My approach to macro has always been “nominal shocks have real effects.” As a result, I’ve never cared for the Keynesian view that inflation was caused by an overheating economy, and disinflation was caused by economic “slack.” If that were true, then it would be the case that “real shocks have nominal effects.” I.e. changes in real GDP affect inflation. And that just didn’t seem right.
Milton Friedman (and Irving Fisher) interpreted the Phillips curve in the same way I do—deflation causes unemployment, not the other way around. As I got older I modified this view slightly, now I see nominal shocks as changes in NGDP growth. But I still believe nominal shocks have real effects. Only now an unexpected change in NGDP would simultaneously change both prices and output. So how does this differ from the Keynesian view?
Mankiw and Reis (2006) identify “three key facts” of modern business cycle theory:
- “The Acceleration Phenomenon . . . inflation tends to rise when the economy is booming and falls when economic activity is depressed.”
- “The Smoothness of Real Wages . . . real wages do not fluctuate as much as labor productivity.”
- “Gradual Response of Real Variables . . . The full impact of shocks is usually felt only after several quarters.”
None of these facts even comes close to fitting the economy of 1933, and the first is especially strongly rejected. Inflation soared in 1933, when unemployment was at the highest level in history. The monetarist model, however, can easily explain 1933. After all, a powerful nominal shock (dollar devaluation) sharply raised output. But I get tired of talking about 1933, unless there are other good examples then the distinction I’m trying to make might not be that important. Fortunately, Paul Krugman has found some recent examples:
What this suggests to me, anyway, is that there’s a rate-of-change effect as well as a level effect: when the economy is growing, even from a low base, some firms gain pricing power, and some firms raise their wage offers a bit. So the acceleration of US growth and the fall in unemployment since last summer has produced an inflation uptick; if past experience is a good guide, however, this will be only temporary unless the economy continues to accelerate.
I’m sure if you add enough epicycles to the Keynesian model you can make it all work out. For my part I’ll stick with Fisher and Friedman—nominal shocks have real effects.
PS. Check out Krugman’s short post. It’ll make more sense if you look at his graphs. I don’t like to copy entire posts, if I can avoid it.
PPS. Krugman refers to an “acceleration of US growth and the fall in unemployment since last summer”. Did QE cause that acceleration? Martin Feldstein says yes. Wasn’t he one of those economists who said the Fed was out of ammo back in 2008-09? Any help from commenters would be appreciated.