The scientific illusion of New Keynesian monetary theory

Abstract

It is shown that New Keynesian monetary theory is a scientific illusion because it rests on moneyless Walrasian general equilibrium microfoundations. Walrasian general equilibrium models require a Walrasian or an Arrow-Debreu auction, but this auction is a substitute for money and empties the model of all the issues of interest to regulators and central bankers. The New Keynesian model perpetuates Patinkin’s “invalid classical dichotomy” and is incapable of providing any guidance on the analysis of interest rate rules or inflation targeting. In its cashless limit, liquidity, inflation, and nominal interest rate rules cannot be defined in the New Keynesian model.