Macro: showing how nominal shocks have real effects

Macro is basically about sticky wages and prices, and why nominal shocks have real effects.  Macroeconomists also talk about other issues, but it’s the nominal shock/sticky price problem that requires a separate field.  Otherwise macro is just applied price theory, i.e. classical economics.

Arnold Kling recently discussed the AS/AD model and suggested:

This aggregate supply mechanism assumes that wages stay fixed while prices move. This sticky wage hypothesis is at the center of the whole mechanism.

. . .

I want to particularly exempt Scott Sumner from this. He understands aggregate demand and supply exactly as I understand it.

I pretty much agree with the first part, although I’d add that sticky prices can also be an issue.  As for the second two sentences, I hope for Arnold’s sake it’s not true, as I don’t understand AS/AD very well at all.  And each time I read Nick Rowe I feel like I understand it a bit less well.  (That’s a dig at myself, not Nick.)  BTW, Arnold is clearly talking about long run equilibrium.

Here’s a Nick Rowe post entitled “What equilibrates AD and AS?”

If a binding minimum wage law sets W/P too high, there will be excess supply of labour. People can’t sell as much labour as they want to. If a binding pro-usury law sets r too high there will be excess demand for bonds. People can’t buy as many bonds as they want to. But if M/P is right, AS will still equal AD. The output market clears, even if the labour market and bond market don’t.

Arnold’s still right in a way. If M/P adjustment can be taken for granted, then if people want less labour and less output, or firms want more output and more labour, then W/P will adjust to coordinate their conflicting desires.

And those Keynesians are still right in a way. If M/P adjustment can be taken for granted, then if people want less consumption today and more consumption tomorrow, or firms want less investment today and more consumption today, then r will adjust to coordinate their conflicting desires.

And in the long run M/P adjustment can be taken for granted. And W/P adjusts if we decide we want to consume more leisure and buy fewer Ipads and BMWs. And r adjusts if we want more consumption tomorrow and less consumption today. But we can’t take M/P adjustment for granted in the short run.

After reading all of this, I’m not even sure what the phrase “equilibrate AD and AS” means.  In the comment section Nick points out that the SRAS curve isn’t really even a supply curve.  (He uses the sticky price Keynesian model, which assumes monopolistic competition.)  I’m actually fine with that model, although for some reason people seem to think I believe in flexible prices, maybe because I talk about wage stickiness as the biggest problem.  But if AS isn’t really a supply curve, but rather a sort of loci of equilibria for various settings of AD, then why even talk about the need to equilibrate AS and AD?

I’ll even go further, since prices are such a distraction, let’s entirely remove the price level from macroeconomics.  While we are at it, let’s dump interest rates as well.  BTW, by “macro” I mean business cycle theory, what I was discussing in the intro.  You need interest rates to explain saving and investment, and you need prices to estimate real economic growth; although as we see from the comments to Tyler Cowen’s new book, nobody has a clue as to what “real economic growth” is supposed to mean.  More stuff?  More enjoyment?  Your guess is as good as mine.

Since macro is about nominal shocks having real effects, we need a nominal variable that actually, you know . . . “shocks.”  Inflation won’t do, as the Keynesians tell us that prices are fixed, and only move in response to an overheating real economy.  So I nominate NGDP.  Even the old Keynesians accept that NGDP can move immediately (or at any rate just as fast as RGDP) in response to factors such as monetary and fiscal policy, as well as financial crises.

So just do AS/AD with NGDP on the vertical axis.  Everything is the same, except the AD curve is flat.  People often assume this requires some sort of assumption about the quantity theory of money being true.  No, 100% of AD shocks might be velocity.  Nor does it assume the Fed targets NGDP.  It would work equally well under a free market gold standard.  It’s true that I often equate monetary policy with expected future NGDP, but that’s not required.  You can use NGDP as AD and define monetary policy any arbitrary way you please.  (To me the only definition that makes sense is easy or tight relative to what would be expected to hit the target.) 

It’s tempting to make the model even simpler by replacing SRAS and LRAS with a single AS, which crosses the horizontal axis at the natural rate.  No need for an AD line.  Just put NGDP minus expected NGDP on the vertical axis.   But I’ve given up on that idea; there is too much misunderstanding about what the term “expected NGDP” really means.  (It means different things in different contexts.)

Obviously if there is no price level and inflation, there is no RGDP, so put hours worked on the horizontal axis.

The real wage is now W/NGDP, (per capita NGDP if you wish, but it doesn’t really matter.)  This is actually a sort of “relative wage,” the share of national income going to an hour’s labor.  The late 2008 crash raised that relative wage rate, and caused mass unemployment.

This model can explain why nominal shocks have real effects in the short run, but hours worked return to the natural rate in the long run.  If you wish you can add the price level, the nominal or real interest rate, or the price of a pound of pistachio nuts, but none of them will add anything useful to the model.

So how about it Arnold, do you still want to claim you understand AS/AD the same way I do, or do you wish to remain a highly respected economist?


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23 Responses to “Macro: showing how nominal shocks have real effects”

  1. Gravatar of Mark A. Sadowski Mark A. Sadowski
    29. January 2011 at 15:30

    Scott wrote:
    “So I nominate NGDP.”

    Or how about nominal FSDP? (See my recent comments.) It exploded in the fourth quarter (QE2?).

    And you wrote:
    “So how about it Arnold, do you still want to claim you understand AS/AD the same way I do, or do you wish to remain a highly respected economist?”

    I read both Nick and Arnold’s postings today. When I read Nick I get what he is saying immediately. When I read Arnold I come away having the sense he is living on another planet. And then I come here and find some confirmation of my intuition. Tralfamadore perhaps? (Or is it Kling?)

  2. Gravatar of woupiestek woupiestek
    29. January 2011 at 16:34

    For symmetry’s sake: hyperinflation is also a shock in NGDP, just in the other direction. It wipes out W/NGDP, meaning labour is no longer rewarding. Or are there some real effects that I am missing?

  3. Gravatar of david david
    29. January 2011 at 16:36

    Kling is a good name for a planet.

    (no prizes for guessing what planet Klingons came from before the Trek writers changed it to “Qo’noS”)

  4. Gravatar of david david
    29. January 2011 at 16:50

    I should point out that, in defense of Kling, to reduce macro to explaining non-neutrality (which is, indeed, what mainstream macro does), you need to rule out any non-Walrasian behavior, imposing new assumptions of auctioneer and basic preferences.

    PSST is, indeed, outside this paradigm, as is any of myriad neo-Austrian/post-Keynesian/etc. approaches. The world is not just monetary non-neutrality or classical price theory.

    More critically – I suspect Kling hesitates to emphasize this point because he had, bluntly, no explanation for how PSST interacts with, say, monetary policy; he wants to leave individual behavior unspecified and rely on cosmic principles, and inevitably the model has nothing to say about money. It is terribly easy to come up with PSST-like behavior in a macroeconomic model, where there are a wide variety of short-run-stable patterns and erratic search approaches toward each pattern. Kling emphasizes the intuition and stamps the label “recalculation” on it. Left unexplained is why, having abandoned Walras, we should even believe that the search process tends towards a desirable equilibria, or how any given monetary police stance affects the process.

  5. Gravatar of Lorenzo from Oz Lorenzo from Oz
    29. January 2011 at 17:31

    David: What is PSST? It is poor form to introduce an unexplained acronym for very good reason.

  6. Gravatar of Mark A. Sadowski Mark A. Sadowski
    29. January 2011 at 17:47

    Scott wrote:
    “Macro is basically about sticky wages and prices, and why nominal shocks have real effects. Macroeconomists also talk about other issues, but it’s the nominal shock/sticky price problem that requires a separate field.”

    Em, Scott I beg to differ. A good chunk of Macro is about long run growth (including my research). And that has almost nothing to do with sticky prices or wages.

    @Lorenzo from Oz,
    PSST stands for Patterns of Sustainable Specialization and Trade. Nobody knows what it stands for so don’t feel embarrassed. It’s just another reason to believe Kling lives on another planet.

  7. Gravatar of david david
    29. January 2011 at 17:49

    Ah, sorry. PSST is Kling’s patterns of sustainable specialization and trade.

    I am interpreting in the lens of stability in general equilibrium dynamics here.

  8. Gravatar of Bogdan Bogdan
    29. January 2011 at 18:18

    You should write the textbook. I sometimes read economics and I’ll look for it.

  9. Gravatar of Indy Indy
    29. January 2011 at 18:28

    @Sumner: If there’s one thing you need to do before you retire, it is to turn this blog post into a Macro-Textbook Chapter with all the pretty picture charts – to compare and contrast your model with the other popular ones circulating around. I would definitely buy that single chapter of Comparative Macro, NGDP vs AS/AD, as an e-book single for $4. The only problem is that the Kindle is currently *pathetic* as displaying images without the assistance of a pro’s touch.

    @Lorenzo, david: “Psst”, at least in American culture, is a kind of low-decibel hissing noise one uses to catch another’s attention inconspicuously, usually to covertly communicate some additional information or point out something embarrassing or humorous, and within audible range of a third party that one wishes to remain unaware of the communication.

  10. Gravatar of david david
    29. January 2011 at 18:34

    PSST is defined in Kling’s post that Sumner linked to, in his second paragraph, so I did not explain it. I suppose I should, though.

    It is an unfortunate acronym, isn’t it?

  11. Gravatar of Lee Kelly Lee Kelly
    29. January 2011 at 18:51

    It’s not so much about sticky prices as it is about one particular sticky price: the price of money. Prices rise and fall to clear their respective markets, and sometimes this can be “sticky”, but money has no particular price or market of its own, because it is “priced” in everything and trades on all markets.

    In a competitive market economy, each individual unilaterally lowers prices to make a profit. However, when the “price” of money is too high or too low, an individual that unilaterally lowers prices is going to suffer losses in the short run. A collective action is required that just does not happen in the real world and so we grope and fumble our way to a lower price level.

  12. Gravatar of Benjamin Cole Benjamin Cole
    29. January 2011 at 19:15

    Um. What is the question again?
    All I know is that the Fed can blows the door open, print money until the plates melt, pull out all the corks in the ink barrels, tip them over and set the whole house on fire, and there still wouldn’t be any inflation, or at least for a few years.
    Did you see the GDP deflator number for the fourth quarter? Essentially zero.
    Zero.
    Zero.
    Where is the effing inflation?

  13. Gravatar of Mark A. Sadowski Mark A. Sadowski
    29. January 2011 at 19:20

    david,
    You wrote:
    “It is an unfortunate acronym, isn’t it?”

    That’s OK. It’s not as bad as the acronym for Obama’s latest slogan: Win The Future.

  14. Gravatar of Mark A. Sadowski Mark A. Sadowski
    29. January 2011 at 19:48

    Benjamin,
    You’re not posting comments over at Calafia Beach Pundit are you? That’s a total waste of time. (I ought to know.) Scott Grannis only cares about the markets, not policy. (Not that one doesn’t influence the other but Grannis obviously does give a flying crap about policy.)

  15. Gravatar of Mark A. Sadowski Mark A. Sadowski
    29. January 2011 at 19:51

    “does give” shoud read “doesn’t give”

    Anyone who’s read his blog would know.

  16. Gravatar of Lorenzo from Oz Lorenzo from Oz
    30. January 2011 at 00:43

    Everyone: thanks. I manage to completely miss it in Kling’s post. I think because I got a bit of brain freeze about two-thirds in.

    Mark: re: WTF? Yes, indeed. But who are we fighting or what are we wagering to win which future? And which ‘we’ is that anyway? (Yes, I get that it is a political slogan, but good ones have an effective resonance while ‘win the future’ seems to have exactly the right acronym.)

  17. Gravatar of Mark A. Sadowski Mark A. Sadowski
    30. January 2011 at 00:51

    Lorenzo,
    I may have voted for the man. But surely you don’t expect me to explain or defend his choice of political slogans, do you?

    WTF?

  18. Gravatar of scott sumner scott sumner
    30. January 2011 at 06:46

    Mark, I used production rather than sales, as I assumed it correlated more closely with labor market equilibrium. Of course it may be that final sales (when much higher than production) are a predictor of future production. Since I favor targeting expected future NGDP, final sales may be quite relevant. Let’s see if the big final sales number leads to more production next quarter. If only we had a NGDP futures market . . .

    woupiestek, Yes, but wages may be more flexible upwards.

    David, I think one of his problems is that he lacks a good theory of monetary shocks. If he denies monetary shocks have real effects, he’s got to explain a mountain of evidence to the contrary. If he concedes monetary shocks have real effects, then Occam’s razor works against his model.

    Mark, You said;

    “Em, Scott I beg to differ. A good chunk of Macro is about long run growth (including my research). And that has almost nothing to do with sticky prices or wages.”

    That doesn’t conflict with what I said. I said macroeconomists look at other issues. But you can use micro models to explain the supply-side effects of taxes. The sticky price model is THE distinctive macro model, not really based on micro principles. The AS/AD model never would have been created to explain long run growth, or inflation. It’s there to explain business cycles.

    Thanks Bogdan and Kling. Maybe I’ll try someday.

    David, Psst, don’t tell Kling that it’s a bad acronym.

    Lee Kelly, I’m not so sure. I think if product and labor markets were competitive, and prices were not sticky, then monetary shocks would have little or no real effects.

    Benjamin, Good question.

    Mark, Regarding WTF, I always assumed there was supposed to be some employee in the White House preventing bloopers like that. Still it’s better than him bringing back Jerry Ford’s “WIN.”

  19. Gravatar of david david
    30. January 2011 at 10:54

    David, I think one of his problems is that he lacks a good theory of monetary shocks. If he denies monetary shocks have real effects, he’s got to explain a mountain of evidence to the contrary. If he concedes monetary shocks have real effects, then Occam’s razor works against his model.

    From the horse’s mouth. #1:

    I do not think of the recalculation story as describing either a demand shock or a supply shock. It is a story about adjustment. As such, I think we ought to be agnostic about the effects of fiscal and monetary policy. The recalculation story does not rule out the possibility that they could speed the process of adjustment. However, it does not offer the sort of reassuring precision that is provided by Keynesian multiplier analysis or faith in a stable velocity of money. Other people want to talk about how more government spending or more money growth changes equilibrium. Recalculationists have to re-cast the question, because we do not think in terms of equilibrium.

    #2:

    That is, in normal times, if nominal GDP wants to grow at a 5 percent annual rate next quarter, the central bank cannot hit a 10 percent target. In hyperinflation, if nominal GDP wants to grow at a 10,000 percent annual rate next quarter, the central bank cannot hit a 10,005 percent target. [...] I view average prices in monetary units as reflecting habits. The government can change people’s habitual price behavior only by making significant, long-lasting changes in the amount of deficit that it finances by printing money. On the other hand, changes in money-printing that are modest and short-term have essentially no effect.

    You read that right – monetary policy has “essentially no effect” on not only real but also nominal variables! Kling calls it bizarre. I agree. It is also coherent, as the comment by Bill Woolsey notes, even if it does conflict with a mountain of monetarist evidence.

  20. Gravatar of david david
    30. January 2011 at 10:58

    Er,the comment by Bill Woolsey is the first comment on the #2 link. I am interpreting Kling slightly differently from Woolsey; I see Kling as claiming nominal price stickiness (habit) and quantity stickiness (recalculation), and any apparent contradiction is resolved by pointing out the logically resulting unemployment and raiding of past capital stock. Regardless, both interpretations are coherent. Coherent, but wrong.

  21. Gravatar of Is Macroeconomics Sticky Wages? « increasingmu Is Macroeconomics Sticky Wages? « increasingmu
    30. January 2011 at 21:35

    [...] Sumner writes, Macro is basically about sticky wages and prices, and why nominal shocks have real effects.  [...]

  22. Gravatar of FT Alphaville » Further reading FT Alphaville » Further reading
    31. January 2011 at 00:12

    [...] – Macro: the real effect of nominal shocks. [...]

  23. Gravatar of Scott Sumner Scott Sumner
    31. January 2011 at 13:12

    David, Thanks for the info, obviously I have a big problem with those quotations. But I like his stuff on banking–his critique of Fannie and Freddie today was quite good.

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