Is price flexibility stabilizing?
Rajat directed me to a post by Miles Kimball, entitled “Pro Gauti Eggertsson”. Over at Econlog I discussed one paragraph from his post. Here I’ll discuss another:
Gauti has also taken a lead in applying the same principles he applied to the Great Depression to the Great Recession. A hallmark of his papers is very careful discussion of how they relate to key controversies in the academic literature, and indeed, they go to the heart of some of the biggest issues in the study of business cycles and stabilization policy. Price flexibility and advance anticipation of inflation are often said to be the keys to monetary policy having no real effect on the economy. But along with Saroj Bhattarai and Raphael Schoenle, Gauti argues in “Is Increased Price Flexibility Stabilizing? Redux” that, short of perfect price flexibility, greater price flexibility is likely to be destabilizing. This idea has a long history, but had not been fully addressed within the context of Dynamic New Keynesian models without investment. Along with Marc Giannoni, Gauti argues in “The Inflation Output Trade-Off Revisited” that contrary to the idea that anticipated inflation does not matter, it can matter greatly when raising expected inflation loosens the zero lower bound. The argument is made in a very elegant and clear way.
In my view, higher expected inflation is not expansionary, holding NGDP expectations constant. Thus if NGDP is expected to grow at 5%, then higher inflation is associated with lower real GDP growth. The proponents of the alternative view would claim that I’m missing the point, that higher inflation expectations will cause higher NGDP growth expectations. I don’t think that’s right. A more expansionary monetary policy may cause both inflation and NGDP growth expectations to rise. On the other hand, supply shocks can affect inflation expectations without impacting NGDP expectations. Never reason from a price level change—always reason from a NGDP growth change.
In 1929-32, President Hoover discouraged companies from cutting wages. This made the Great Contraction of 1929-32 even worse than it otherwise would have been. In contrast, wages were cut sharply during the severe deflation of 1920-21. Some free market purists make too much of this comparison, suggesting that tight money is not a problem if the government allows wages to be flexible. Not true, the 1921 depression was quite deep.
But also pretty short. And one reason it was so short is that in 1921 and 1922, wages adjusted quickly to the lower price level. If Hoover (and FDR) had allowed wages to adjust in the 1930s, the Great Depression would have been much shorter.
Stable NGDP growth and non-intervention in wages and prices, these policies work together like a hand and glove.
PS. I encourage people to read Giles Wilkes’s new piece on blogging. Wilkes was nice enough to include me in with a group of much more deserving bloggers. I was also pleased to see him talk about Steve Waldman, a wonderful blogger and also a good example of how the blogosphere is a meritocracy, where professional credentials do not matter.
PPS. Trump? Still . . . an . . . idiot.
HT: Tyler Cowen, Tom Brown
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28. July 2016 at 12:39
FYI, very interesting interview with Greenspan this morning on Bloomberg. There’s probably video of it. He talked about a lot of things in ways I haven’t heard. He talked about negative interest rates and those relate to sovereign bond yields, today’s rates in relation to historical averages going back to the 17th century, differences in capex spending between short term (software) and long term (structures) assets and how that’s affecting productivity growth and also how the lack of long term capex investments reflects the accurate uncertainty of the long run. This uncertainty he returned to a few times and the most pressing source of it is entitlements. This problem is across the developed world too. Oh and he said he’s worried about “stagflation.” Not immediately but he said the ratio of the money supply to real GDP was increasing and that means inflation will begin to rise as well.
I don’t want to hijack your post, but thought you might be interested.
28. July 2016 at 12:58
“Stable NGDP growth and non-intervention in wages and prices, these policies work together like a hand and glove.”
-Agreed.
I don’t read the Financial Times.
I’m listening to the Democratic National Convention right now. Black supremacy and Mexican imperialism. Way worse than anything Trump could come up with. The Democrats have become the Party of Radical Reconstruction.
I watched that video. I trust Trump way more than I do the foul Truman or rotten Hillary.
28. July 2016 at 13:34
Thanks, Scott, your Econlog post was about what I was expecting; but this post helpfully explains why price flexibility is not destabilising. As I said before, after reading your views over the years, I find much of NKism just weird.
PS. Both my vanity and modesty prevents me from claiming to be the RBI Governor 🙂
28. July 2016 at 13:36
@Harding: typical 96 IQ blather.
You realize that your odiousness means that an endorsement from you only hurts Trump, don’t you? Maybe not, that IQ problem again.
28. July 2016 at 14:32
Scott, thanks for the H/T. Here’s a follow up on how the evening in Trump’s safe space went. All possible un-tPC micro-aggressive questions and participants were eliminated. They even deleted a question from Breitbart’s own alt-Rightist, fanatical Trump devotee and self described “dangerous faggot” Milo Yiannopoulos (Milo calls Trump “Daddy”). I guess his softball was just too dangerous. Sounds like the whole affair was a pathetic waste of time. Sad!
28. July 2016 at 15:26
There was no credit crisis associated with the 1921 Depression. It was a retooling recession, from what I have read. And certainly, it cannot be compared to the Great Depression. In the Great Depression, the Fed liquidated the economy. That isn’t far off from what happened when Bernanke liquidated the economy by doing nothing in 2008.
You can’t be pro NGDP targeting and a Mises liquidator at the same time, Scott.
28. July 2016 at 15:30
Sumner: “In my view…” and a paragraph written in mud follows. Sumner should quit trying to be obtuse using words, and stick with math or some graphs. He makes it seem that there’s disagreement when in fact the disagreement is because Sumner is not being clear.
Put simply: NGDP = RGDP + Inflation, ex post, we all agree on this, as it’s an accounting identity. The issue then is whether this holds “ex ante” (before a relevant time period expires). Sumner should be explicit: in the long run, we all agree (Sumner included), RGDP is not a function of inflation. In the short run, apparently Sumner thinks RGDP = RGDP (i, NGDP), that is, it’s a function of inflation and NGDP due to sticky prices and money illusion. But then Sumner seemingly states the opposite: “In my view, higher expected inflation is not expansionary, holding NGDP expectations constant. Thus if NGDP is expected to grow at 5%, then higher inflation is associated with lower real GDP growth. ” which implies RGDP will decrease if inflation increases (thus implying an inverse relationship), yet later Sumner now states the opposite to this view (!): “I don’t think that’s right. A more expansionary monetary policy may cause both inflation and NGDP growth expectations to rise.” – which specifically is stating RGDP will *not* decrease (but stay constant). Then, Sumner states a third view: “On the other hand, supply shocks can affect inflation expectations without impacting NGDP expectations.” – so now Sumner is saying there’s *no* nexus between NGDP, RGDP, inflation ex ante (that is, before the ex post accounting identity, NGDP = RGDP + inflation). This last view is btw my view, so we’ve come full circle, since I claim the “accounting identity” is only true “ex post” (after the year is up, you can say, with mathematical certainty, that NGDP = RGDP + I, but before the year is up anything can happen).
Sumner, please be clear. Do you believe short term, ex ante (that is looking forwards in a given year or time period) that RGDP is affected by either NGDP and/or inflation? If so, you should write: (ex ante) NGDP(i,RGDP) = RGDP (NGDP, i) + inflation (NGDP,RGDP), which is saying every variable influences the other in a difference equation sort of way.
But, if Sumner doesn’t believe this, he should be explicit in what he believes. He should not use “monetary policy” as a shorthand for a sort of Deux Ex Machina (as he does in this post) but specifically link it to how it influences NGDP in his scheme. If NGDP is ‘targeted’ as a sort of independent variable, then NGDP = NGDP (no additional variable on the LHS of the above equation) but it’s not clear if Sumner means this. His words are sloppy, no doubt like his eating habits. Words and food falling out of his open mouth like a sloppy word salad. Then again, he’s admitted he’s no math wiz and depends on others to ‘do the math’. Sumner simply ‘pounds the table’ in conviction that he is right, without even trying to define his framework except with sloppy, vague words.
Shorter post (a conclusion): Sumner = fraud.
28. July 2016 at 16:49
When I read these models, I sense they do not take consideration the increased level of price competition in the last 40 years. For example, the nominal price of a new car in the United States has not changed in 20 years.
Ergo, our monetary authorities have a lot more leeway to step on the gas.
The US economy sources goods and services globally, an inexhaustible supply side. If the supply side is really really fat, how do you get inflation?
Restrict the supply of housing.
28. July 2016 at 16:54
Thanks Anthony.
Rajat, (Or do you prefer Rajan?). You should be honored that I confused you two.
Twice. 🙂
Tom, Those poor Trumpkins, wouldn’t want to see their feeling get hurt.
Ray, You said:
“Put simply: NGDP = RGDP + Inflation, ex post, we all agree on this, as it’s an accounting identity.”
That’s right. Just take this one step at a time. In a few years it will all make sense.
28. July 2016 at 17:12
Cheers, mate!
29. July 2016 at 03:36
Sumner: “Ray, You said: “Put simply: NGDP = RGDP + Inflation, ex post, we all agree on this, as it’s an accounting identity.” – That’s right. Just take this one step at a time. In a few years it will all make sense.”
You ignore the rest of my post. And as another blogger said about you, monetarists are the only people who try to construct some kind of profound economic law out of an accounting identity. 1 + 1 = 2, and 2 = 2, agree? Deep.
29. July 2016 at 04:26
I believe Scott is referencing this 1986 DeLong-Summers paper;
http://faculty.wcas.northwestern.edu/~lchrist/course/CIED_2010/priceflexibilityandstabilization.pdf
29. July 2016 at 05:08
I have a home in the low country on a creek that runs through the salt marsh. I am often asked if I’ve noticed a sea level rise. My answer is that high tides are higher. But low tides are lower. This was confirmed by a recent study that focused on lower sea levels in the area around Greenland where the ice has been melting, a result that seems counter-intuitive. But more water in the ocean means more shifting of water and, hence, higher and lower sea levels, making it more difficult to predict the sea level tomorrow. And so it is with volatile prices. Paul Volcker is often venerated for having “cured” inflation in the 1980s with extremely high interest rates. I’ll suggest that those doing the venerating have it wrong. Goldwater said that extremism in defense of liberty is no vice. Yes, it is. Warren Buffett once said that the greatest “financial innovation” is the automatic teller machine. No, the greatest financial innovation is the futures market. Why? Because futures markets moderate fluctuations in supply and price. Moderation is the key to a growing economy, and a happy life. I’m a cradle Episcopalean, which means I am tolerant of most any behavior, as long as it’s done in moderation.
29. July 2016 at 06:38
I’m having trouble with this part: In my view, higher expected inflation is not expansionary, holding NGDP expectations constant.
On one level, it’s obviously true. But since future shocks to real GDP can’t be “expected” (ie, predicted. We always expect that shocks will happen, but they’re random. Like your forecast of no recession for China), how can the Fed raise inflation expectations without raising NGDP growth expectations?
Thanks.
29. July 2016 at 06:50
Bill, The Fed cannot raise inflation expectations without also raising NGDP expectations. But this post was about non-Fed actions that raise inflation expectations. And these sort of inflationary shocks (say a higher minimum wage) can do so with raising NGDP growth expectations.
29. July 2016 at 07:49
Got it. Makes sense.
To be clear, the fifth word from the end of your response is “without” not “with”?
29. July 2016 at 12:25
Also interesting;
http://journals.cambridge.org/action/displayFulltext?type=1&fid=10322748&jid=JEH&volumeId=76&issueId=02&aid=10322743&bodyId=&membershipNumber=&societyETOCSession=
————quote———-
I ask what explains the peculiar behavior of the auto industry [in 1937-38], and how exogenous developments in this industry affected the rest of the economy. I argue that a cost shock in the auto industry and consequent auto price increases explain the industry’s extraordinary behavior.
The unionization of General Motors and Chrysler and an increase in raw material costs led auto manufacturers to raise prices in fall 1937. Equally important, the increase in costs combined with nominal rigidity to make the price increase predictable. Expectations of price increases brought auto sales forward and thus sustained sales during the summer and early fall of 1937, despite negative monetary and fiscal factors. When auto prices did increase in fall 1937 sales plummeted. Narrative evidence confirms this explanation.
The auto industry was a significant part of the U.S. economy, so
this large shock to auto sales almost certainly had large effects on the economy as a whole. …. Along most dimensions, the industry was more important in 1937 than it is today. Sales were a larger share of GDP, and auto industry employment was a much larger share of total employment. Furthermore, in 1937, most inputs to car production were supplied domestically, so accounting for
linkages to other sectors would increase the discrepancy between the
industry’s importance then and its importance now.
———–endquote———-
30. July 2016 at 08:50
Bill, Yes, my typo.
Patrick, Yes, that sounds right.
30. July 2016 at 19:36
Scott, it looks like the debate stage may not be a Trumpian “safe space”:
http://bipartisanreport.com/2016/07/30/just-in-donald-trump-starts-backing-out-of-debates-with-hillary-his-lame-excuse-is-pathetic/
30. July 2016 at 19:37
http://www.redstate.com/joesquire/2016/07/30/nfl-calls-trump-another-lie/
31. July 2016 at 05:48
Scott, it looks like the debate stage may not be a Trumpian “safe space”:
The one who needs the safe space has spent the last couple of years ducking reporters and appearing at scripted events salted with planted questions.
31. July 2016 at 09:10
Tom, The weird thing about Trump is the scale of his lies. Other candidates lie on occasion, but at least they try to look like they are telling the truth.
Trump’s kind of like the leaders of Russia, Turkey, Iran, Venezuela, etc.; he lies with a sort of “what are you going to do about it” attitude. He doesn’t even care if people think he’s a pathological liar.
31. July 2016 at 11:42
Agreed!
We’ll see who tries to back out of the debates.
31. July 2016 at 14:54
We’ll see who tries to back out of the debates.
He debated Ted Cruz (star appellate litigator, college forensics champion) and Chris Christie (working prosecutor) for months. Hilligula’s a piece of cake.