Credit and Prices in Woodford’s New Neoclassical Synthesis

Download full paper

This paper is closed for comments.


Following the recent debates in the New Neoclassical Synthesis, the theory of monetary policy had been renewed. The method that prevails, illustrated by Woodford’s Interest and Prices, is a Dynamic General Stochastic Equilibrium Model (DGSE) in which the old LM curve is voluntarily substituted by an optimal monetary rule. Such a turning point requires a peculiar set of assumptions especially regarding the monetary prices. The recent debate puts attention on the de-emphasis on nominal monetary aggregate that doesn’t play any explicit role in monetary policy deliberations. Following Calvo’s model, Woodford’s neo-Wicksellian framework only considered monetary prices in equilibrium. As a consequence no cumulative process in the spirit of Wicksell is allowed since monetary policy—under the form of a Taylor rule—always corrects any deviation of monetary prices from its target value. The monetary nature of Woodford’s approach is, then, purely arbitrary. Contrary to Woodford’s ambitions to provide microeconomic foundations of a monetary policy theory, this article tries to demonstrate that Woodford’s approach contains the same problem as the one embodied in the old static macroeconomics model: the lack of an explicit mechanism that endogenously explains the formation of monetary prices emerging from the spontaneous behaviour of the agents in the market.

Posted for comments on 21 Jan 2014, 10:04 am.

Comments (2)

  • David Laidler says:

    This is an interesting paper that makes a point that I have not come across before. It argues that, for all its sophisticated dynamic analysis, the Woodford model of monetary policy shares an important defect with the old comparative static IS-LM + Phillips Curve framework, namely that it is silent about the mechanisms whereby monetary policy induces agents to adjust individual money prices to values that generate an equilibrium value for the general price level. This just happens in each model. The paper also suggests – the authors are not quite explicit about this, but see their comment on the absence of Wicksell’s ideas about disequilibrium from Woodford’s system (p.7 and p.8) – that the old problem did not arise from the system’s static nature, as many of us used to think, but from the fact that, like the new one, it dealt only with equilibrium values. Finally, less originally, they recommend that a better way of analysing these issues might be found in following up Wicksell’s ideas about disequilibrium processes using modern tools.

    As the paper stands at present, I have a few misgivings about it.

    (1)The heart of the above argument is presented on pp. 8 – 11, but I found it extremely difficult to follow. I think that the essence of the story told there is something like the following: each individual price setter faces the task of choosing a profit maximising price relative to the general price level, but the outcome of these individual decisions is that same general price level, and this must attain a value that maintains equilibrium for the aggregate system. However, there is nothing endogenous to the system to guide price setters towards such an outcome. The outcome just happens with the help of a mysterious parameter “phi” whose value arrives out of the blue. This is my summary, and I am prepared to believe that I have not got the argument quit right. Either way, more clarity in its exposition is needed, at least by me! The final paragraph of p. 9 would be a possible place to start a revision, with more intuition about the price setting decisions there described being provided, and more stress on the apparently important role that will be played by “phi” in the argument that is to follow.

    (2) The above argument is presented (quite appropriately) in the context of a more general discussion of the similarities and differences between Wicksell and Woodford. This discussion, however, would benefit from being explicitly related to a symposium on this broader topic that appeared in the June 2006 issue of the JHET. The authors there are Boianovsky, Hoover, Laidler, Mehrling, Trautwein and Woodford himself, and between them they cover much of the ground traversed here, though I don’t recall encountering the specific arguments of pp. 8 – 11 there. Even so the authors should check this, and also pay explicit attention to Woodford’s responses to his critics. His thinking has not remained static since 2003, and it would be a pity if the Tobon and Barbaroux point was left vulnerable to being brushed off with the argument that its authors have failed to consider at least some ofWoodford’s post-2003 writings. It would probably also be a good idea to say something about Woodford’s recent work on “forward guidance” – see his paper at the 2013 FRB Kansas City Jackson Hole conference. This tool attempts to link policy actions to outcomes by influencing agents’ expectations and hence their behavoiour by pre-announcements of the time path of future policy actions. I wonder if this idea, which has already been influential at a number of central banks (with mixed results), can be read as an attempt on Woodford’s part to close the gap in his story that the current paper exposes, and I also wonder if it succeeds in this. I certainly don’t know the answers here, but some discussion of these issues would make this paper both more interesting and more topical.

    (3) I have certain reservations, all within the bounds of what reasonable people can disagree about, concerning the treatment of Wicksell’s (1898) analysis in this paper. On my reading, which follows Patinkin Money Interest and Prices Note E (an essay merits a separate citation in the current paper), Wicksell does discuss in turn a pure cash system and a pure credit system, but treats both of these, not just the first, as imaginary. They are set out as a prelude to his discussion of the system he was actually living with in the 1890s. This – commercial banking constrained by the gold standard – blended the two simpler cases, and Wicksell showed that, within it, when a disturbance to the “natural” rate of interest leads to a credit driven inflation, this would drain cash from the banks and induce them to adjust the “market” rate, thus bringing a cumulative rise in the price level to an end. In Wicksell’s complete system, that is to say, the demand for cash does indeed put a limit to credit creation (a point that is finally acknowledged here, much too late, in the last full para of p. 7). Closely related, the authors refer frequently to Wicksell’s ideas about the role of “money” without noting that, almost always, he used this word as synonymous with “currency”, thus making the distance between his analysis and any based on the quantity theory of money appear greater than perhaps it really is. Fisher and Hawtrey, both a bit younger than Wicksell, used two interest rate systems as well, but because they included deposit liabilities created as a by-product of bank lending, in their idea of money, their work looks much more quantity theoretic than his at first sight. The same, incidentally, may be said of Thornton (1802) who usually used the phrase “circulating medium” for what we call “money”. Only in those highly speculative passages of Interest and Prices where Wicksell envisions abandoning the gold standard and substituting internationally co-ordinated interest rate policies, does his pure credit economy begins to look like a possible real world monetary system in and of itself, and similar to Woodford’s “cashless economy” as well, of course.

    (4) Wicksell’s three conditions for monetary equilibrium, (p. 7 para. 1) are accepted uncritically here, and they shouldn’t be, because sorting out the inconsistencies among them was a major impetus to the efforts of both the Austrian and Swedish economists who followed up his work. On this and many related matters the authors should consult and cite Leijonhufvud’s still vitally important article on “The Wicksell Connection” in his Information and Co-ordination, and perhaps also take a look at Part I, “The Wicksellians”, of Laidler’s Fabricating the Keynesian Revolution . This point is important for this paper, because these problems are also relevant to the theoretical soundness of today’s real business cycle theory. Since the latter plays a large role in the models of the “New-Neoclassical Synthesis”. perhaps there might be more wrong with them than this paper suggests. Finally, let me draw attention to an unduly neglected (2009 – or 2011?) working paper – Tamborini, Trautwein & Mazzochi “The two triangles – what did Wicksell and Keynes know about macroeconomics that modern economists do not (consider)?” This is written very much in the same spirit as the current paper, and includes an exposition of a neo-Wicksellian three equation disequilibrium model that ought to appeal to its authors, as well as a systematic comparison of its properties with those of a generic new-neoclassical three equation system. Tamborini, at Trento, is listed as the corresponding author, and I found the paper very easily with a Google search of its full title. Tobon and Barbaroux should look at it, refer to it and show how their work relates to its results.

  • Colin Rogers says:

    This paper points out that Woodford’s (2003) model has no mechanism for the determination of money or nominal prices. The authors conclude correctly (on page 11) that the process of nominal price formation in Woodford’s model is something of a mystery. However, the mystery they point to is inevitable; a symptom of a deeper conceptual flaw in Woodford’s (2003) model outlined by Rogers (2006, 2011).

    Essentially what Rogers shows is that Woodford is trying to pass off a model of a moneyless economy as the foundation for a theory of monetary policy! Clearly this is an endeavour that will produce the sorts of mystery to which the author’s draw attention. Furthermore, the limits to Woodford’s (2003) analysis have been noticed in the literature by others. For example, Borio and Disyatat (2011, p. 30, emphasis added), explain the problem correctly:

    “The canonical model is that of a money-less economy that can do away with the ultimate settlement medium (Woodford’s (2003) “cashless economy”). Indeed, paradoxically, when settlement balances (money) are introduced, they act as a “friction”, not as the indispensable lubricant in an otherwise inefficient barter-exchange mechanism. It is an economy in which credit is just a vague shadow in the background [the time-0 auction]: since credit does not affect behaviour, its evolution does not need to be tracked. But, even then, intermediaries do not generate purchasing power they simply transfer real resources from one sector to the other. The underlying economy is, in this sense, a real economy disguised as a monetary one. Credit is just another real resource that households make available to entrepreneurs. This contrasts sharply with the essence of monetary analysis. ”

    So it should come as no surprise that the authors reach the correct conclusion (p.11) that the process of nominal price formation in Woodford’s model is something of a mystery. In fact Woodford’s (2003) analysis is ultimately incoherent because it attempts to find a role for money in a model where money is not required; the real business cycle core (Rogers 2013, 2014).

    Thus although I agree with the author’s conclusions, before supporting publication some reference to the fundamental theoretical flaws that lead to that conclusion should be made. By overlooking that critique the authors are too generous to Woodford.

    Borio, C. and Disyatat, P. 2011. “Global imbalances and the financial crisis: Link or no link?” Bank of International Settlements, Working Paper 346.
    Rogers, C. 2006. ‘Doing without money: a critical assessment of Woodford’s analysis’, Cambridge Journal of Economics, vol. 30(2) (March), pp. 293-306.
    Rogers, C. 2011. “The failure of Woodford’s model of the channel system at the cashless limit”, Journal of Money Credit and Banking, 43(2-3), pp. 535-563.
    Rogers, C. 2013. “The Scientific Illusion of New Keynesian Monetary Theory, The Handbook of Post Keynesian Economics, Oxford University Press.
    Rogers, C. (2014). “Why ‘state of the art’ monetary theory was unable to anticipate the global financial crisis; A child’s guide”, The European Journal of Economics and Economic Policies, forthcoming.