, according to those models, our labor market problems would be absent if only employers were charging less for the goods their employees make. "Price stickiness" stops them from doing so.
- Assuming the New Keynesian models were correct, I offered a calculation of what the CPI would have been if prices had been fully flexible.
- I claimed that, with the passage of time, prices and wages in the New Keynesian model would fall, thereby moving in the direction of what a fully flexible CPI would have done.
Professor Krugman would have his readers believe that, among other things, none of the above items are correct. My purpose here is to provide further evidence on items 1-4 so that readers might decide for themselves.
- Definition. By "New Keynesian," I had in mind neoclassical growth models with flexible wages but augmented with Calvo-type staggered price setting (I have written separately about sticky wage models).
According to Clarida, Gali, and Gertler's 1999 Journal of Economic Literature article, those setups are workhorses in the "New Keynesian" (their terminology, not mine) literature. More recently, Woodford (2010) used such a model to characterize the government expenditure multiplier and Eggertsson (2010) use such a model to describe the recent recession as a consequence of a time preference shock (and perhaps also in increase in the willingness to work).
The Clarida, Gali, Gertler survey, the Woodford paper, the Eggertsson paper, and many other papers that call themselves "New Keynesian" feature sluggish price adjustment, and make no mention of "debt overhang."
A number of economists, including myself, have written about debt overhang in FULLY FLEXIBLE price models, and did not describe their analysis as "New Keynesian." I think that debt overhang has a lot to do with this recession, but nothing to do with New Keynesian economics. So I see absolutely no reason to revise the accepted definition of New Keynesian.
- If only prices were flexible. In order to see that my claim (2) is correct for the above defined models, take a look at Eggertsson (2010), p. 8. His equations (21) and (25) describe the impact of the time preference shock (embodied in his rs*) on output and labor.
- In each equation, the size of the impact depends on the speed of price adjustment as parameterized by k. The more flexible are prices, the larger is k. Think of fully flexible prices as k à¥.
- Equations (23) and (25) show that a time preference shock of a given size has no effect on labor in the fully flexible price limit k à ¥. In other words, the model blames the recession on the combination of sticky prices and the time preference shock: eliminate either of those, and there would have been no recession.
- Fully flexible hypothetical. Assuming for the sake of argument that the recession is to be blamed on price stickiness (i.e., labor would have followed its previous trend but for price stickiness), I calculated the flexible price hypothetical by using a money demand function that relates the quantity of money to the price level, output (which is the same as labor in Eggertsson's model), and nominal interest rates. The percentage gap between actual and hypothetical CPI is equal to the percentage gap that labor has fallen short of trend (about 10) times the income elasticity of money demand (about one) times the elasticity of output with respect to labor (about ¾) plus an interest rate term (I assumed that money demand is insensitive to interest rates in the relevant range).
- Deflation will continue as long as the recession does. I gave the intuition in my original article, but that's too much "bar talk" for Professor Krugman, so let's look at Eggertsson's equations again. His equations (23) and (25) say that the inflation rate has the same sign as the deviation of labor from its steady state. Since a recession is a negative deviation for labor, inflation must be negative.