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I. The Need for an Alternative Assessment
We think it is best to start by conducting a fresh set of simulations with a
macroeconomic model other than one of those used in Figure 1. We focus on the Smets-
Wouters model of the U.S. economy.
3
The Smets-Wouters model is representative of current
thinking in macroeconomics. It was recently published in the American Economic Review and
is one of the best known of the empirically-estimated “new Keynesian” models. It is very
similar to, and “largely based on” according to Smets and Wouters, another well-known
empirically-estimated new Keynesian model developed by Christiano, Eichenbaum and Evans
(2005). The Smets-Wouters model was highlighted by Michael Woodford (2009) as one of
the leading models in his review of the current consensus in macroeconomics.
4
The term “new Keynesian” is used to indicate that the models have forward looking,
or rational, expectations by individuals and firms, and some form of price rigidity, usually
staggered price or wage setting. The term also is used to contrast these models with “old
Keynesian” models without rational expectations of the kind used by Romer and Bernstein.
5
New Keynesian models rather than old Keynesian models are the ones commonly taught in
graduate schools because they capture how people’s expectations and microeconomic
behavior change over time in response to policy interventions and because they are
empirically est
imated and fit the data. They are therefore viewed as better for policy
ev
aluation. In assessing the effect of government actions on the economy, it is important to
3
See Smets and Wouters (2007) for a complete review of their model. It determines 14 endogenous variables:
output, consumption, investment, the price of capital, the capital stock, capital services, the capital utilization
rate, labor supply, the interest rate, the inflation rate, the rental rate on capital, the wage rate, the marginal
product of labor, and the marginal rate of substitution between work and consumption. The 14 equations include
forward looking consumption, investment, price and wage setting as well as several identities.
4
See Woodford (2009), which also contains a useful survey of the whole “new Keynesian” literature.
5
There is a rational expectations version of the FRB/US model. We simulated a permanent increase in
government purchases in this version and found that the multipliers declined sharply over time unlike those
reported by Romer and Bernstein (2009) but similar to the Taylor (1993) rational expectations model as shown
in Figure1. We infer that the FRB/US model and the private sector model used by Romer and Bernstien are not
new Keynesian models with rational expectations. Also, as explained below, new Keynesian models would not
allow an assumption of a constant zero interest rate forever.