The Neomonetarist Perspective

In May 2000 I gave a series of three lectures on business cycle theory at Harvard’s Economics Department. In the first lecture, I presented a set of slides on “The Neomonetarist Perspective.” I have copied the contents of those slides below. Let me provide a few annotations. First, in the slides, I mention the concept of “real rigidity” introduced by Larry Ball and David Romer in 1990. Real rigidity makes prices adjust less even when firms have the chance to adjust their prices. My own treatment of real rigidity is in my 1995 paper “The Quantitative Analytics of the Basic Neomonetarist Model.”  Second, my views on the labor supply elasticity have shifted as a result of my 2008 paper with Matthew Shapiro: “Labor Supply: Are the Income and Substitution Effect Both Large or Both Small?” toward larger values since I wrote these slides. (However, the intensive Frisch labor supply elasticity of around 1 that Matthew and I find is still somewhat lower than that used in many real business cycle models.) Third, the qualitative analytics I mention are best illustrated by my working paper “Q-Theory and Real Business Cycle Analytics”–which also provides a methodological discussion consistent with “The Neomonetarist Perspective” below. Fourth, my textbook draft “Business Cycle Analytics” provides many illustrations of quantitative analytics. (Both of these are on my University of Michigan website.) 

Four Elements of the Neomonetarist Perspective

  1. Attributing the fluctuations at business cycle frequency primarily to the interaction of real and monetary shocks with sticky prices.
  2. Seeing the qualitative properties of “Real Business Cycle” models as descriptions of the decadal fluctuations of the economy rather than fluctuations at business cycle frequencies.
  3. Viewing with skepticism many of the parameter values, functional forms, and mechanisms that have become traditional in much of business cycle theory.
  4. Pursuing a research strategy that emphasizes detailed intuitive understanding and systematic analytical methods over purely numerical results.

Neomonetarist Modeling of Sticky Prices

(a) Background requirements for plausibility:

  • imperfect competition.
  • increasing returns to scale.
  • real rigidity.

(b) Macroeconomic effects of imperfect price flexibility lasting several years.

  • Price adjustment that is fast relative to adjustment of the capital stock, but slow relative to adjustment of output to demand. 
  • Overlapping price setting.  At any one time, only a small fraction of prices will be changed.
  • Leaning toward optimization.
  • Neoclassical, fully optimizing households.
  • Cost-Minimizing firms.
  • Price-setting modeled as optimization subject to important procedural constraints.
  • Variation in the actual markup as the link between the monetary, nominally sticky side of the model and the real equations of the model. 

The Argument for “Real Business Cycle Models” as Models of the Medium-Run Adjustment of the Capital Stock Rather than Models of Business Cycle Fluctuations:

(a) Basic “Real Business Cycle Models” are sophisticated versions of the “Solow Growth Model” of capital adjustment.

(b) With plausible parameter values, the endogenous rate of adjustment of the capital stock is on the order of ten years. 

(c ) Most shocks to total factor productivity (“technology”) should be essentially permanent; therefore, business cycle fluctuations must result from an endogenous business-cycle-frequency (about three-year) mechanism rather than from business-cycle-frequency movements in the driving variable of technology. 

(d) If the degree of imperfect competition and increasing returns to scale are relatively small–and prices adjust several times faster than the capital stock–“Real Business Cycle Models” are good models of the medium-run adjustment of the capital stock even when prices are sticky in the short run.

A New Take on Parameter Values and Functional Forms

(a) Prescott’s original strategy of calibrating models of economic fluctuations by looking at a wide range of micro-economic, partial equilibrium and long-run trend evidence and logic needs to be pursued with greater earnestness.  Prescott’s genuine contribution here is the approach, not the particular parameter values and functional forms he chooses.  Flexible functional forms should be preferred where possible; functional form restrictions need to be justified.  

(b) There is no microeconomic or partial equilibrium evidence of high labor supply elasticities.  The arguments of Rogerson and Hanson are not an adequate defense of high labor supply elasticities.  Effort-elicitation models of efficiency wages also do not justify high labor supply elasticities. 

(c ) There is no microeconomic or partial equilibrium evidence of a strong response of nondurable consumption to the real interest rate. 

(d) There is a great deal of microeconomic and long-run-trend evidence that the income and substitution effects of a permanent increase in the real wage approximately cancel.

Three Analytical Toolboxes

(a) Approximation theory.

  • The certainty equivalence approximation links the perfect foresight model to the corresponding stochastic model.
  • Writing down a discrete-time model and then taking a continuous-time limit yields the most insight into a model. 
  • The approximation of a hierarchy of adjustment speeds allows one to deal with more than one state variable in an intuitive way. 

(b) Qualitative analytics.

  • Analyzing the partial equilibrium pieces of a model with model-specific graphs and the principles of monotone comparative statics. 
  • Contemporaneous general equilibrium.
  • Dynamic general equilibrium on the phase diagram. 
  • Steady state comparative statics.

(c ) Quantitative analytics.

  • Steady-state relationships.
  • Log-linearization around the steady-state.
  • Calculation of the convergence rate and impulse responses.