ABSTRACT
The failure of the Lucasian model prompted the need for an alternative orthodox model. The main requisite was to keep the neutrality of money, which had become a distinctive feature of orthodoxy.
In 1982 Kydland and Prescott modeled business cycles as the efficient response of the economy to technology disturbances. They replaced monetary shocks with technological ones. They added a new methodology of soft hypothesis testing: calibration.
One of the strong assumptions the authors make is that markets are always in equilibrium.
Some orthodox economists admit that there is a wide gap between mainstream economic theory assumptions and the real world. Their conclusion is that, for this reason, reality should be modified to adjust to what theory assumes. This is the philosophy which lies behind proposals like the Washington Consensus or the World Bank structural reforms program.
The New Keynesians are economists who accepted many of Lucas’s methodological critiques but tried, however, to develop models which arrive at Keynesian-flavored results. Their program was mainly interested in proving the non-neutrality of money in the short run. If money is not neutral, its expansion or contraction will have an impact on output, which marks a reversal of the previous Friedman-Lucas monetary policy neutrality view.
The result of this marriage between real business cycle tradition and certain tenets of Keynesianism was dynamic stochastic general equilibrium (DSGE) models.
A difficulty with this New Keynesian model is that unemployment is not very Keynesian.
