This economic paper is strange:
Over the past thirty years, a great deal of business cycle research has been based on purely real models that abstract from the presence of nominal rigidities, and so (at least implicitly) assume that the Phillips curve is vertical. In this paper, I show that such models are fragile, in the sense that their implications change significantly when the Phillips curve is even slightly less than vertical. I consider a wide class of purely real macroeconomic models and perturb them by introducing a non-vertical Phillips curve. I show that in the perturbed models, if there is a lower bound on the nominal interest rate, then current outcomes necessarily depend on agents’ beliefs about the long-run level of economic activity. The magnitude of this dependence becomes arbitrarily large as the slope of the Phillips curve becomes arbitrarily large in absolute value (closer to vertical). In contrast, the limiting purely real model ignores this form of monetary non-neutrality and macroeconomic instability. I conclude that purely real models are too incomplete to provide useful guides to questions about business cycles. I describe what elements should be added to such models in order to make them useful.
Isn’t this…obvious? Keynes, after all, expected that at full employment the economy would be basically classical.
In the Phillips curve context, that is to say that the slope is shallow with significant unemployment, gets steeper as we approach full employment, and is vertical thereafter. If you relax the assumption of a vertical Phillips curve, of course you’ll get different results. What on earth would you expect otherwise?
And it’s pretty common in economics that changing a parameter estimate has profound qualitative consequences. I remember learning IS-LM as a student and being really impressed by the insight that changing the slope of the LM schedule implies a fundamentally different world – if it’s steep, we’re in a monetary dominance, Brad DeLong-ish republic of the central bankers, if it’s shallow, we’re in a Keynesian or at least Hicksian world. Uh…better be right on that one!
That said, the second half of the abstract seems to suggest Kocherlakota’s point is more fundamental and there’s a domain of unusually great instability where the slope is high, but less than unity. Which makes me think about the fixprice/flexprice distinction and what institutional arrangements would be associated with different Phillips curves.
Anyway, I guess I better think of a way of reading the whole paper.