The Model Behind the Madness

Central banks typically make decisions based upon the NK (New Keynesian) model. Its goal is to provide a framework to understand how interest rate decisions end up affecting the various measures of an economy’s performance. It differs primarily from the RBC and Neoclassical models in that it includes the real short term effects of monetary policy, friction in price changes, and monopolistic competition. Essentially, firms can earn profits, they can’t constantly change prices, and interest rate changes actually affect the economy. The dominance of this model at first glance seems natural, as every one of its key distinctions is true.  It often does a good job of modeling reality in the short term. If one were to predict the effect of an interest rate change in 6 months to a year, the NK model would far outperform the RBC or neoclassical model. This simple truth disguises some very troubling ramifications. While the New Keynesian model can certainly help the Fed understand the results of its actions in the short term, it creates perverse long-run incentives.

The first difficulty results from the model’s accuracy. While the number of variables and parameters allow the NK to be uniquely accurate in the short-run, its predictive power dies off over a longer time span because time gives all of those parameters time to change. Any one parameter changing could spell disaster for a prediction that held true for even a year. Some of these parameters are almost ethereal and have no guardrails as to their change. For example, household time discounting can change rapidly based on just a few bad news headlines, yet it plays a massive role in the NK model’s calculations. Estimating any one of these parameters is possible yet not nearly as precise as one would hope for a model that was used to determine significant policy changes.  

Another problem with the NK model is that it can incentivize present action too strongly. The desire to stabilize things in the short term is naturally increased by the model’s ability to show how short term variables affect one another. While the addition of sticky prices adds short term accuracy, it also creates temptations that can be disastrous in the long run. Even while the model recognizes that price rigidity will not last forever, it can be used to support policy meant to “unstick” all prices. Additionally, the interest rate’s ability to influence real variables in the short is often used as a justification to adjust rates. The fact that we can use monetary policy to escape a short term recession is used to override the question of whether we should use monetary policy to spur short term growth. Long term monetary stability’s benefits are nearly impossible to spot in the NK model. The expectation of inflation parameter does internalize some of the benefits of long-term stability, but the rest of the model can very easily be used to create a crisis from what would otherwise be considered a transitory adjustment period. The NK model gives central banks an ability to focus on fixing short-term deviations with solutions that have long-term consequences. 

The results of policy built upon the NK model reinforce the desire to continue destructive fixation on the present. In a generally functioning country, inflation typically has sweet rewards for a few years. In America, economic dominance has allowed it to thrive by many measures, even while utilizing an inflating currency. Policy built upon the NK model will naturally support spending increases and expansionary money policy far more than a model that took into account the inherent necessity of short term shocks and the dull reward of years of consistently tiny increases in inflation. We are constantly surprised that the Fed acts like there’s no tomorrow when it comes to enabling government wastefulness. However, we must remember that the members of the Fed are doing their job, which, as of now, means listening to results found using the NK model. While the NK model is often accurate, we have clearly seen how it creates a sort of ping-pong game of reacting to reactions to previous policy. The intellectual humility needed to recognize that they cannot figure this issue out as precisely as they want will enable some critical evaluation of monetary policy that can allow for a new era of American economic growth.  Until the Fed becomes open to more holistic analysis techniques that incorporate some understanding of the market’s unpredictability and theory that promotes monetary responsibility, they will continue to fall into the same trap.

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