FRBSF Economic Letter
2004-17; July 9, 2004
New Keynesian Models and Their Fit to the Data
Central banks use macroeconomic
models to help frame the issues that they face, to mold their ideas,
and to guide them in their decisionmaking. While a wide range of
models are available, economists are increasingly examining monetary
policy issues and the design of optimal monetary policies in the
context of "New Keynesian" macroeconomic models. New
Keynesian models are notable for using microeconomic principles
to describe the behavior of households and firms, while allowing
price and/or wage rigidities and inefficient market outcomes. One
particular model, often called the canonical New Keynesian model,
has received special attention, not only because it is easy to
work with, but also because it succinctly summarizes the principal
mechanisms through which policy interventions affect the economy.
The
canonical model does have some drawbacks, however. For example,
it arguably does an abysmal job of explaining movements in inflation,
interest rates, and output in the U.S. and elsewhere (Estrella
and Fuhrer 2002). This poor empirical performance calls into question
the value of the policy recommendations that emerge from it. Recognizing
this weakness, researchers have developed a new generation of models
that retain the microeconomic approach to describing household
and firm behavior while also seeking to explain statistically movements
in observed data. These "hybrid" New Keynesian models,
as they are known, are important because they are rapidly becoming
the workhorse models in academic studies of monetary policy. They
are often used to construct a benchmark for what constitutes optimal
policy behavior, to assess past policy decisions, to study the
sources and importance of macroeconomic disturbances, and to quantify
the broad economic impact of policy interventions.
In this Economic
Letter, we discuss the basic properties of hybrid New Keynesian
models and examine the extent to which they successfully
explain U.S. macroeconomic data.
Hybrid New Keynesian models
Hybrid New Keynesian models have the canonical model at their
core, but they introduce a number of important modifications. Typically
these modifications seek to generate persistence in output and
inflation in order to slow down the rapid adjustments that occur
in the canonical model.
Consider, for a moment, the canonical model
(see, for example, Rotemberg and Woodford 1997). Households are
assumed to smooth
consumption by saving or by borrowing against expected future income;
specifically, they save more when interest rates are high and consume
more when interest rates are low. Firms are assumed to have some
market power, allowing those selling similar products to charge
different prices. Although firms choose the price that they charge
for their product, costs associated with changing prices—re-labeling
prices on goods, reprinting menus, etc.—hinder firms from changing
prices frequently. As a result, a firm chooses today's price based
not only on current demand for its product but also on the price
it expects to be able to sell its product for tomorrow.
The problem
with the canonical model is that the behavior of output, consumption,
prices, and interest rates suggested by the model
are fundamentally at odds with observed data. Ball (1991) shows
that the inflation equation in the canonical model implies that
a central bank can lower inflation to whatever level it desires
without any sacrifice in output or employment, let alone a recession.
The reason for this is that models with costly price adjustments
lead to persistence, or inertia, in prices, but not in inflation
(the rate of change in prices). Measured inflation, however, is
highly persistent, and the reduction in inflation that occurred
in the early 1980s—commonly associated with tighter monetary
policy—was demonstrably not costless in terms of output or
employment: from
July 1981 to November 1982—the "Volcker recession"—over
2.8 million nonfarm payroll jobs were lost. Similarly, the canonical
model suggests that consumers can easily save or borrow against
future income to smooth out fluctuations in current income. In
contrast, studies typically find little evidence for consumption
smoothing (see Hall 1988), finding instead that a reduction in
current income generally leads to a decline in consumption (Shea
1995).
Hybrid New Keynesian models modify the canonical model by
adding habit formation into consumption behavior. Roughly speaking,
habit
formation corresponds to the idea that households become accustomed
to a certain standard of living and that they dislike having
their consumption fall below that standard; but, if their consumption
level does drop, then they gradually become accustomed to the
lower
living standard. Habit formation, in various forms, has been
used to explain survey results finding that people in rich countries
appear to be no happier than people in poor countries, that some
people tend to be less concerned with their own consumption than
with what others consume, and that some people tend to change
their
consumption patterns gradually even after sudden large increases
in income. In terms of the hybrid model's properties, habit formation
leads to gradual changes in consumption over time because the
standard of living that people become accustomed to depends on
past consumption.
Increasingly, hybrid models also modify the canonical
model by introducing indexation into firms' pricing decisions.
The basic
idea behind price indexation is that firms recognize that prices
will tend to rise over time, but they also find it costly to
determine continuously the price they should charge for their
goods. So,
rather than reassess what price they should charge frequently,
firms reassess their optimal price setting once a year (say)
and simply change their price according to observed inflation
on other
occasions. While its theoretical motivation is loose, the effect
of price indexation is to make inflation persistent. This persistence
arises because at any point in time some firms are simply changing
their prices according to past inflation.
With these modifications,
the canonical model, which had no mechanism for generating persistence,
is transformed into a framework in
which both households and firms make decisions based on past
outcomes as well as on expected future outcomes.
Do hybrid models fit the data?
Given that hybrid New Keynesian models are widely applied and
are used to explore policy issues, the question arises whether
they adequately describe the behavior of an economy like the U.S.
Of course, because they invariably encompass the canonical model,
hybrid models will outperform the canonical model from an empirical
standpoint, but this does not imply that they necessarily fit the
data well. Dennis (2003) develops and estimates a number of hybrid
New Keynesian models and assesses how well they describe the U.S.
economy between 1982.Q1 and 2002.Q2. Figures 1 and 2 show the estimated
responses of inflation and consumption to a transitory supply shock—say,
a short-lived oil price shock—using the hybrid model and a Vector
AutoRegression (VAR). The VAR uses the past history of the data
to uncover statistical relationships among variables, restricting
these relationships as little as possible, and, in particular,
without imposing the New Keynesian theory on the data. The VAR
responses provide a benchmark for comparing the hybrid New Keynesian
model results. The shaded regions represent 95% confidence bands
around the VAR responses; in other words, according to the VAR,
only 5% of the time should we observe outcomes that lie outside
these shaded areas. With the VAR providing the benchmark, occasions
where the hybrid model's responses lie outside the shaded regions
indicate noteworthy departures from the benchmark behavior.
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To understand
the figures, it is useful to interpret the responses from the
hybrid model in terms of the underlying theory. An adverse
supply shock pushes inflation up (Figure 1) causing the central
bank to raise interest rates. Higher interest rates induce consumers
to defer consumption, causing consumption to fall (Figure 2).
Facing lower demand for their product, firms gradually begin to
lower
their prices, and inflation begins to fall. As time passes, more
and more firms lower their prices, and indexing firms respond
to falling inflation by also lowering their prices. With inflation
gradually falling, the central bank is able to lower interest
rates,
which stimulates consumption spending. Through this process,
inflation and interest rates slowly decline, and consumption slowly
rises,
back to their previous levels. After about seven years (30 quarters)
the shock has largely passed through the economy, having little
further impact.
Looking at the responses from the hybrid model,
it is clear that habit formation and price indexation introduce
considerable inertia
into the model—shocks that last only one period lead to sustained
movements in consumption and inflation. This inertia represents
the hybrid model's contribution over and above the canonical
model. Although the hybrid model does reasonably well in response
to demand
shocks (not shown), in response to a supply shock there are
a number of areas where the hybrid model's responses differ importantly
from the VAR. Specifically, in response to the shock, the hybrid
model predicts that consumption and (particularly) inflation
will
take much longer to return to normal than is evident in U.S.
data.
Conclusions
Hybrid New Keynesian models are widely used to explore monetary
policy issues and to identify and study the sources and importance
of macroeconomic fluctuations. This Economic Letter has discussed
the economic behavior that underpins many hybrid New Keynesian
models, described how they improve on the canonical model, and
examined their ability to replicate important characteristics of
U.S. data. By comparing the predictions of an estimated hybrid
model to those from a VAR, we found that the hybrid model generally
performed well. However, the hybrid model struggled to capture
the economy's response to supply shocks, suggesting that additional
work is needed to improve the model's supply side and its rationale
for why inflation is persistent.
Richard Dennis
Economist
References
Ball, Laurence. 1991. "The Genesis of Inflation and the Costs
of Disinflation." Journal of Money, Credit and Banking 23(3)
pp. 439-451.
Estrella, Arturo, and Jeffrey Fuhrer. 2002. "Dynamic
Inconsistencies: Counterfactual Implications of a Class of Rational-Expectations
Models." American Economic Review 92(4), pp. 1013-1028.
Dennis,
Richard. 2003. "New Keynesian Optimal-Policy Models:
An Empirical Assessment." FRBSF Working Paper 2003-16 (August).
Hall,
Robert. 1988. "Intertemporal Substitution in Consumption." Journal
of Political Economy 96(2), pp. 339-357.
Rotemberg, Julio, and Michael
Woodford. 1997. "An Optimization-based
Econometric Framework for the Evaluation of Monetary Policy." In
Ben Bernanke and Julio Rotemberg, eds., NBER Macroeconomics
Annual.
Cambridge, MA: MIT Press.
Shea, John. 1995. "Union Contracts
and the Life-Cycle/Permanent Income Hypothesis." American
Economic Review 85, pp. 186-200.
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