The Quantitative Analytics of the Basic Neomonetarist Model
Kimball, Miles S., Woodford, Michael, Journal of Money, Credit & Banking
A great deal of macroeconomic research in the last decade or two has been motivated by a lively debate over whether or not prices are sticky and whether and how much money matters. What are the lessons those who have not been active partisans can take away from this debate? I cannot claim true impartiality, because of my saltwater graduate school background on one side and my attraction to the elegance of the Real Business Cycle picture of an economy of optimizing agents responding to the fundamental economic forces of preferences and technology on the other. But like a bystander to the battle who moves among the dead and wounded to see what valuables he can gather, I have tried to collect things of worth from both sides. Thus, this paper is meant to stimulate discussion, not to be the final word on anything.
I will argue that a hybrid model should be taken much more seriously--a model following the Real Business Cycle paradigm as closely as possible except for adding what is logically necessary in order to graft in sticky prices. In order to avoid implicating either the New Keynesians or the New Classicals in my crimes, I will call such a hybrid model--grafting sticky prices into what would otherwise be a Real Business Cycle model--a "Neomonetarist" model. Such models are not unknown in the literature--for example, King (1991) and Cho and Cooley (1992) study models with both imperfect price flexibility and Real Business Cycle elements--but they have not been studied by as many people with as great intensity as other models. To justify more attention to such hybrid models, I must defend the assumption of sticky prices and defend the essence of the Real Business Cycle approach.
The main reason to be interested in sticky prices is that they provide one of the few means of generating large monetary nonneutralities. The basic evidence for the existence of large monetary nonneutralities is the evidence assembled by Friedman and Schwartz (1963), together with events after the end of their sample, such as the Volcker deflation. The details of the historical record discussed by Friedman and Schwartz (1963) have persuaded most macroeconomists that there has been a substantial exogenous component to the timing of monetary policy and sometimes even the direction of monetary policy based on the personalities and the inner workings of the Federal Open Market Committee and the Federal Reserve System more generally. The most exogenous shifts in monetary policy seem to have the clearest effects. Such historical evidence for the potency of monetary policy is also available for a host of other countries as well.
Despite considerable effort, there has been little success at generating large monetary nonneutralities in flexible-price models using plausible parameters for anything short of a hyperinflationary situation. The basic problem is that, if prices are perfectly flexible, the monetary services subsector (which is a small part of the financial services sector) looks a lot like any other type of service subsector in the economy. Short of massive bank failures or hyperinflation, the fraction of a percent share monetary services have in GDP(1) is simply too small for what happens to this sector to be a big deal if prices are perfectly flexible. (During hyperinflations, monetary services as a share of GDP do become substantial, sometimes rising above 10 percent of GDP.) By contrast, if prices are sticky, what happens in the monetary services sector can distort the decisions of firms in all sectors of the economy that have sticky prices.(2)
Real business cycle research has sometimes (though not always) been pursued in opposition to the idea of sticky prices, but this approach has many important strengths even if one is willing to entertain the idea that prices are sticky. Real Business Cycle research has consistently taken dynamics, sensible anticipation of the future, quantitative calibration and the welfare implications of models very seriously. …