One of the Fundamental Differences Between Modern Monetary Theory and New Keynesian Economics

With Modern Monetary Theory (MMT) making inroads in the public policy debate, some New Keynesians have transitioned from ignoring or dismissing the approach to engaging with it. This is healthy for both sides. There has been a tendency, though, to make “we’ve known it all along” type statements. A comprehensive response to the “nothing new” claims is provided by Bill Mitchell in a recent three-part series of posts (part 1, part 2 and part 3). My focus here is narrower and concerns a view (for example, expressed in a considered response here) along the lines that MMT has nothing new to say when the economy is at full employment.

Leaving aside that MMT and New Keynesian Economics (NKE) define full employment differently, this claim obscures a fundamental difference between the two theories. In NKE, as with neoclassical approaches more generally, there would be an automatic tendency to full employment in the long run if there were no imperfections or rigidities to impede the supposed adjustment process (including, in the case of NKE, no impediment to appropriate interest-setting monetary policy). For example, the favored justification for a fiscal response to unemployment in the wake of the global financial crisis was that the economy was in a liquidity trap, taken to mean that the real rate of interest was stuck above its so-called ‘natural’ rate due to monetary authorities confronting the zero lower bound. Absent this rigidity and any other rigidity (sticky wages, sluggish revision of expectations, etc), NKE implies that there will be full employment in the long run.

MMT is not neoclassical. It comes out of a different, broad theoretical tradition (which includes Post Keynesian economics and related Kalecki and Keynes influenced approaches) in which there is no general tendency for the economy to tend toward full employment even in the absence of imperfections and rigidities. In these theories, complete wage, price and interest-rate flexibility would not imply spontaneous adjustment to full employment over any time frame. Nor could policy administered interest-rate adjustments be relied upon to generate full employment, even when the economy was not at the zero lower bound, in contrast to the conclusion of NKE. The notion of a natural rate actually makes no sense in MMT or in the theoretical tradition from which it emerged.

The rejection of natural rate reasoning, and by extension appeals to a liquidity trap in the sense this term has been used since the global financial crisis, is theoretically informed by the capital debates (Matias Vernengo provides an informative introduction) and various arguments of Keynes (Bill Mitchell has a long series of posts entitled ‘Keynes and the classics’ beginning here). It is also consistent with the paucity of empirical support for a significant inverse relationship between the rate of interest and private investment upon which neoclassical spontaneous adjustment to full employment depends (see, for example, papers by Robert Chirinko, Jamus Lim and Steve Sharp and Gustavo Suarez).

Why is this relevant to the present comparisons between MMT and NKE?

It is relevant because it means the policy implications of MMT are in fact different to NKE over any time frame. In MMT there is no presumption that the economy will be at full employment in the long run. (This is so unless a job guarantee is in place, in which case there will be what MMTers refer to as ‘loose full employment’ at all times. This will be full employment in the sense that anyone who is willing and able to take a job at the job-guarantee wage will be employed.) In the absence of a job guarantee, there is no presumption in MMT that the economy tends toward full employment. An implication is that larger government deficits now do not necessarily imply smaller deficits or higher taxes in the future. It may be that full employment requires deficits in the future just as it does now. True, if it turns out in the future that full employment can be achieved with a smaller deficit, MMT will call for a smaller deficit. But it could go the other way.

If, as MMT prescribes, a job guarantee is put in place, full employment will not even be the relevant benchmark. With a job guarantee implemented, loose full employment will be achieved at all times irrespective of the overall level of demand. The relevant benchmark will then be the “non-acceleraiting buffer employment ratio” (NAIBER), meaning the smallest fraction of total employment that can be located in the job guarantee sector while still maintaining low, stable inflation. On the basis of MMT, there would be no spontaneous tendency for the economy to move toward the NAIBER, just as there is no tendency in the absence of a job guarantee for the economy to move toward full employment.

The premises and logic of MMT lead to the job guarantee as the means of simultaneously achieving and maintaining both full employment and price stability. Unless this is also the conclusion of NKE, based on its premises and logic, it can hardly be said that MMT “has nothing new to say at full employment”. Clearly it is not the obvious conclusion of NKE. If it were, New Keynesians would have drawn the conclusion long ago. Within the framework of NKE there need to be rigidities (e.g. a liquidity trap) to justify fiscal demand management. Even under conditions of unemployment, there is no place for fiscal demand management in NKE unless a rigidity can be identified.

It is perhaps also worth noting that a related claim – that MMT can be reduced to NKE with the policy tools switched (with fiscal rather than monetary policy assigned to demand management and monetary rather than fiscal policy geared toward controlling the level of interest on public debt) – is similarly unfounded. The observation so far as it distinguishes MMT’s preferred assignment of policy tools from NKE’s preferred assignment is a good one in my view (discussed previously here). However, the notion that MMT can be characterized simply by assuming within the New Keynesian framework that the interest rate can be geared solely toward keeping interest rates on public debt low relies on monetary authorities being able to choose the interest rate without regard to the so-called natural rate of interest and to do so indefinitely. This notion is unproblematic in MMT since within this framework there is no valid reason for supposing the existence of a natural rate of interest. The interest rate, in the MMT framework, is a policy variable, including in the long run. But in NKE, the existence of a natural rate follows from its neoclassical premises (including its marginalist microfoundations). So to impose, within the New Keynesian framework, the arbitrary restriction that the interest rate must be set according to public debt considerations is not only ad hoc but violates the constraint on policymakers that is implied by the existence of a natural rate, an existence that follows from the premises of the theory.

In short, MMT is not merely a policy position on government deficits that can be faithfully and fully represented by placing arbitrary restrictions on New Keynesian models. It is a theory built upon non-neoclassical foundations in which even under complete wage, price and interest-rate flexibility there would be no tendency for output to move to any particular level independently of fiscal policy, over any time frame. One implication of this – but only one implication – is that there is no reason to suppose that the fiscal stance called for today is in any particular relationship to the fiscal stance called for in the future. Fiscal surpluses today will not necessarily call for tax cuts in the future and fiscal deficits today will not necessarily call for higher tax rates in the future.

The foregoing argument is not intended to deny that there has been considerable common ground between MMT and NKE when it comes to the appropriateness of fiscal deficits in the aftermath of the global financial crisis. Economists of both persuasions have quite rightly been supportive of expansionary fiscal policy. The argument concerns the theoretical justification for this policy stance in the short term and the implications of this policy stance in the long term.

Related Posts

Balancing the Budget Over the Cycle

Institutions, Monetary Operations and a Demand-Led Global Economy

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More on Keynes vs the Neoclassical Synthesis


11 thoughts on “One of the Fundamental Differences Between Modern Monetary Theory and New Keynesian Economics

  1. “Economists of both persuasions have quite rightly been supportive of expansionary fiscal policy”

    Can you give some examples? All I see is that NKE all around the world were and still are calling for austerity. They claim that somehow austerity will bring growth and reduce unemployment. They were supportive of lowering interest rates and relaxing labor laws, not expansionary fiscal policy…

  2. NKE is a pretty broad grouping. Some on the liberal wing have been supportive of deficits or argued that the deficits should have been larger in the immediate aftermath of the gfc. Some of these economists may self-identify differently but a glance at a Wikipedia list (admittedly not a great source when it comes to economics) of leading New Keynesians includes names such as Stiglitz, Krugman, DeLong and Blinder (but also Rogoff). Simon Wren-Lewis also comes to mind. The grouping can remain broad because it is possible to argue many different things by imposing various restrictions on New Keynesian models.

    Maybe some of these economists would self-identify as Keynesian rather than New Keynesian. For the purposes of the present discussion, the relevant point is that, unlike MMTers, they appear to remain neoclassical in their microfoundations. This represents a fundamental difference in the two approaches.

  3. Pete

    Although you link to it, I understand that your post is not meant as a reply specifically to Josh Barro’s article. You are taking his particular post as an illustrative example of the view that MMT can be reduced to NKE.

    I find your answer persuasive.

    So, when Barro (quoting Jason Furman) writes

    “Those people [i.e. NKErs] may have the right model and the wrong parameters. MMT may have the wrong model, but it may get you the same thing as the right model if you have the right parameters.”

    I think he (and Furman) is mistaken. In his defense, I’d say his article is thoughtful and if he is mistaken in that particular, he (and NKErs, more generally) is not alone: there are plenty heterodox economists who should know better and yet make similar claims.


    Having said all that, Barro asked something that needs to be addressed, I think. At least, that’s something others have wondered and, in all honesty, I myself have wondered. How would tax increases and cuts be implemented, exactly? Barro:

    Whatever the Federal Reserve’s demerits, the idea of depending on Congress to pass surplus-generating tax increases in order to keep the economy stable and prevent runaway inflation gives me hives.

    The key question about MMT is whether expecting Congress to implement a novel model of economic management in a way that could go haywire is really the best way to address biases in economic policymaking when those biases could be addressed more directly.

    Interest rates are routinely set by central banks, as their key monetary policy tool. They may be a blunt, ineffective tool, but setting them is easy. Central bank bosses meet, some advisors make presentations reviewing data, models, projections and make recommendations. The big wigs discuss and decide. Some signatures and stamps is all it takes.

    How would tax rates be modified? Who would set them?

    Moreover, once contracts are signed (say, to build infrastructure), wouldn’t the government be constrained in its ability to reduce its financial obligations?

  4. Yes, you are right, the post was not intended as a direct response to anyone in particular. I linked to Josh Barro’s post as an example because I found it among the best.

    MMTers point out that, along with taxes, there are other tools to curb inflation. In a recent interview on the CNN website, Stephanie Kelton is quoted as saying:

    [T]axes aren’t the only way to curb inflation. The most important thing is to understand what’s actually driving the inflation. Historically, the big drivers of inflation have been: energy, housing, and health care. So even if the political reality means you can’t raise taxes, you can still fight inflation with policies that increase the supply of available housing units, promote energy efficiency, and lower health care costs.

    But in relation to taxes she also added:

    I also wouldn’t discount the possibility that our political realities might evolve rather quickly with an MMT-informed Congress.

    More generally, MMTers put a priority on avoiding inflationary pressures from emerging in the first place. There is an emphasis on automatic stabilizers. The proposed JG is a prime example. Expenditure would be withdrawn automatically as the JG pool is depleted during a boom.

    Bill Mitchell has done a lot of work on spatial considerations, the basic idea being to spend in areas and on activities most in need of demand injections and to anticipate and address likely bottlenecks. He has also discussed the use of public sector projects that can be put on hold or accelerated depending on the current needs of the economy.

    I’d also throw into the mix – though I’m not sure if MMTers would place much weight on this – that demand-side inflation, when it emerges, will tend to be temporary in a demand-led economy because the high utilization rates will be inducing private productive investment that while temporarily adding to demand will ease the inflationary pressures once the extra capacity comes on line.

    Regarding interest rates, the ease with which they can be adjusted needs to be weighed against the long lags in their effects. And as you (and Josh Barro) note, the effects themselves may well be weak. Although there are channels through which a rate hike should be expected to constrain prices (demand for credit, mortgage interest payments) there are also channels through which they can add to price pressures (cost of production, consumption out of interest income). The overall effect is not certain and probably pretty weak unless the rate hike is so extreme as to precipitate severe debt stress and a crisis.

    By way of comparison, fiscal policy’s automatic stabilizers respond quickly and have immediate effects. Discretionary fiscal policy has longer implementation lags than monetary policy, but once a change in government spending occurs, its effects begin immediately.

  5. Thanks, Pete.

    Just one more question. It’s not entirely clear to me how one can “fight inflation with policies that increase the supply of available housing units, promote energy efficiency, and lower health care costs”.

    Can you give me some examples? You know, a scenario where those things can be used.

  6. I am guessing a mix of supply-side and demand-side measures. Some examples:

    housing – expand public housing or the stock of affordable housing, release land for residential use, incentives to share accommodation

    energy – public investment in efficient energy, education/restrictions on energy use, incentives to carpool

    health care – public provision (or single payer) involves government exogenously setting prices (there is huge scope to cut health care prices in the US, in particular, by making an institutional change in this direction)


    As an aside, I am not so pessimistic about the likelihood of governments raising tax rates or imposing new taxes if and when this becomes appropriate. If a leftish government happened to get elected – under, say, Corbyn in the UK or Sanders in the US – I think it would be pretty likely that the tax environment would change quite a lot. For instance, it appears that a sharp increase in taxes on the wealthy would actually have considerable electoral support. Needless to say, election of a right-wing government seems at least as likely, in which case taxes would probably only rise, if at all, on the working class (or US middle class) and poor.

    Even at given tax rates, inflation that does occur automatically brings with it bracket creep so long as income tax scales are not indexed to inflation. This has some dampening effect on demand.


    There was a big omission from my previous comment when it comes to avoiding and/or addressing inflation. I may as well put it here.

    Historically, some Post Keynesians have argued for an incomes policy as a way to maintain strong demand alongside low, stable inflation. Bill Mitchell makes clear in his 1998 paper on the BER approach that a JG would be compatible with an incomes policy. It is not a question that MMT dictates an answer on.

    Personally, I do favor an incomes policy. I also support centralized wage determination. This preference has no necessary connection to the views of MMTers. Among the reasons for my preference are:

    sustainable demand – by ensuring that wages grow in line with average productivity, consumption demand can grow in a financially sustainable fashion (without excessive recourse to private debt)

    inflation control – wages growing in line with productivity is also consistent with low, stable inflation

    equity – to a large extent productivity growth is “in the job, not in the worker” (in particular it depends on the technology used in a given industry) and so its benefits should be widely distributed

    efficiency – the requirement to pay wages in line with average productivity applies pressure on private-sector firms to adopt the best available techniques and technologies in their industry (this does not prevent firms in low-productivity industries from raising prices in response to the generalized wage increase so long as their goods or services are in demand – e.g. hair cuts – and they are operating at the level of productivity appropriate to their industry)


    At the risk of getting even further off topic – although it is really the most pressing topic – there is a feeling in all of the above, of course, that we are ignoring the elephant in the room: the environment.

    The political challenges in raising taxes are likely child’s play compared with the environmental disaster we confront and the political challenges this presents. Although, in principle, growth does not need to be material – for example, we could sit around thinking up cleverer and cleverer ideas and pay ourselves for it (the growth of ideas) – the nature of our present economy is such that it’s not clear that positive growth (or even zero growth) is going to be sustainable.

    Quite a few posts on the blog have focused on demand-led growth as a way of conceptualizing growth under capitalism. If the view that capitalist economies are demand led is correct, then capitalism is a problem when it comes to addressing the environmental emergency. The demand requirements of capitalism conflict with environmental priorities.

    MMT, though, is equally applicable whether we are considering growth or degrowth. It also seems equally applicable whether we are considering capitalism or socialism.

    The JG proposal, for instance, will probably become even more relevant rather than less if it turns out that we need to operate at lower real levels of GDP. The JG is a way of maintaining full employment irrespective of the level of demand. This is a key point in my opinion.

    Personally, I think basic income has a legitimate, complementary role to play as well, in combination with a JG. A combined ‘job or income guarantee’ would be a way to allow people to self-select into low-income, low-consumption lifestyles. (This is me speaking, not MMT.)

    Greater public control of investment and public ownership of the means of production also seem necessary. (Again, this is me speaking, not MMT.)

  7. Thanks again, Pete.

    I’ll give this some more thought.


    Have you followed some recent debates between Green New Deal and Degrowth proponents?

    Dean Baker debated Jason Hickel at CEPR blog; Branko Milanovic’s review of Kate Rawthorne’s Doughnut Economics ended up with him debating Hickel. INET also hosted a more formal debate.

  8. Always, I ponder – is the theoretical cart being put before the horse? Be interested in what other people think.

    Analogy: – maybe 45 years ago I went to a Buddhist meditation retreat. I wanted someone to put me in touch with something inside of myself, that was ‘divine’ – a universal energy if you will. I was not interested in theory – I wanted to experience something, for myself; decide for myself what that experience was. I certainly didn’t want to sit there and listen to endless hours of theory. If the teacher had the experience for himself and could show me – all good. Otherwise it was a waste of time for both of us. If I had the experience I could learn from the experience: – corroborate or dismiss the theory later on.

    The first thing the Buddhist monk told us was that food was sparse, and we must take a vow of silence. That was it – after which without any further instruction, we were to sit down and ‘meditate’ twice a day. I asked for a private meeting with him and explained the above. He couldn’t help me. I said to him of what use is the mind held in silence or sprouting a forest; of what use is my belly full or fasting – the result is the same. Nice to have met you …

    So, rightfully or mistakenly, I confer on economic theory the same circumstance, albeit circumstance on the outside rather than on the inside. The inner experience in this case, becomes the human being, human personality on the outside.

    So, at the centre of my economic theory, there is a human being. Is this person kind, generous, caring – or this person greedy and cruel? Because whoever they are, their theory will follow. It is not until you restore human nature to economic theory, will it all begin to make sense. Side by side with all of the economic theory in this world, is a ring of missiles pointing at other human beings. Their launch pads are theory. The ones pointing back at the people of the countries are austerity and class.

    What we need first of all, is to experience, come back home, to being human. Look at a little baby and a mother: – compassion and love are coded in to the DNA – that is our core; our quintessential human essence. Then look how far we have wandered from that. Why? Ahem — because of theory, ego, and all the rest of it … it’s why the world is such a confused place.

    If that Buddhist monk had been wise, he would have told me to un-change everything and find my way back home. For me, that would be economical …. 🙂 !!

  9. ‘People before money and machines.’

    People come in layers – the political economy is one layer, always subject to change, because we made it up in the first place. The question is this: – was Marx correct when he said it was only possible to change the layer violently? Well, violence is not our essential nature, because if it was, the baby and mother above would not have survived; and all of those people using violence, lies, to maintain their grip on the layers would have disappeared with them. The real problem is – how far has humanity wandered from its essential nature? Seriously? Being human – that is what we have not consciously tried yet – successfully! Being cooperative, as in the early evolutionary years. Instead we are lost in the layers, trying to use the same tool that created the layers, and all of the problems inherent in the layers, to fix the layers. It is not going to work. I am sorry to be the bearer of such bad news. It does not employ our natural intelligence. It will take people deciding how they want to live, for themselves – what does it mean, to be human? Prem explains the flip side far better than I: Life – it begins with you, your understanding, your life, your existence

    #Although I think such an understanding is pivotal to any approach to the layers, will make such a comment very infrequently (6-12 months) in respect for Peter and the heteconomist blog. I believe people need to learn to stand on their own two feet, in regard to their existence, and the ‘world view’ that is daily shoved down their throats. A layer is just a layer – nothing else.

  10. I get the feeling that “New Keynesian Economics” is just a recycling of “Bastard Keynesianism” that was the post-WWII neoclassical consensus. Do correct me if I’m wrong, though.

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