10
Goodfriend and King (1997) highlighted the monetarist character of the NK model by
pointing out that a policy of price stability eliminates the nominal friction that prevents the economy
from behaving as a competitive market economy. Blanchard and Gali (2007) referred to the
simultaneous occurrence of price stability and full employment as “divine coincidence.” The
practical implication of an objective of price stability is that the Fed follows a rule that turns the
determination of real variables over to market forces. In the monetarist literature, the nominal anchor
entailed a real balance effect based on the assumption of an exogenously given monetary aggregate
(Patinkin 1965). In the NK model, the nominal anchor is a monetary policy that causes “sticky-
price” firms, which set dollar prices for multiple periods, to coordinate on the central bank’s inflation
target. The counterpart of the objective of price stability is the objective of maintaining expected
inflation equal to the inflation target. With that nominal anchor, the central bank can control trend
inflation while allowing firms to separate the determination of relative from absolute prices. The NK
model thus embodies the spirit of monetarism that the central bank can follow a rule that provides for
economic stability by separating the determination of relative prices from the price level.
To counter this version, which does not allow for Phillips curve trade-offs as part of optimal
policy, Blanchard and Gali (2007) introduced markup shocks, which reflect the exercise of monopoly
power in pushing up prices and make such trade-offs optimal. However, in the stop-go period, the
Fed was not successful in using Phillips-curve trade-offs in order to achieve a socially acceptable
combination of inflation and unemployment. In this period, the Fed interpreted inflation as arising
from cost-push shocks, that is, from markup shocks reflecting the exercise of monopoly power by
large corporations and unions. It misjudged the character of inflation and introduced instability
through attempts to exploit inflation-unemployment trade-offs (Hetzel 2008; Orphanides 2001).
In the spirit of the Cowles/Klein agenda of estimating large-scale econometric models,
economists have estimated structural versions of the NK model in order to identify the shocks that
drive the business cycle, for example, Smets-Wouters (2007). Motivated by the disruption to
financial intermediation that followed the Lehman bankruptcy on September 15, 2008, economists
have worked on models that allow for financial intermediation and financial frictions, for example,
Christiano et al. (2013). As in Bernanke et al. (1999), an external finance premium that moves
negatively with the net worth of firms creates a financial-accelerator mechanism that amplifies the
effect of macroeconomic shocks. A “credit-risk” shock in the form of a positive exogenous shock to
the external finance premium captures the idea of a financial crisis.
Nevertheless, in the NK model, monetary policy still possesses strong stabilizing powers.
The reason is that the output gap equals the cumulated sum of the current and future values of the
differences between the real rate of interest and the natural rate of interest (multiplied by the negative
of the intertemporal rate of substitution in consumption). Even with the zero lower bound, policy
retains its stabilizing powers because the central bank can commit to keeping the real rate below the
natural rate after the latter turns positive (Eggertsson and Woodford 2003).
12
Stated negatively, in
order to explain a recession with the NK model, one must assume contractionary monetary policy.
12
Kaplan et al. (2016) limit the power of monetary power by assuming liquidity-constrained
households, which cannot borrow in order to redistribute consumption to the present. The issue then
is empirical: what fraction of households is liquidity constrained? At the same time, the existence of
11
The stabilizing power of monetary policy also appears in the NK model in that the central
bank can neutralize the impact on consumption of a demand shock (a shock to the intertemporal
consumption Euler equation) by following the change in the natural rate with its policy rate. In the
basic NK large-scale DSGE model without financial frictions, a demand shock (a positive savings
shock) would by itself raise investment by lowering consumption.
13
Similarly, in a model with
financial frictions, a credit-risk shock that depresses investment increases consumption (see for
example, Kollmann et al. 2016, Fig. 3e). Models that include financial frictions then also include
demand shocks. As just noted, however, with demand shocks, the central bank can neutralize the
impact on the real economy by keeping the real rate equal to the natural rate. At the same time,
adding a financial friction in addition to sticky prices creates one more objective in the central bank’s
objective function. The central bank should go beyond the divine coincidence that entails tracking
the natural rate and trade off among objectives (Carlstrom et al. 2010). Optimal policy in a financial
crisis would then require missing the inflation and output objectives on the upside, not on the
downside as occurred in the Great Recession.
14
6.
Monetarism and the Great Recession
The Great Recession has posed a challenge to acceptance of the NK model. Economists have
criticized the objective of price stability or “inflation targeting” as preventing central banks from
intervening in order to prevent the financial excess presumed responsible for the Great Recession
(Curdia and Woodford 2009). Such explanations often assume that the low interest rates in the early
2000s initiated a boom-bust cycle in housing whose fallout led to the Great Recession (Taylor 2009).
With the Great Recession, one confronts the difficulties of identification caused by the poor
experimental design that generates the data given to economists. It is plausible that the uncertainty
surrounding the Lehman bankruptcy in September 2008 produced a sharp decline in the natural rate
of interest.
15
If the central bank puts inertia into declines in the policy rate relative to the natural rate,
liquidity-constrained households offers the central bank additional avenues to stimulate demand. The
issue is empirical. The monetarist hypothesis is that as long as the central bank does not disturb the
operation of the economy by interfering with the price system, households will remain optimistic
about the future. Friedman’s permanent income hypothesis will then be a valid characterization of
household behavior.
13
In order to generate the simultaneous decline in consumption and investment characteristic of
recession, modelers include a marginal efficiency of investment (MEI) shock that increases the
relative price of investment in terms of the consumption good.
14
Del Negro et al. (2016) simulate a model in which a liquidity shock can explain a decline in output
and the nominal interest rate. However, they do not perform a simulation with optimal credit policy
in which the central bank replaces risky assets in the public’s portfolio on a massive scale with safe
assets or a simulation with optimal monetary policy in which the central bank commits to keeping the
real rate below the natural rate after the natural rate again becomes positive.
15
Using a DSGE model for the United States, for the period 2008Q1 through 2009Q1, Gali et al.
(2012) estimated a decline of about 6 percentage points for the output gap and 12.5 percentage points
for the natural rate of interest. Numbers kindly supplied by Rafael Wouters.