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NK Models

Author(s): Stephen Williamson

In defense of microfounded models.

From New Monetarist Economics:

Brad DeLong has a post on New Keynesian (NK) models. Things are certainly looking up, as I'm finding DeLong more agreeable by the day. As far as I can tell, we both think there is a deficiency of safe assets in the world, and we're not big fans of NK. Soon Brad will be doing monetary theory and quoting Neil Wallace, I have no doubt.

It's not like Brad has everything right though. He says:

The baseline New Keynesian model was not, originally, intended to become a workhorse. It was intended as a proof-of-concept...

That's definitely not correct. Mike Woodford can correct me on this, but my impression is that he came out of graduate school with a specific goal in mind, which was creating a version of Keynesian economics that would fit into modern macro. Ed Prescott's project left central bankers scratching their heads about what they were supposed to be doing, and Woodford and others stepped into the void. Interest and Prices is, I think, intended as a handbook for central bankers. There was a lot of effort put into marketing the whole NK project to the world's central banks. This is ongoing, and has been institutionalized, for example here.

But then, Brad gets to his criticisms:

But the extraordinary shortcuts needed for tractability were and are a straitjacket that makes it extremely hazardous for policy analysis. It cannot fit the time series. And when it does fit the time series, it does so for the wrong reasons.

He's not specific enough, but I agree with him. And other people do too. For example Chari/Kehoe/McGrattan.

But then we part ways again:

So why require everything to fit in this Procrustean Box? This is a serious question–closely related to the question of why models that are microfounded in ways we know to be wrong are preferable in the discourse to models that try to get the aggregate emergent properties right.

Again, Brad needs to expand on this to make clear what he's thinking, but my understanding is that the "Procrustean Box" of preferences/endowments/technology/information/equilibrium concept is too confining for him. He also might think that post-1970s macroeconomics opened a Pandora's box - setting loose evil forces that ruined much of the profession. Just guessing of course.

In any case, we're left wondering who the "we" is that knows microfounded models to be wrong. What are those microfounded models that are wrong, and how are they wrong in ways that mislead us? What specific "aggregate emergent properties" are there that some other models are trying to get right, and what are those models anyway?

Several points:

1. Saying a macroeconomic model is wrong misses the point. These models are all wrong, in the sense that, with sufficiently good data in sufficiently large quantities, which has in some sense performed the right natural experiments for us, we can reject any model. But that doesn't make these models useless - they can indeed be useful in carrying out the purpose for which they were intended. You could also stick to the letter of the law, and come up with a crappy model, of course.


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