**Nick Rowe:** Worthwhile Canadian Initiative: Old and New Keynesians and self-equilibration:

Old Keynesian Income-Expenditure model…. This model has zero tendency to self-equilibrate at full employment…. Old Keynesian ISLM model…. This model may or may not have a tendency towards full employment "in the long run"…. It depends on the shapes of the IS and LM curves, because it may be that no fall in the price level or increase in the money supply can get the rate of interest low enough to get the economy to full employment. It also depends on the interaction between expected inflation/deflation and actual inflation/deflation…. The model tells you what it depends on.

The… "canonical" New Keynesian model… has three equations. The new "IS curve"… the ratio of current demand to expected future demand is a negative function of the real rate of interest. There is an equation for the expectations-augmented Phillips Curve, which both defines "full-employment" and tells you the relationship between deviations of output from full employment and deviations of actual from expected inflation. And there is an equation for the monetary policy reaction function…. (You can call the assumption of rational expectations a fourth equation, if you wish.)… This model has zero tendency towards full employment, even if you assume a sensible monetary policy.

New Keynesian modellers just assume a tendency towards "long run" full employment, even though it's not there in the model…. Even if monetary policy is perfect… all that tells you is that the ratio of today's demand to tomorrow's demand will be exactly right. But we will only be at full employment today if people expect full employment tomorrow; and they will only expect full employment tomorrow if they expect full employment the day after tomorrow, and so on. A cut in real interest rates does not increase today's demand; it only increases the ratio of today's demand to expected tomorrow's demand. And there are two ways a ratio can increase: a rise in the numerator; or a fall in the denominator…