Nominal Wage Rigidity Inwards Macro: An Event Of Methodological Failure

This postal service develops a point made past times Bryan Caplan (HT MT). I receive got 2 stock complaints nearly the authority of the microfoundations approach inwards macro. Neither imply that the microfoundations approach is ‘fundamentally flawed’ or should hold upwardly abandoned: I all the same larn useful things from edifice DSGE models. My commencement electrical load is that likewise many economists follow what I call the microfoundations purist position: if it cannot hold upwardly microfounded, it should non hold upwardly inwards your model. Perhaps a ameliorate means of putting it is that they exclusively model what they tin microfound, non what they see. This corresponds to a measure method of rejecting an innovative macro paper: the conception is ‘ad hoc’.

My minute electrical load is that the microfoundations used past times macroeconomists is then out of date. Behavioural economic science simply does non acquire a await in. H5N1 proficient too really of import illustration comes from the reluctance of firms to cutting nominal wages. There is overwhelming empirical evidence for this phenomenon (see for illustration Timothy Taylor) or the function of Jennifer Smith at Warwick). The behavioural reasons for this are explored inwards item inwards this book past times Truman Bewley, which Bryan Caplan discusses here. Both coin illusion too the importance of workforce morale are forthwith good accepted ideas inwards behavioural economics.

Yet debates alongside macroeconomists nearly whether too why reward are viscid become on. As this excellent example (I’ve been wanting to link to it for some time, simply because of its quality) shows, they are non simply debates betwixt Keynesians too anti-Keynesians, then I produce non intend you lot tin pose this all downwards to some form of ideological divide. I suspect nearly all economists are naturally reluctant to comprehend cases where agents appear to immature adult woman opportunities for Pareto improvement - I hand some other illustration related to wage setting here. However inwards most other areas of the dependent patch overwhelming evidence is forthwith able to trump these suspicions. But not, it seems, inwards macro.

While nosotros tin debate why this is at the score of full general methodology, the importance of this especial illustration to electrical flow policy is huge. Many receive got argued that the failure of inflation to autumn farther inwards the recession is evidence that the output gap is non that large. As Paul Krugman inwards especial has repeatedly suggested, the reluctance of workers or firms to cutting nominal reward may hateful that inflation could hold upwardly much to a greater extent than viscid at really depression levels, then the electrical flow behavior of inflation is non inconsistent with a large output gap. here, the Commission forthwith intend they receive got been underestimating the output gap. As he suggests, the ground is pretty obvious: they receive got overestimated how much the natural charge per unit of measurement of unemployment has risen inwards this recession. Here is the illustration he gives for Spain.

Actual unemployment too European Commission estimates of the NAWRU for Spain, from Jeremie Cohen-Setton

How could the Commission receive got been then foolish every bit to believe the natural charge per unit of measurement had risen from 10% to 27% inwards a few years? Might it hold upwardly because they looked at nominal reward inwards Spain, too inferred from the fact that nominal reward were non falling that so actual unemployment must hold upwardly around its natural rate? If empirical macromodels every bit a affair of course of teaching allowed for the absence of nominal wage cuts, would they receive got made such an obvious (to anyone who is non a macroeconomist) mistake?

I intend this illustration illustrates why it tin hold upwardly unsafe to rely on DSGE models to guide policy. Yet the influence of DSGE models inwards policy making institutions is potent too growing. The Bank of England’s heart too individual forecasting model (pdf) is a fairly basic DSGE construct, too every bit far every bit I tin encounter its wage equation is a measure New Keynesian specification, with no non-linearity when wage inflation approaches zero. Now I know the Bank receive got many other models they await at, too they volition undoubtedly receive got looked at the implications of a reluctance to cutting nominal wages. (I hash out the Bank’s ‘new’ model inwards to a greater extent than item here.). However default positions are important, every bit the examples I discussed before show. Focusing on models where consistency with fairly simplistic microfoundations is all important, too consistency with empirical evidence is less of a concern, tin distort the means macroeconomists think.