Fragility of Purely Real Macroeconomic Models

Narayana Kocherlakota

NBER Working Paper No. 21866
Issued in January 2016
NBER Program(s):   EFG   ME

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.

Narayana R. Kocherlakota

Department of Economics
University of Rochester
202 Harkness Hall
P.O. Box 270156
Rochester, NY 14627

E-Mail: 
WWW: http://sites.google.com/site/kocherlakota009
NBER Program Affiliations: EFG , AP 
NBER Affiliation: Research Associate 

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Narayana R. Kocherlakota (born October 12, 1963) is an American economist and is the Lionel W. McKenzie Professor of Economics at the University of Rochester. Previously, he served as the 12th president of the Federal Reserve Bank of Minneapolis until December 31, 2015. Appointed in 2009, he joined the Federal Open Markets Committee in 2011. In 2012, he was named one of the top 100 Global Thinkers by Foreign Policy magazine.

Kocherlakota was born in Baltimore, Maryland, to an American mother and an Indian American father (of Telugu descent), both of whom earned PhDs in statistics from Johns Hopkins University. They taught at the University of Manitoba in Winnipeg, Manitoba, Canada, where Kocherlakota spent most of his childhood.

He entered Princeton University at age 15 and graduated four years later with an A.B. in Mathematics in 1983. He earned a Ph.D. in economics from the University of Chicago in 1987.