June 10th, 2012 by Hafiz Noor Shams
A good theory has two characteristics: internal consistency and external consistency. An internally consistent theory is one that is parsimonious; it invokes no ad hoc or peculiar axioms. An externally consistent theory is one that fits the facts; it makes empirically refutable predictions that are not refuted. All scientists, including economists, strive for theories that are both internally and externally consistent. Yet, like all optimizing agents, scientists face tradeoffs. One theory may be more “beautiful,” while another may be easier to reconcile with observation.
The choice between alternative theories of the business cycle—in particular, between real business cycle theory and new Keynesian theory—is partly a choice between internal and external consistency. Real business cycle theory extends the Walrasian paradigm, the most widely understood and taught model in economics, and provides a unified explanation for economic growth and economic fluctuations. New Keynesian theory, in its attempt to mimic the world more accurately, relies on nominal rigidities that are observed but only little understood. Indeed, new Keynesians sometimes suggest that to understand the business cycle, it may be necessary to reject the axiom of rational, optimizing individuals, an act that for economists would be the ultimate abandonment of internal consistency. [Real Business Cycles: A New Keynesian Perspective. Gregory N. Mankiw. Journal of Economic Perspectives. Volume 3, Number 3. 1989.