Balancing the Budget Over the Cycle

It seems to me that those, including New Keynesians, who support the maintenance of a “balanced budget over the cycle” are either not recognizing or rejecting a number of points made by heterodox Keynesian (or Kaleckian) critics of such a policy approach, including proponents of Modern Monetary Theory (MMT) as well as many other Post Keynesian and Sraffian economists.

1. Growth with financial stability – which depends on maintaining strong demand without excessive reliance on private debt – probably requires, among other things, ongoing domestic private sector surpluses (S – I > 0), at least in most years and on average. A capacity for the private sector persistently to net save (maintain S > I) will reduce the likely incidence of private debt stress and bankruptcy, other factors (notably distribution and the regulatory regime) remaining equal. For most countries, the average government budget over the cycle and over the long run should be in deficit to an extent consistent with a domestic private sector surplus conducive to (private-sector) financial sustainability. (A stylized illustration of this point is provided in a previous post.)

2. Just as proponents of a balanced budget over the cycle understand the need for the government’s budget position to move countercyclically, Modern Monetary Theorists see the same need except that the fluctuation, in their view, should be around an average government budget that is, for most countries, somewhat in deficit rather than balanced (due to point 1 above). The appropriate level of the government’s deficit will be the one that enables net private saving, on average, alongside full employment while preventing the emergence of excessive demand-side inflationary pressures.

3. Scott Fullwiler has argued that the functional finance approach (implicit in point 2) is, by coincidence, “Ricardian”. That is, the public debt-to-GDP ratio will not rise without bound. To the extent proponents of a balanced budget over the cycle take their position in order to be Ricardian, perhaps they are unaware (or reject) Scott’s point that functional finance would cause no disappointment of this aspiration.

4. Among economists and the community in general, we appear to lack a unified understanding of what is meant by “austerity”. The term seems to mean different things to different people, including to heterodox Keynesian economists. From a heterodox Keynesian perspective, I think it would make sense to define austerity as policy that, by being too tight, prevents the economy from moving toward – and then from maintaining – a level of full employment. Since, in heterodox Keynesian approaches, there is no automatic tendency to full employment (even with flexible prices), and fiscal policy clearly matters, this suggested definition might have merit. It would reflect, for instance, that a shrinking of the government deficit during an upturn is not necessarily due to austerity, as economists of all persuasions understand. A rise in tax revenues due to growth might well be consistent with the re-establishment of full employment, and so not provide evidence of austerity, on this definition.

The trouble is, the mainstream (including the liberal wing of the New Keynesian school) still does, implicitly, assume a long-run tendency to full employment in the (hypothetical) absence of so-called rigidities and imperfections. The liquidity trap is one example of a rigidity, and it is the one the New Keynesians mostly blame, at the moment, for a persistence of unemployment. But if it is believed that under ideal conditions there would be an automatic tendency to full employment, then defining austerity in terms of full employment, which would make sense within the context of heterodox Keynesian economics, does not make sense in the context of New Keynesianism. In the New Keynesian view (even though only implicitly), no fiscal policy stance could prevent a long-run convergence to full employment in the absence of (so-called) rigidities and imperfections. So, in that view, austerity must have some other meaning.

5. The fundamental disagreement between New Keynesians and heterodox Keynesian economists largely seems to come down to this difference in view over the existence or otherwise of an automatic tendency to full employment (absent imperfections). New Keynesians either reject, ignore or remain unaware of what heterodox economists regard as one of the key implications of the Cambridge Capital Controversy, which is that there is currently no valid theoretical basis for supposing an automatic tendency to full employment, even under the assumption of full price flexibility. Most heterodox economists take this finding as read. Samuelson himself appears to have conceded it in his famous “summing up”. John Eatwell gives a succinct statement of the heterodox position from about 39:45 – 49:40 in this video (h/t Matias Vernengo):

Since, for New Keynesians, the economy will return to full employment irrespective of fiscal policy (again, in theory, under idealized conditions), it will seem to them that any additional demand created now through fiscal stimulus will need to be reversed in the future, once full employment is re-established. For heterodox Keynesians, that is not necessarily the case, and there is no general tendency for it to be the case. In the absence of ongoing injections of demand through government expenditure, aggregate demand both now and later will, on average, simply be lower than otherwise, as would the level of employment. In the future, growth might – but will not necessarily – call for tighter fiscal policy (the enactment of higher tax rates or spending cuts). If it does, such fiscal tightening will not amount to austerity (in the sense suggested above) since all that is necessary is application of the functional finance principle of alleviating inflationary pressures associated with full employment and moderating an aggregate demand that is growing faster than productive capacity can be expanded to accommodate it. (Again, according to Scott Fullwiler, such a functional finance rule will actually turn out to be “Ricardian”.)

6. The New Keynesian rejection or unawareness of the implications of the Cambridge Capital Controversy also appears to manifest in a fundamental disagreement over the rate of interest. In the heterodox Keynesian view, the controversy established that there is no valid theoretical basis for supposing the existence of a natural rate. Consistent with this, heterodox Keynesians take as read that there is no such thing as a natural rate of interest. For most heterodox Keynesian economists, the rate of interest is a policy variable and exogenous. In their view, the monetary authorities are not compelled, in the long run, to conform to a supposed (real) natural rate of interest. For this reason, the extent of any interest obligation associated with ongoing budget deficits is considered to be entirely at the discretion of the consolidated government.

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15 thoughts on “Balancing the Budget Over the Cycle

  1. Half the reason there is an obsession with balanced budgets is because Keynes mentioned it at some point.

    The context in which he did – a Gold Standard world – is generally ignored.

  2. Doesn’t Bill (or is it Warren) always say that the natural rate of interest is zero ? If so, does this conflict with :

    ” In the heterodox Keynesian view, the controversy established that there is no valid theoretical basis for supposing the existence of a natural rate. Consistent with this, heterodox Keynesians take as read that there is no such thing as a natural rate of interest.”

  3. They say ‘the natural rate is zero’ in an ironic way. In other words it doesn’t move around like some mystical Deus Ex Machina magically putting things right that are wrong.

    Humans have to do that via planning and system design.

  4. Peter-

    This is one the best written blog articles I’ve read in a while. Its very clear and succinct. And it describes what is ultimately one of the main crux of the differences between heterodox and new keynesian worldviews. Excellent, nicely done.

  5. My understanding of the basic New Keynesian model is that full employment is only achieved through an active monetary policy (in the sense of applying some kind of Taylor rule). There is no automatic tendency to full employment In these models if monetary policy is passive (in the sense of holding the nominal interest rate constant).

    I think the key difference here between New Keynesians and post-Keynesians is that New Keynesians believe that (nominal) interest rate manipulation is an efficient way of regulating aggregate demand in normal circumstances and post-Keynesians don’t.

  6. I would say that the absence of automatic convergence to full employment in the New Keynesian framework is due to so-called rigidities and imperfections. (This is one of John Eatwell’s points in the linked video.) It is the imposition of stickiness of one kind or another that prevents the price mechanism, in such models, from inducing demand sufficient to sustain full employment.

    The Cambridge Capital Controversy demonstrated, in the estimation of heterodox Keynesians, that the price mechanism could not be said to bring about automatic convergence to full employment even in the absence of rigidities and imperfections.

    I agree that differing assessments of monetary policy effectiveness are a notable aspect of the disagreement between New Keynesians and heterodox Keynesians but see this as a manifestation of the different reactions of the two groups to the capital debates. The debates brought into question the validity of supposing a well-behaved ‘demand for capital’ function and monotonic inverse relation between private investment and the rate of interest.

  7. “Austerity” has not yet become a technical term in economics. I am not so sure that it would be a good idea if it did, as that would mean another term adopted from the vernacular with a different meaning, so that public economic discourse is misunderstood by the general populace. However, I suppose that it is inevitable that it will be adopted by economics, and thereby lose some or all of its meaning of harshness or severity.

    Defining it in terms of unemployment and full employment is not a bad idea, but “full employment” has become a moving target. Perhaps it would be good to define it in terms of its concomitants, such as the suicide rate. Make no mistake. Austerity kills.

  8. My understanding is that there are two models that the New Keynesians use, ISLM and ISMP. They understand that the central banks set a policy rate and they believe that this is best done iaw some rule. Then the issue becomes how to establish that rule. From what Krugman has been saying, I assume it is ISLM, which assumes a natural rate of interest in a competitive marketplace where money is neutral. Since the natural rate is unobservable, it must be estimated based on expectations. The cb sets the policy rate iaw its own expectation of market expectations about the natural rate. A Taylor rule is supposed to provide a formalization for this so that ISMP will closely approximate ISLM at all times. The problem is only when owing to some external shock the economy is stuck at the zero bound and monetary policy becomes ineffective in the model unless the policy rate can be set to a negative number.

    Other Keynesians argue that money is not neutral, as neoclassical economists including so-called Keynesians that assume the Keynesian-neoclassical synthesis assume. The “natural rate” is not only not observable as a theoretical construct, it is based on erroneous assumptions and is simply a fiction of highly stylized modeling. The natural rate only has significance in a stylized model and not in relation to the real world.

    Mosler and Forstater jump off on this and show how in a ISMP model the natural tendency of the overnight rate in the interbank market is toward zero since governments tend to run cumulative deficits that accumulate as national savings of net financial assets in the form of government securities. This results in excess reserves that drive the overnight rate toward zero unless the central bank intervenes artificially to set a rate above zero. Left to itself, the rate will go to zero in most cases. ISLM doesn’t apply whereas ISMP does, and examining the actual operations involved in monetary and fiscal policy, the “natural” state toward which the system tends is zero.

    The implication is that if naturalness is a priority (which it is for neoclassical economics and by extension New Keynesianism) then the rate should be allowed to tend to zero on principle. (Hoist by their own petard!) The rate can only be set above zero in the long run if either fiscal policy prevents accumulation of excess reserves, which would result in financial disaster based on historical evidence, or the rate must be set artificially either by paying interest on excess reserves at the desired rate, or monetary policy must be brought into play to adjust price (interest rate) to quantity (rb available for interbank lending).

    In addition, since there is no natural rate other than in stylized models that are not representational, the cb has no criterion for setting a policy rate based on a rule that has a solid foundation in a model with realistic assumptions. So the cb is operating on its own expectations about market expectations, both of which are infected with uncertainty.

    The rule here would be to be based on Bayesianism, which is feeling the way by adjusting expectations iaw feedback. Where does the feedback come from information provided by DSGE modeling, which is the tool that central banks favor. But his model is based on neoclassical general equilibrium that Keynesians also reject, in part because it is based on there being a natural rate of interest (at a natural rate of employment).

    The basic disagreement is over the assumption that economics is and should be modeling nature in a way similar to the natural science (presumption of ergodicty) versus the opposing assumption that what economics studies is socially constructed through culture and institutions and develops though a historical process of interaction of complex (social) systems (national economies in a global economy subject to uncertain social, political and economic factors and conditions). Of course, there are also disagreements over money & banking and finance in relation to economics, such as the neutrality of money, as well as accounting being the language of economics rather than higher math.

    Summing it up, the distinction is between naturalists and institutionalists. There is also a distinction between those who believe that economics as a discipline can be both a pure science (formalized) as well as an applied science based on context, and those who believe that that economics can only be formalized in rather limited aspects and not as a whole, as in the neoclassical paradigm, because most of economics is thoroughly contextual and historical. This can be further summarized as the difference between those who think that economics is law-like and those who don’t because ontological and epistemic uncertainty, reflexivity, and emergence.

    So virtually all disagreements can be traced to these foundational assumptions that conflict, including the so-called natural rate in neoclassical economics. Mosler and Forstater’s “natural rate” is not based on assuming a law of supply and demand but on banking operations and accounting rules, both of which are based on institutional arrangements, including legal. In this view, “nature” is not the basis of economics, but rather law, regulation, custom and convention. The law involved is positive law, and it is the result of political choices.

  9. I agree with Auburn – this is a nice post. Peter, do you think there would be any merit in going back to the description put forth by old keynesians such as Alvin Hansen (and Samuelson in his old textbook) that distinguishes between different policy stances, each of which would depend on the economic situation? Their basic point is that balancing the budget over the cycle is only one among many policy stances. For instance, in a context of high corporate surplus and depressed investment, Samuelson says running persistent deficits is normal. In contrast, where there is high growth and surging investment, surpluses would be the norm.

    Tom: I’m not sure that ISLM is the analytical device of choice for New Keynesians. Rather, it was primarily used by old Keynesians. Also, I wouldn’t say that ISLM assumes a natural rate of interest. Rather, the rate of interest at which the IS and LM (or MP) curves intersect is better seen as a (policy-induced) rate of interest. That said, ISLM is a useful device and can be used to *illustrate* a situation where the natural rate is above or below the interest rate at which the IS and LM (or MP) curves intersect (which, as Krugman argues, would require a policy move to shift the policy rate so that it matches the level of the natural rate). That’s all Krugman is doing. In a world where the central bank can target any nominal rate of interest (which almost every Keynesian economist, old or new, recognizes), the ISLM provides a useful way of illustrating a situation when the natural rate and the real rate of interest diverges. (All that said, Krugman’s view on **how** to hit the natural rate is flawed, for reasons I showed in my most recent post. Essentially, Krugman says the central bank could hit the natural rate on its own via expectations, which, in practical terms, is impossible).

    Finally, I find it useful to view the natural rate as a “neutral rate”, or the rate of interest at which real GDP would grow according to trend, with stable inflation. Based on the concept, if the real rate of interest is below (above) the neutral rate, aggregate demand would eventually exceed (fall short of) potential GDP, resulting in inflation (unused capacity and unemployment). For central banks, estimating the neutral rate is a technical detail (there are several ways to do so, all of which have their challenges and upsides). That said, it’s actually a useful operational concept if it can be used appropriately (that is, **not** in a limiting sense or rigid manner as many commentators believe, but as a reference for tracking the policy path and considering policy options when changes to the economy affecting real variables arise).

  10. Thanks for the clear explanation, circuit.

    I was thinking in terms of monetarism v fiscalism, with the New Keynesians actually being monetarists, while Old Keynesians and Post Keynesians are fiscalists. So Krugman would actually be a monetarist, which is a big reason that he opposes the MMT-Post Keynesian fiscalist approach. He’s “Keynesian” in that he allows fiscalism at the ZLB, but otherwise favors using monetary policy.

    John Cochrane, New vs. Old Keynesian Stimulus:

    This new-Keynesian model is an utterly and completely different mechanism and story. The heart of the New-Keynesian model is Milton Friedman’s permanent income theory of consumption, against which old-Keynesians fought so long and hard! Actually, it’s more radical than Friedman: The marginal propensity to consume is exactly and precisely zero in the new-Keynesian model. There is no income at all on the right hand side. Why? By holding expected future consumption constant, i.e. by assuming the economy reverts to trend and no more, there is no such thing as a permanent increase in consumption.

    The old-Keynesian model is driven completely by an income effect with no substitution effect. Consumers don’t think about today vs. the future at all. The new-Keynesian model based on the intertemporal substitution effect with no income effect at all.

    The whole post is worth reading. Here is some more:

    Many Keynesian commentators have been arguing for much more stimulus. They like to write the nice story, how we put money in people’s pockets, and then they go and spend, and that puts more money in other people’s pockets, and so on.

    But, alas, the old-Keynesian model of that story is wrong. It’s just not economics. A 40 year quest for “microfoundations” came up with nothing. How many Nobel prizes have they given for demolishing the old-Keynesian model? At least Friedman, Lucas, Prescott, Kydland, Sargent and Sims. Since about 1980, if you send a paper with this model to any half respectable journal, they will reject it instantly.

    But people love the story. Policy makers love the story. Most of Washington loves the story. Most of Washington policy analysis uses Keynesian models or Keynesian thinking. This is really curious. Our whole policy establishment uses a model that cannot be published in a peer-reviewed journal. Imagine if the climate scientists were telling us to spend a trillion dollars on carbon dioxide mitigation — but they had not been able to publish any of their models in peer-reviewed journals for 35 years.

    What to do? Part of the fashion is to say that all of academic economics is nuts and just abandoned the eternal verities of Keynes 35 years ago, even if nobody ever really did get the foundations right. But they know that such anti-intellectualism is not totally convincing, so it’s also fashionable to use new-Keynesian models as holy water. Something like “well, I didn’t read all the equations, but Woodford’s book sprinkles all the right Lucas-Sargent-Prescott holy water on it and makes this all respectable again.” Cognitive dissonance allows one to make these contradictory arguments simultaneously.

    Except new-Keynesian economics does no such thing, as I think this example makes clear. If you want to use new-Keynesian models to defend stimulus, do it forthrightly: “The government should spend money, even if on totally wasted projects, because that will cause inflation, inflation will lower real interest rates, lower real interest rates will induce people to consume today rather than tomorrow, we believe tomorrow’s consumption will revert to trend anyway, so this step will increase demand. We disclaim any income-based “multiplier,” sorry, our new models have no such effect, and we’ll stand up in public and tell any politician who uses this argument that it’s wrong.”

    That, at least, would be honest. If not particularly effective!

    Mankiew on ISLM v. ISMP.

    The IS-LM Model:

    The IS-LM model takes the money supply as the exogenous variable, while the IS-MP model takes the monetary policy reaction function as exogenous. In practice, both the money supply and the monetary policy reaction function can and do change in response to events. Exogeneity here is meant to be more of a thought experiment than it is a claim about the world. The two approaches focus the student’s attention on different sets of thought experiments.

    I like the IS-LM model because it keeps the student focused on the important connections between the money supply, interest rates, and economic activity, whereas the IS-MP model leaves some of that in the background. The IS-MP model also has some quirky features: In this model, for instance, an increase in government purchases causes a permanent increase in the inflation rate. No one really believes that result as an empirical prediction, for the simple reason that the monetary policy reaction function would change if the natural interest rate (that is, the real interest rate consistent with full employment) changed. This observation highlights that neither model’s exogeneity assumption should be taken too seriously.

  11. Although I dislike the retention of marginalist aspects in the work of the old Keynesians (and in Keynes, for that matter), I do agree with circuit that there is a fair bit to admire in the old Keynesian understanding of the macroeconomy.

    In countries with a zero current account balance, the statement of Samuelson mentioned by circuit makes sense to me, though there is still a need, I think, to keep in view any implications for financial stability of movements in the sectoral balances over time. If it is a matter of strong private investment pushing the government deficit toward or into surplus while private consumption levels are maintained through rising income without excessive recourse to private debt, the situation is probably manageable for quite some time. But the longer growth continues at a rate more rapid than the rate of growth in government expenditure, the more the overall domestic private sector will move toward or into deficit, unless the external sector happens to be offsetting the effect.

    Basically, there is a sector (government) that faces no risk of involuntary insolvency and another sector (domestic private) that does face such a risk. To me, it makes sense that, normally, the one without an insolvency risk should be providing a cushion for the other.

    I can see the sense in central banks attempting to identify, empirically, a neutral rate (neutral in its effects on aggregate demand). It seems a difficult task, and I tend to doubt that any such rate, if it exists, would be stable over time. Then again, errors in estimating such a neutral rate wouldn’t matter very much in practice if the overall demand effect of interest-rate changes is normally weak in any case. That is not to say that central banks should ignore the question. Considering that interest rates are the main tool of monetary policy, it certainly makes sense that central banks would make every effort to disentangle, empirically, the complicated effects of changes in the policy rate on the real economy. However, even if a particular rate were found to be neutral under one set of fiscal policy settings, it probably wouldn’t carry the same neutrality under another set of fiscal policy settings.

    Of course, if the view is taken that fiscal policy doesn’t matter under normal circumstances, it may be felt that the neutral rate, if identified, will be more stable. To form a view on that, we are essentially back to the question of whether fiscal or monetary policy is more effective, which IMO again takes us back to different assessments of, and reactions to, the capital debates. Are price changes (in this case interest-rate changes) sufficient to push the economy toward full employment (monetary policy), or instead is the only reliable method of boosting spending to go ahead and spend (fiscal policy)?

    To me, it seems that it would be easier to use fiscal policy to underpin ongoing healthy demand (as well as underpin ongoing expansion of productive capacity through appropriate public investment) with the automatic stabilizers kicking in when necessary in a timely way. Ideally, MMT’s proposed job-guarantee mechanism would be introduced to provide extra margin for error, especially to minimize negative employment consequences in situations where fiscal tightening is undertaken to limit inflation. Then interest-rate policy could be focused on achieving desired distributive effects.

    The precise nature of the central bank’s distributive choice would depend on the institutional setting. In a society with strong public pensions, public health care provision, employment protection or job guarantee, and publicly provided unemployment compensation or basic income guarantee, the rationale for interest on private saving would be largely removed and the short-term interest rate could be left at zero with a view to minimizing the income share of rentiers to the benefit of workers and productive investors. In a society that placed the onus on private saving, the central bank might be less intent on euthanizing rentiers in order to provide an attractive saving vehicle for households and in this way help to support financially sustainable growth.

  12. (Cochrane:) “The old-Keynesian model is driven completely by an income effect with no substitution effect. Consumers don’t think about today vs. the future at all. The new-Keynesian model based on the intertemporal substitution effect with no income effect at all.”

    I would say that, in reality, consumers do think about the future. They just aren’t deceived into believing, against logic and evidence to the contrary, that higher consumption spending now in line with higher current income necessarily requires lower consumption spending later when, almost always, the economy is in a position characterized by excess capacity and unemployment and it is normally possible for government spending, private investment, tax revenue and private saving all to rise together in a growing economy. In the long run, capacity itself is likely to be expanded in response to persistently strong consumption demand (underpinned, in part, by multiplier effects of autonomous non-capacity-enhancing public expenditures) and enable this concomitant rise in consumption and saving to continue more or less in line with trend growth.

    Cochrane appears to believe that consumers, unlike Keynesians, are really “smarter” than that and think just like the Chicago school who, despite their pretensions to credibility, have been publicly and professionally embarrassed by recent economic history and everybody knows it. What use is their theory if any government callous enough to follow it through even in part causes harm to the economy and community? And what use is it if, come a crisis, more sensible policymakers turn to anything but Chicago-school prescriptions because they know perfectly well that the latter won’t work?

    I would say that consumers, quite correctly, refuse to believe that there is always full employment or that, no matter what the situation, more consumption now means less consumption later, or (blind to realities of accounting and currency sovereignty) that budget deficits now dictate budget surpluses later (a glance at US budget history — which has been a history of government deficits almost always — shows that to hold such a belief in the past would have been wildly incorrect.)

    In reality, consumers are actually smarter than neoclassical optimizers, even if unconsciously so. They look to the future, but not through the distorted prism of neoclassical microfoundations that are, despite the name, largely without sound theoretical foundation. It is hard to see why old Keynesians should have insisted on basing their macro reasoning — which was light years ahead of the Chicago approach – on supposed microfoundations that happen to be theoretically incoherent and exposed as such in a major way by real-world outcomes both in recent history and in the 1930s and 1940s. There is nothing wrong with micro as such — quite the contrary — provided it has coherence and relevance and is not in violation of known accounting relationships, causation implicit in money endogeneity, and properties of currency sovereignty. But the claimed microfoundations of neoclassical macro are not that.

    I do think, though, that Cochrane touches on at least one truth. The reason New Keynesians until recently wrapped their analyses inside incoherent neoclassical microfoundations seems to have been for reasons of career preservation. It is almost certainly true that they would not have been published in mainstream journals without doing so. That is an indictment on the discipline. The apparent reality that, post crisis, mainstream economists still have to adopt this strategy in their academic writing is an even bigger indictment when it is clear that any policy prescription even halfway sensible needs to ignore, to a significant degree, the neoclassical microfoundations. The way these are ignored (or selectively frozen) without the work becoming heterodox (and hence unpublishable in the mainstream journals) is to impose, it seems, ad hoc rigidities on the standard model.

  13. Tom: You’re absolutely right that new keynesians (NK) are essentially old monetarists (OM) (in fact, some economists are now dropping the term NK and using OM).

    In many ways, NK was a sort of half-way house for economists who believed there was a need for government policy and who thought it was necessary to ground macro in microfoundations and apply some of the insights of newclassicals (who we now know are useless for policy purposes). IMO, the NK were mistaken when they adopted these insight from newclassicals. It was a mistake because there is no compromising with newclassicals. It’s all ideological. None of it is evidence based. One example: in the 80s newclassicals wrote papers about the 70s with no mention of the word oil (apparently, it was all about the money supply). Also, according to their students (who developed real business cycle theory), the great depression was a massive negative technology shock that set in motion a contraction in inputs, such as total hours worked, because supposedly workers substituted leisure for labor due to falling productivity and wages. What is a negative technology? Answer: ‘forgetfulness’ (I’m not kidding).

    Cochrane is truly useless, especially to policymakers, but he is right in your quote about the assumptions in NK. However, Cochrane is totally wrong about old Keynesian economics. There’s lots of evidence that demonstrate that people violate the permanent income hypothesis (PIH), or its business equivalent, the modigliani-miller theorem (MM), which states that under VERY specific conditions firms’ cash flow don’t matter. In fact, evidence shows that there is a correlation between profits and business investment. Anyway, some NK economists can be saved, but only if they drop the PIH, realize that MM rarely applies to the real world, and abandon the notion that a central bank can influence expected inflation (it can’t because agents who set prices look at this year`s and last year`s inflation — they don’t care what the central bank says it will do next year if inflation in the recent past has been significantly different from what the central says it can achieve).

    Once you abandon these assumptions, you’ve pretty much reverted back to old Keynesian economics, where *current* income matters (for both individuals and firms) and inflation expectations are inertial (which means essentially that it’s based on past inflation for several reasons, including bargaining power, excess demand, etc).

    About Mankiw, his take on ISLM and ISMP is actually quite good. However, Mankiw is really not associated with ISLM or ISMP. In many ways, he and David Romer are responsible for the popularity of NK modeling. ISLM was set aside because it assumes fixed prices.

    Peter, you’re point about old Keynesian is well taken. Some of the marginalist elements were counterproductive, which paved the way for some economists to fall for the newclassical nonsense. I agree entirely with the rest of your comment. And you are correct about Samuelson in the sense that his textbook really focused on the closed economy, which at the time he wrote it was casually assumed to be adequate.

  14. What is a negative technology? Answer: ‘forgetfulness’ (I’m not kidding). Well I have to say they’re right about that. There was a tremendous technology shock around 1970 – much bigger than the oil shock in the long run – of forgetting the social technology of applied (old) “Keynesian” economics & replacement with these guys “theories”.

    If one delves a bit into the murky history of sciences, philosophy, mathematics – you know that the same forgetting happens there too, often enough – although people try to keep it hush-hush from the kids & the textbooks. Oh well, there is usually progress & even somewhat accurate history after a few centuries usually.

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