Thursday, June 23, 2011

What is a sticky price?

An amazing amount of scholarly effort is devoted to figuring out optimal stabilization policies in developed economies. I am not convinced this effort is well-placed, as fluctuations in developing economies are much larger and long-term trends quickly swamp short-term fluctuations in welfare assessment for developed economies. The last recession in the US may make it worth to look at stabilization though.

Greg Mankiw and Matthew Weinzierl have a piece of rather pedagogical nature trying to convince us that stabilization policy is worthwhile. Their model is essentially the one that is taught to undergraduates: a two-period model with households maximizing intertemporal utility from consumption, a government, and firms that maximize discounted profits. Oddly, firms do not care about the resale value of capital in the second period, which makes investment largely irrelevant. Finally, prices are fixed the first period, but can be changed in the second period.

Beyond the pedagogical merit, can this model be used for serious policy prescriptions, which Mankiw and Weinzierl even quantify? For one, the last recession was sufficiently important that prices and wages actually adjusted down in the short term, which violates the critical premise of the model. Indeed, all what policy tries to do is undo the frictions stemming from price rigidity. Second, when prices do indeed not change in the short-term, it is presumably when it is not worth doing do so, thus policy intervention also does not seem worth it. Of course, it could be that there is a genuine Keynesian lack of demand, but this can be attacked best by dealing with what causes the lack of demand, not by creating artificial demand through government expenses. For the last recession, this would have been easing collateral constraints. Third, the model assumes a money quantity equation, which imposes a constant money velocity. I thought we all had agreed long ago this was a silly assumption.

I really do not understand the point of this paper. After all, as Mankiw likes to say on his blog, all this can already be found in his favorite textbook.

1 comment:

Vilfredo said...

The paper is indeed a pedagogical piece. Apart from its lack of merit for policy recommendation, why would the NBER publish it? Does it have some mandate to publish pedagogical pieces? I always regarded NBER working papers at the research frontier.