Arnold Kling comments on a post by John Cochrane who links to a paper purporting to show that the New Keynesian model did not ‘work’:
John Cochrane has been going after the New Keynesian model. The other day, he linked to a paper by Bill Dupor and Rong Li. They argue that the stimulus did not increase expected inflation, which is a channel by which fiscal policy is supposed to create an expansion in the New Keynesian model.
The fact is that students leave graduate school with no inkling about money. Monetary policy is all about interest rate policy. And they´re quite comfortable writing papers with titles such as: “Monetary Policy less powerful in recessions”:
Changes to key interest rates by central banks have a significant impact on economic activity during periods when the economy is expanding. Unfortunately, they seem to have virtually no effect during recessions – the time when the stimulus of monetary policy is most needed.
‘Our findings have important implications for the design of economic policy.
‘If changes in the policy rate have little impact in a recession, central banks need to resort to other measures to achieve the desired expansionary effect – ‘quantitative easing’ and ‘forward guidance’ are current examples.
‘Our results also suggest that policy-makers may need to rely more heavily on fiscal or financial policies to stabilise the economy in a deep or protracted slump.’
Unfortunately, more reliance on fiscal stimulus does not seem to work. In addition, high and rising rates in the 1970s didn´t stop inflation from booming and low and falling rates in 2001-03 did not stop real output growth (and inflation) from dropping. Instead, if you define the objective of monetary policy as ‘providing nominal stability’, there´s no problem with observing rising inflation in the 1970s and falling real output and inflation in 2001-03.
In the former period, nominal spending growth was on a rising trend and during the latter period it was on a declining trend. With nominal spending growth following a stable trend level path (constant growth) for most of 1987-06, nominal stability (low/stable inflation and stable RGDP growth) was obtained.
The charts illustrate:
HT David Levey