Criticisms of New Keynesian Economics
The new Keynesian research programme has been driven by the view that the
orthodox Keynesian model lacked coherent microfoundations with respect to
wage and price rigidities. As a result the new Keynesian literature has been,
until recently, heavily biased towards theoretical developments. Many economists
have been critical of the lack of empirical work, and Fair (1992)
suggests that this literature has moved macroeconomics away from its econometric
base and advises new Keynesians to ‘entertain the possibility of putting
their various ideas together to produce a testable structural macroeconometric
model’. Laidler (1992a) also argues forcefully for the reinstatement of empirical
evidence as a research priority in macroeconomics.
Table 7.2 Evidence on reasons for price stickiness
Theory of price stickiness Percentage of firms
accepting theory
Coordination failure – each firm waiting for others to 60.6
change price first
Cost-based pricing with lags 55.5
Preference for varying product attributes other than price 54.8
Implicit contracts – fairness to customers necessitates 50.4
stable prices
Explicit nominal contracts 35.7
Costly price adjustment – menu costs 30.0
Procyclical elasticity – demand curves become more 29.7
inelastic as they shift to the left
Psychological significance of pricing points 24.0
Preference for varying inventories rather than change price 20.9
Constant marginal cost and constant mark-ups 19.7
Bureaucratic delays 13.6
Judging quality by price – fear that customers will interpret 10.0
reductions in price as a reduction in quality
Source: Adapted from Blinder (1994).
In response, new Keynesians can point to the non-orthodox but interesting
and innovative research by Blinder (1991, 1994) into the pricing behaviour of
firms, the empirical work related to testing the efficiency wage hypothesis
(for example, Drago and Heywood, 1992; Capelli and Chauvin, 1991) and
the influential paper by Ball et al. (1988) testing menu cost models using
cross-country data. In seeking an answer to the important question ‘Why are
prices sticky?’, Blinder’s research utilizes the data collected from interviews
to discriminate between alternative explanations of price stickiness, which is
regarded as a stylized fact by Keynesian economists (see Carlton, 1986, for
evidence on price rigidities). Blinder’s results, reproduced in Table 7.2, give
some support to Keynesian explanations which emphasize coordination failures,
cost-plus pricing, preference for changing product attributes other than
price, and implicit contracts.
In an interview (Snowdon, 2001a) Blinder summarized his findings on
price stickiness in the following way:
of the twelve theories tested, many of the ones which come out best have a
Keynesian flavour. When you list the twelve theories in the order that the respondents
liked and agreed with them, the first is co-ordination failure – which is a very
Keynesian idea. The second relates to the simple mark-up pricing model, which I
might say is a very British-Keynesian idea. Some of the reasons given for price
stickiness are not Keynesian at all. For example, non-price competition during a
recession. The Okun (1981) implicit contract idea is also very Keynesian … if you
look at the top five reasons given by firms as to why prices are sticky, four of them
look distinctly Keynesian in character … To the extent that you are prepared to
believe survey results, and some people won’t, I think this research strikes several
blows in favour of Keynesian ideas.
Similar work by Bhaskar et al. (1993), utilizing data collected in the UK
during the 1980s, confirms that most firms tend not to increase prices in
booms or reduce them in recessions, but quantity adjustment responses via
variations in hours, shift work, inventories or customer rationing are ‘overwhelmingly
important’.
A second major problem with the new Keynesian literature is that it has
yielded numerous elegant theories which are often unrelated (Gordon, 1990).
This makes the pulling together of these ideas in order to produce a testable
new Keynesian model all the more difficult. New Keynesians have themselves
recognized this problem, with Blanchard (1992) reflecting that ‘we
have constructed too many monsters’ with ‘few interesting results’. The
fascination with constructing a ‘bewildering array’ of theories with their
‘quasi religious’ adherence to microfoundations has become a disease. Because
there are too many reasons for wage and price inertia, no agreement
exists on which source of rigidity is the most important (for a critique of
efficiency wage theory, see Katz, 1986; Weiss, 1999
A third line of criticism also relates to the menu cost literature. Critics
doubt that the small costs of price adjustment can possibly account for major
contractions of output and employment (Barro, 1989a). Caplin and Spulber
(1987) also cast doubt on the menu cost result by showing that, although
menu costs may be important to an individual firm, this influence can disappear
in the aggregate. In response to these criticisms, new Keynesians argue
that the emerging literature which incorporates real rigidities widens the
scope for nominal rigidities to have an impact on output and employment
(see Ball and Romer, 1990; D. Romer, 2001). A further weakness of models
incorporating small costs of changing prices is that they generate multiple
equilibria. Rotemberg (1987) suggests that ‘if many things can happen the
models are more difficult to reject’ and ‘when there are multiple equilibria it
is impossible to know how the economy will react to any particular government
policy’. Golosov and Lucas (2003) also highlight that in calibration
exercises their menu cost model is consistent with the fact that ‘even large
disinflations have small real effects if credibly carried out’.
A fourth criticism of new Keynesian economics relates to the emphasis it
gives to deriving rigidities from microfoundations. Tobin (1993) denies that
Keynesian macroeconomics ‘asserts or requires’ nominal and/or price rigidity.
In Tobin’s view, wage and price flexibility would, in all likelihood,
exacerbate a recession and he supports Keynes’s (1936) intuition that rigidity
of nominal wages will act as a stabilizing influence in the face of aggregate
demand shocks. Tobin also reminds the new Keynesians that Keynes had a
‘theoretically impeccable’ and ‘empirically realistic’ explanation of nominal
wage rigidity based on workers’ concern with wage relativities. Since a
nominal wage cut will be viewed by each group of workers as a relative real
wage reduction (because workers have no guarantee in a decentralized system
of knowing what wage cuts other groups of workers are accepting), it
will be resisted by rational workers. Summers (1988) has taken up this
neglected issue and suggests relative wage influences give rise to significant
coordination problems. Greenwald and Stiglitz (1993b) have also developed
a strand of new Keynesian theorizing which highlights the destabilizing
impact of price flexibility.
A fifth criticism relates to the acceptance by many new Keynesians of the
rational expectations hypothesis. Phelps (1992) regards the rational expectations
hypothesis as ‘unsatisfactory’ and Blinder (1992a) notes that the empirical
evidence in its favour is ‘at best weak and at worst damning’. Until someone
comes up with a better idea, it seems unlikely that this line of criticism will lead
to the abandonment of the rational expectations hypothesis in macroeconomics.
However, with respect to the formation of expectations Leijonhufvud is enthusiastic
about recent research into ‘Learning’ (see Evans and Honkapohja, 2001;
Snowdon, 2004a).
A sixth problem identified with new Keynesian economics relates to the
continued acceptance by the ‘new’ school of the ‘old’ IS–LM model as the
best way of understanding the determinants of aggregate demand. King (1993)
argues that the IS–LM model has ‘no greater prospect of being a viable
analytical vehicle for macroeconomics in the 1990s than the Ford Pinto has
of being a sporty, reliable car for the 1990s’. The basic problem identified by
King is that, in order to use the IS–LM model as an analytical tool, economists
must essentially ignore expectations, but ‘we now know that this
simplification eliminates key determinants of aggregate demand’ (King, 1993).
King advises macroeconomists and policy makers to ignore new Keynesian
advertising because, despite the new packaging, the new product is as unsound
as the original one (however, see section 7.12 above).
Finally, Paul Davidson (1994) has been very critical of new Keynesian
analysis, claiming that ‘there is no Keynesian beef in new Keynesianism’.
From Davidson’s Post Keynesian perspective, new Keynesians pay no attention
to crucial aspects of Keynes’s monetary theory (see Chapter 8). However,
Mankiw (1992) does not regard consistency between new Keynesian analysis
and the General Theory, which he describes as ‘an obscure book’, as an
important issue.
The new Keynesian research programme has been driven by the view that the
orthodox Keynesian model lacked coherent microfoundations with respect to
wage and price rigidities. As a result the new Keynesian literature has been,
until recently, heavily biased towards theoretical developments. Many economists
have been critical of the lack of empirical work, and Fair (1992)
suggests that this literature has moved macroeconomics away from its econometric
base and advises new Keynesians to ‘entertain the possibility of putting
their various ideas together to produce a testable structural macroeconometric
model’. Laidler (1992a) also argues forcefully for the reinstatement of empirical
evidence as a research priority in macroeconomics.
Table 7.2 Evidence on reasons for price stickiness
Theory of price stickiness Percentage of firms
accepting theory
Coordination failure – each firm waiting for others to 60.6
change price first
Cost-based pricing with lags 55.5
Preference for varying product attributes other than price 54.8
Implicit contracts – fairness to customers necessitates 50.4
stable prices
Explicit nominal contracts 35.7
Costly price adjustment – menu costs 30.0
Procyclical elasticity – demand curves become more 29.7
inelastic as they shift to the left
Psychological significance of pricing points 24.0
Preference for varying inventories rather than change price 20.9
Constant marginal cost and constant mark-ups 19.7
Bureaucratic delays 13.6
Judging quality by price – fear that customers will interpret 10.0
reductions in price as a reduction in quality
Source: Adapted from Blinder (1994).
In response, new Keynesians can point to the non-orthodox but interesting
and innovative research by Blinder (1991, 1994) into the pricing behaviour of
firms, the empirical work related to testing the efficiency wage hypothesis
(for example, Drago and Heywood, 1992; Capelli and Chauvin, 1991) and
the influential paper by Ball et al. (1988) testing menu cost models using
cross-country data. In seeking an answer to the important question ‘Why are
prices sticky?’, Blinder’s research utilizes the data collected from interviews
to discriminate between alternative explanations of price stickiness, which is
regarded as a stylized fact by Keynesian economists (see Carlton, 1986, for
evidence on price rigidities). Blinder’s results, reproduced in Table 7.2, give
some support to Keynesian explanations which emphasize coordination failures,
cost-plus pricing, preference for changing product attributes other than
price, and implicit contracts.
In an interview (Snowdon, 2001a) Blinder summarized his findings on
price stickiness in the following way:
of the twelve theories tested, many of the ones which come out best have a
Keynesian flavour. When you list the twelve theories in the order that the respondents
liked and agreed with them, the first is co-ordination failure – which is a very
Keynesian idea. The second relates to the simple mark-up pricing model, which I
might say is a very British-Keynesian idea. Some of the reasons given for price
stickiness are not Keynesian at all. For example, non-price competition during a
recession. The Okun (1981) implicit contract idea is also very Keynesian … if you
look at the top five reasons given by firms as to why prices are sticky, four of them
look distinctly Keynesian in character … To the extent that you are prepared to
believe survey results, and some people won’t, I think this research strikes several
blows in favour of Keynesian ideas.
Similar work by Bhaskar et al. (1993), utilizing data collected in the UK
during the 1980s, confirms that most firms tend not to increase prices in
booms or reduce them in recessions, but quantity adjustment responses via
variations in hours, shift work, inventories or customer rationing are ‘overwhelmingly
important’.
A second major problem with the new Keynesian literature is that it has
yielded numerous elegant theories which are often unrelated (Gordon, 1990).
This makes the pulling together of these ideas in order to produce a testable
new Keynesian model all the more difficult. New Keynesians have themselves
recognized this problem, with Blanchard (1992) reflecting that ‘we
have constructed too many monsters’ with ‘few interesting results’. The
fascination with constructing a ‘bewildering array’ of theories with their
‘quasi religious’ adherence to microfoundations has become a disease. Because
there are too many reasons for wage and price inertia, no agreement
exists on which source of rigidity is the most important (for a critique of
efficiency wage theory, see Katz, 1986; Weiss, 1999
A third line of criticism also relates to the menu cost literature. Critics
doubt that the small costs of price adjustment can possibly account for major
contractions of output and employment (Barro, 1989a). Caplin and Spulber
(1987) also cast doubt on the menu cost result by showing that, although
menu costs may be important to an individual firm, this influence can disappear
in the aggregate. In response to these criticisms, new Keynesians argue
that the emerging literature which incorporates real rigidities widens the
scope for nominal rigidities to have an impact on output and employment
(see Ball and Romer, 1990; D. Romer, 2001). A further weakness of models
incorporating small costs of changing prices is that they generate multiple
equilibria. Rotemberg (1987) suggests that ‘if many things can happen the
models are more difficult to reject’ and ‘when there are multiple equilibria it
is impossible to know how the economy will react to any particular government
policy’. Golosov and Lucas (2003) also highlight that in calibration
exercises their menu cost model is consistent with the fact that ‘even large
disinflations have small real effects if credibly carried out’.
A fourth criticism of new Keynesian economics relates to the emphasis it
gives to deriving rigidities from microfoundations. Tobin (1993) denies that
Keynesian macroeconomics ‘asserts or requires’ nominal and/or price rigidity.
In Tobin’s view, wage and price flexibility would, in all likelihood,
exacerbate a recession and he supports Keynes’s (1936) intuition that rigidity
of nominal wages will act as a stabilizing influence in the face of aggregate
demand shocks. Tobin also reminds the new Keynesians that Keynes had a
‘theoretically impeccable’ and ‘empirically realistic’ explanation of nominal
wage rigidity based on workers’ concern with wage relativities. Since a
nominal wage cut will be viewed by each group of workers as a relative real
wage reduction (because workers have no guarantee in a decentralized system
of knowing what wage cuts other groups of workers are accepting), it
will be resisted by rational workers. Summers (1988) has taken up this
neglected issue and suggests relative wage influences give rise to significant
coordination problems. Greenwald and Stiglitz (1993b) have also developed
a strand of new Keynesian theorizing which highlights the destabilizing
impact of price flexibility.
A fifth criticism relates to the acceptance by many new Keynesians of the
rational expectations hypothesis. Phelps (1992) regards the rational expectations
hypothesis as ‘unsatisfactory’ and Blinder (1992a) notes that the empirical
evidence in its favour is ‘at best weak and at worst damning’. Until someone
comes up with a better idea, it seems unlikely that this line of criticism will lead
to the abandonment of the rational expectations hypothesis in macroeconomics.
However, with respect to the formation of expectations Leijonhufvud is enthusiastic
about recent research into ‘Learning’ (see Evans and Honkapohja, 2001;
Snowdon, 2004a).
A sixth problem identified with new Keynesian economics relates to the
continued acceptance by the ‘new’ school of the ‘old’ IS–LM model as the
best way of understanding the determinants of aggregate demand. King (1993)
argues that the IS–LM model has ‘no greater prospect of being a viable
analytical vehicle for macroeconomics in the 1990s than the Ford Pinto has
of being a sporty, reliable car for the 1990s’. The basic problem identified by
King is that, in order to use the IS–LM model as an analytical tool, economists
must essentially ignore expectations, but ‘we now know that this
simplification eliminates key determinants of aggregate demand’ (King, 1993).
King advises macroeconomists and policy makers to ignore new Keynesian
advertising because, despite the new packaging, the new product is as unsound
as the original one (however, see section 7.12 above).
Finally, Paul Davidson (1994) has been very critical of new Keynesian
analysis, claiming that ‘there is no Keynesian beef in new Keynesianism’.
From Davidson’s Post Keynesian perspective, new Keynesians pay no attention
to crucial aspects of Keynes’s monetary theory (see Chapter 8). However,
Mankiw (1992) does not regard consistency between new Keynesian analysis
and the General Theory, which he describes as ‘an obscure book’, as an
important issue.
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