Divine Coincidence is Unlikely

The details of this paper may not interest all of you as the paper involves fairly technical issues regarding New Keynesian models and monetary policy, but the general question is straightforward. Do policymakers face an inflation-output tradeoff when conducting monetary policy? In standard versions of the New Keynesian model they do not, a situation known as divine coincidence. Greg Mankiw’s discussion of divine coincidence, an ideal situation for a policymaker, was presented here.  Here’s another paper on this topic that will be presented at this conference sponsored by the Federal Reserve Board and The Journal of Money, Credit, and Banking (the link has other interesting conference papers as well) showing that divine coincidence is due to a special feature of the New Keynesian model:

"Real Wage Rigidities and the New Keynesian Model," Olivier Blanchard and Jordi Gali, September 9, 2005: Abstract Most central banks perceive a trade-off between stabilizing inflation and stabilizing the gap between output and desired output. However, the standard new Keynesian framework implies no such trade-off. In that framework, stabilizing inflation is equivalent to stabilizing the welfare-relevant output gap. In this paper, we argue that this property of the new Keynesian framework, which we call the divine coincidence, is due to a special feature of the model, the absence of non trivial real imperfections. We focus on one such real imperfection, namely real wage rigidities. When the baseline new Keynesian model is extended to allow for real wage rigidities, the divine coincidence disappears, and central banks indeed face a trade-off between stabilizing inflation and stabilizing the welfare-relevant output gap. We show that not only does the extended model have more realistic normative implications, but it also has appealing positive properties. In particular, it provides a natural interpretation for the dynamic inflation-unemployment relation found in the data.

Comments

[Ian D-B]

Check out the Rudd-Whelan paper from the same conference. They tear apart the NKPC. It's absolutely brutal, but extremely effective. NKPC models don't have nearly the sound micro foundation that they claim, and as we already know, the empirical results are laughable next to standard models.

[PEmberton]

Well I was going to make a similar point to Ian D-B, but he beat me to it. Lucas and Sargent ripped Keynesian models as "jerry-built" back in 1978 and then gave them the Katrina treatment. The NK version is the same old failed sticky price model.
"Is there a core of usable macroeconomics we can all agree on" ? John Taylor once asked in the AER.
Looks like not...

[Ian D-B]

Well now hold on. throwing out NKPC models doesn't mean throwing out price stickiness altogether. I wish the NKPC people could have just ended with the old Ball-Mankiw papers. Price stickiness is obviously a big issue, and Sargent and Lucas pointed out some errors, but the models, generally exemlified by the Gordon papers, have held up better than almost any econometric relationships yet found. Ball and Mankiw (along with some coauthors) showed that small menu costs, skewed idiosyncratic shocks, and other factors, could explain the reduced form relationship that Gordon still finds. Why do you say that sticky-price models are failed?

[PEmberton]

Well Gordon's econometric results only hold by allowing an ever-expanding array of extra-ordinary supply shocks.
Lucas and Golosev have shown sticky prices are a non-issue.

But my bigger issue with the NK approach is that it is looking in the wrong place for co-ordination failure. The papers of Clower, Howitt and especially John Bryant (see his latest in Eastern Economic Journal) are it seems to me, genuinely getting to grips with these issues rather than positing spurious stickiness as the source of coordination failure. Of course, Leijonhufvud was making the same point in the 1960s.

[Ian D-B]

You don't need coordination failure, you just need small nominal costs of changing prices. Look at Ball, Mankiw, and Romer. And as to Gordon, his model is still robust when some of the supply shocks are dropped. Look at Staiger, Stock, and Watson's work. They don't go to the lengths he does, but still find that the standard expectationsaugmented PC holds. Take gordon's specifications from a few years ago, before he added the supply shocks you don't like, and see if they hold up. Every specification I've ever run has worked fine, and even shows a stable slope coefficient.

I get the feeling you want an RBC model like Hall prefers and talks about in his Jackson Hole paper form this year.