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Source link: http://archive.mises.org/9861/mankiws-differing-views-on-deflation/

Mankiw’s Differing Views on Deflation

April 28, 2009 by

In response to my Mises Daily criticizing his call for massive inflation, Greg Mankiw actually concedes that my own suggested remedy–allowing prices to fall in order to clear the market–would work, at least in theory. The problem, according to Mankiw, is that in the real world, prices are “sticky” and so it might take an unacceptable amount of pain while we wait for prices to come down and get idle resources back into operation.

As usual, this is just another case where government interventions are causing the alleged “market failure” that require–you guessed it–government interventions.

Here is Mankiw’s specific response to my point that rapid price falls in the near term would allow for a “negative real interest rate” if (for the sake of argument) that’s really what the market needed to clear:


I think this analysis is correct, under the maintained assumption that prices (including wages) are completely and instantaneously flexible. But if prices are sticky, then the immediate deflation and concurrent increase in expected inflation won’t occur painlessly. Instead, it would take a while for the price level to fall, and as we wait, the economy would suffer through a period of depressed economic activity.

According to conventional new Keynesian analysis, sticky prices are the ultimate market imperfection that makes aggregate demand matter. If you deny that prices are sticky and assume they can instantaneously jump downward to new equilibrium levels, many macroeconomic problems become much easier to solve. Indeed, you don’t need to solve them at all, as the market would do it.

I wish we lived in the world that Mr Murphy describes, but my reading of the evidence is that we don’t.

I have written a fuller reply on my own blog, but let me give the highlight here: It is ironic that Mankiw seems to be saying that the poor market economy can’t yield rapid price falls in the short run, when after all it was Mankiw who wrote back in November:


What is the Fed to do (other than pray)? Expectations management is the key.

Here is one idea. Suppose the Fed cuts the federal funds rate once again to, say, 25 basis points. More important, at the same time, the Fed announces a target path for the price level as measured by the core CPI….

The credibility of the promise is paramount. To get long-term real interest rates down, the Fed needs to convince markets that it will vigorously combat deflation, and that if deflation happens in the short run, the Fed will reverse it by subsequently producing extra inflation. A credible promise of subsequent price reversal after any deflation ensures that long-term expected inflation stays close to the inflation rate implied by the Fed’s target price path. Monetary economists will recognize that this policy is price-level targeting rather than inflation targeting.

And so we see that in November, Mankiw called for the Fed to promise to pump in new money in the present, to combat any falling prices. And then just a month later, he started calling for the Fed to promise to pump in new money in the future, because…the imperfect market economy doesn’t allow for prices to fall in the short run.

{ 11 comments }

fundamentalist April 28, 2009 at 9:22 am

Keep in mind that changes in M1 and M2 have their greatest impact on prices only after about 18 quarters, or about 4.5 years. It takes a long time for Fed policy to work its way throught he economy and show up in CPI stats. So the price deflation we see today is the result of past actions by the Feds.

fundamentalist April 28, 2009 at 9:25 am

PS, I should have added that this supports Murphy’s view that Fed action keep prices from falling as they should, because past Fed action was very loose. That looseness years ago is keeping prices today from falling the way they should as a result of falling demand.

fundamentalist April 28, 2009 at 9:30 am

PSS, I don’t think Mankiw is being fair with his insistance that wages from instantaneously. Since when is “instantaneous” reaction a requirement of a market economy, other than in the fevered imagination of equilibrium theorizing? And as Murphy pointed out, wages aren’t that big of a problem. Mankiw seems to have forgotten econ 101 when we learn about marginal pricing. All wages in the country don’t need to fall; just the desired wages of the unemployed. But the effective wages of the employed fall because as workers are laid off and the remaining workers do more work for the same pay, their productivity rises and the effective wage declines.

Current April 28, 2009 at 9:30 am

Whether the new-Keynesian short-run model is correct depends on whether wages are stickier than other prices. If they are (and they probably are) then it is likely to be quite a correct description of the very short-run.

What is more problematic is the longer-run (by which I only mean ~2-3 years in this case). The Keynesian stimulus will cause distortions of relative prices. Those distortion will cause misallocations.

Mankiw may well be right in the term he is interested in, but that’s not the interesting problem.

Lucas M. Engelhardt April 28, 2009 at 9:34 am

Sadly, this inconsistency is extremely common in mainstream economics. “We have to fight deflation by printing money.” “We can’t count on falling prices to get us to equilibrium.”

Also, it seems odd to me that any economist can claim that prices are sticky. Apparently, they:

(1) haven’t been watching prices in the housing market over the past 8 years. (Especially the last 18 months or so, when housing prices have fallen over 25%.)

(2) don’t drive past gas stations – ever. Or they’d see that some prices change daily – and often more than once a day.

(3) don’t get ads for grocery stores – which advertise weekly “sales” (or, put differently, temporary PRICE CHANGES, expected to last about a week)

(4) haven’t been to Wendy’s recently – This weekend I discovered that their “99 cent” value menu has been replaced with a plain old “super value menu” – where most items cost more than 99 cents.

I really wish more mainstream economists would read Altig, Christiano, Eichenbaum, and Linde’s paper on firm-specific capital. It’s VERY “mainstream” in its approach, but shows something interesting: if capital is firm-specific, then price aggregates will LOOK far more sticky (technically, “inertial”) than the underlying prices actually are.

Matthew April 28, 2009 at 9:51 am

Right on. It will be interesting to see if and how Mankiw attempts to wiggle out of this logical trap he got himself into. Being a pessimist, I’m guessing that he’ll just walk away from the chessboard without resigning despite the fact that checkmate is right around the corner. Hopefully I’ll be proven wrong though and the game will continue to its rightful end.

monteverdi April 28, 2009 at 10:22 am

What about China?How salaries and price can go up if China is providing everything at very low cost?

newson April 28, 2009 at 10:38 am

if labour prices are sticky, there’s the problem. attack the government and union-imposed rigidities and the stickiness disappears. magic.

newson April 28, 2009 at 10:44 am

to monteverdi:
if the american worker earns twenty times his chinese counterpart, it’s because he’s twenty times more productive. increase the capital structure at his disposal and the american worker’s output increases, with his earnings. work smart, not hard. the third world is not poor for want of hard work, but for the lack of investment.

Larry N. Martin April 28, 2009 at 10:57 am

If these mainstream economists would stop trying to chew gum and work at the same time, prices wouldn’t be so ‘sticky’. ;-)

monteverdi April 28, 2009 at 12:45 pm

If China continue to keep the currency link to the dollar we cannot count in a free market here because there is a huge distortion in the capital structure

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