Sticky Prices: How Nosotros Confuse Students, As Well As Sometimes Ourselves

For teachers as well as students of macroeconomics.

I’m nearly to learn a modest divulge of commencement twelvemonth undergraduate students Keynesian macroeconomics, as well as my aim volition travel not to enjoin them that this is the macroeconomics of glutinous prices. Yet I realise I’ve already gone wrong. In calendar week i I talked nearly fourth dimension periods inward macro, as well as how the ‘short run’ was the length of fourth dimension ‘it takes prices to fully adjust’. I must take away maintain been maxim this for years. But it is at best highly misleading.

In both the New Keynesian shut economic scheme model, as well as the IS/LM model, the brusk run is the length of fourth dimension it takes the fundamental banking concern to stabilise inflation (output goes to its natural rate), or less exactly to attain amount employment. For students nosotros could every bit say it is the catamenia it takes monetary policy to attain the existent charge per unit of measurement of involvement implied yesteryear the RBC, or Classical, model.  Calling this the fourth dimension catamenia it takes prices to fully accommodate alone makes feel when monetary policy involves around variety of nominal anchor, similar a fixed coin target inward IS/LM. It makes no feel when monetary policy involves a fundamental banking concern trying to take away the best nominal involvement rate. The bear upon of an unexpected but later known preference/demand shock, for example, would travel really brusk lived when such a fundamental banking concern knew what it was doing. (See this first-class post from Nick Rowe.)  

The big danger inward equating Keynesian economic science alongside glutinous prices is that students forget nearly the crucial component monetary policy is playing. Too many scream back that after an growth inward aggregate demand, if contracts as well as bill of fare costs were absent, higher prices would in themselves choke off the growth inward aggregate demand.  As they take away maintain simply learnt micro, it is a natural error to make. They as well as therefore acquire really confused when cost flexibility does (at best) nil at the null lower bound.

Yet the linking of the brusk run alongside glutinous prices is ubiquitous. In the edition of Mankiw I take away maintain to manus it says

“In the long run, prices are flexible as well as tin answer to changes inward render or demand. In the brusk run, many prices are glutinous at around predetermined level. Because prices deport differently inward the brusk run than the long run, economical policies take away maintain dissimilar effects over dissimilar fourth dimension horizons.”

This variety of controversy makes feel inward a fixed coin render world, but it makes much less feel inward the existent world. (Mankiw uses the term ‘long run’ where others would purpose ‘medium run’, but allow us non worry nearly that.) Compare it alongside this option statement:

“In the long run, monetary policy adjusts to attain steady inflation, which agency output goes to its ‘natural’ or Classical level. In the brusk run, monetary policy fails to attain this, therefore nosotros quest to aspect at movements inward aggregate need to explicate output.”

This plant for whatever sensible monetary policy.

In my minute twelvemonth lectures, I inquire my students to scream back nearly a monetary policy that involved moving existent involvement rates inward response to the output gap, but non to excess inflation.  If that policy stabilised a shut economy, as well as therefore what bear upon would the speed of cost adjustment take away maintain on anything except inflation? Inflation aside, a globe where cost adjustment was quick would aspect much similar a globe where prices were much stickier. The ‘short run’ would take away maintain the same length, irrespective of how apace prices adjusted.

All this is nearly how Keynesian economic science is taught, rather than nearly how it is done. Yet how it is taught tin also influence how it is eventually understood. One of the problems around people take away maintain alongside agreement that nosotros are notwithstanding inward a province of affairs of deficient need is that it is 5 years after the recession ‘and sure enough prices should take away maintain adjusted yesteryear now’. There is also a rather to a greater extent than profound point. Many anti-Keynesians purpose this misunderstanding nearly cost adjustment to transportation away Keynesian economics. When they say ‘I ignore Keynesian economics, because I scream back prices accommodate rapidly’ they are actually maxim ‘I ignore Keynesian economic science because I scream back monetary policy is really successful’. And inward the existent world, monetary policy tin alone travel really successful yesteryear agreement Keynesian economics!