Paul Krugman: License To Stagnate - NYTimes.com:
I think it’s useful to ask why, as a practical matter, conventional policy-oriented macroeconomists (myself included) used to think we could normally count on a fairly quick return to full employment after a shock--and why we shouldn’t think so anymore…. So what’s wrong with this pretty picture? Two ugly zeroes. First is the zero lower bound on the interest rate… you should keep cutting rates, but you can’t. Second is downward nominal rigidity… [which] lead[s] the [long-run] Phillips curve to be non-vertical in the face of very low inflation… even years of a deeply depressed economy tend to produce at most slow, grinding deflation, and more usually slight positive inflation, not the ever-accelerating deflation the standard model would have predicted. In the Bond movies, two zeroes meant a license to kill. In monetary policy, two zeroes — the hard zero on interest rates and the soft zero on wage changes — can, all too easily, give central bankers a de facto license to let the economy stagnate.
Here is a very simple version of a standard New Keynesian model…. The individual agent's consumption-Euler equation, with r(t) as the one-period real interest rate, is therefore: C(t)/C(t+1) = (1+n)/(1+r(t))…. Assume the central bank sets a real interest rate r(t)…. The central bank's job is to set r(t) such that C(t)=100, for all t. Inspecting the consumption-Euler equation, we see that this requires the central bank to set r(t)=n for all t. Assume the central bank does this…. [But] setting r(t)=n for all t only pins down the expected growth rate of consumption…. It does not pin down the level of consumption…. What [could] the central bank do to counter the bad animal spirits?
If it cuts r(t) below n… we know is that we must have negative equilibrium growth in consumption…. It is not obvious to me how making people expect negative growth in their incomes from now on should cause everyone to expect a higher level of income right now…. Sacrificing a goat sounds more promising as a method of restoring full employment….
Under the assumption that the effects of nominal rigidities vanish asymptotically [lim as T goes to infinity of the output gap at time T goes to zero]. In that case one can solve the [consumption-Euler equation] forward to yield….
Bullshit…. What he really means is:
We need to just assume the economy always approaches full employment in the limit as time goes to infinity, otherwise our Phillips Curve tells us we will eventually get hyperinflation or hyperdeflation, and we can't have our model predicting that, can we?
That Neo-Wicksellian/New Keynesian nonsense is what the best schools have been teaching their best students for the last decade or so. They have been teaching their students to just assume the economy eventually approaches full employment, even though there is absolutely nothing in the model to say it should…. New Keynesians simply must put money back into the model.