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.