Simon Wren-Lewis — Why do central banks use New Keynesian models?

Advanced macro for non-economists (no math). Simple explanation of how and why central banks use New Keynesian (DSGE) models and how they differ from RBC models.

Mainly Macro
Why do central banks use New Keynesian models?
Simon Wren-Lewis | Professor of Economics, Oxford University

Why is this significant. Because modern monetarism, based on central banks setting a policy rate, depends on some tool or tools for determining the correct rate to set. According to John Taylor, some rule is required. Therefore, a model in which a key methodological assumption is the real interest rate is needed, and since the policy rate is an adjustment for expected inflation, some tool for determining change in price level is also required.

In the simplest case, this involves setting a nominal rate that achieves, or moves towards, the level of real interest rates that is assumed to occur in the inner RBC model: the natural real rate. 

So even though New Keynesianism is called "Keynesian," it is a form of monetarism since it is chiefly concerned with interest rates and price level rather than effective demand and employment, which are functions of a full employment budget rather than than the a natural rate of interest and natural rate of employment.

In the view of fiscalism, monetary is the wrong approach for several reasons, for example, monetary policy that it is less effective as a policy tool than fiscal policy, and monetarism is ineffective because of it's assumptions. Rather, a policywise government must adjust fiscal policy to accommodate variable non-government saving desire in order to keep the production-distribution-consumption cycle virtuous instead of allowing it to turn vicious.

For example, this is at the heart of Robert Skidelsky's recent post a Project Syndicate on the divergence of economic thought and its effect on policy, to which a link was posted here at MNE yesterday.

There are basically two approaches, monetarist and fiscalist, and two major schools in each. Monetarism is divided into the New Classical and New Keynesian schools, and fiscalism into the Old Keynesian and Post Keynesian schools.

So it's important to understand the basic issues from a policy standpoint to engage in political debate intelligently. Fortunately, it is not necessary to understand the advanced macro background in econometrics since economists have framed the basic issues quite simply.

See

NBER Working Paper Series
Keynesian, New Keynesian, And New Classical Economics
Bruce Grenwald Joseph E. Stiglitz

Also

This paper examines in how far the DSGE model which is often dubbed the New Keynesian Consensus is compatible with a Post- Keynesian or traditional Keynesian understanding of the economy. It is argued that while at first sight DSGE models seem to include a lot of traditional Keynesian or even Post-Keynesian elements such as endogeneous money or the need for an active central bank, the mechanisms at work are completely incompatible with a traditional or Post-Keynesian understanding of the working of the macroeconomy.

IMK
The New Consensus from a Traditional Keynesian and Post-Keynesian Perspective: A worthwhile foundation for research or just a waste of time?
Sebastian Dullien