When I was a young economics graduate student at UCLA in the early 1970s during the heyday of that wonderful department, convinced, like most of the other UCLA grad students, that I was in the best graduate program in the country (and therefore the world), where the deepest, most creative, economic theorists in the world, under the relaxed and amiable leadership of Armen Alchian — whose failure to win a Nobel Prize is really the failure of the Nobel selection committee — would eventually succeed in unifying economic theory by reformulating macroeconomics on a correctly specified micro-foundation, I entertained for a while the idea that I would write my Ph.D. dissertation on some aspect of the problem of price rigidity. However, I never could do more than formulate some general observations about the theoretical role of price rigidity in macroeconomic models and compose a superficial survey of the empirical literature on price rigidity, starting with the work of Gardiner Means in the 1930s on administered prices up to a volume, The Behavior of Industrial Prices, by Stigler and Kindahl that had just appeared. After many months of frustrating and fruitless efforts to come up with a hook on which to base a dissertation, I came to the painful conclusion that my theoretical ambition exceeded my intellectual resources and I would have to look for a dissertation topic that I could get my arms around.
I then went to the other extreme, choosing a fairly straightforward empirical topic, a comparison of car insurance premiums in states with different regulatory regimes, eventually finding that, as suggested by the regulatory capture theory, stricter regulation was associated with higher, not lower, premiums. But by not choosing a dissertation topic in which I could get emotionally or intellectually invested, I paid an unforeseen cost of another sort; my lack of passion for my dissertation made me a poor candidate in the job market. As a result, the only job offer I got was from a middling mid-western university with an undistinguished economics department.
These not entirely pleasant reminiscences were triggered by my response a couple of days ago to the comments of Nick Rowe, Scott Sumner, Anon, and Wonks Anonymous on my posting “Krugman on Keynes and the Moderns.” In that post, I had chided Krugman for dismissing without any, much less adequate, explanation Robert Barro’s assertion that Keynes’s theory of high unemployment could be reduced to the following: wages and prices are stuck at a level too high to allow full employment; the problem could therefore be solved by monetary expansion raising equilibrium wages and prices, thereby obviating the reduction in wages and prices that “price stickiness” had been blocking. In response, Krugman merely harrumphs, and complains that Barro doesn’t get it.
In his comment, Nick distinguished between the cause for the decline in AD and why, once AD has declined, it is translated into a reduction in output and employment rather than a pure reduction in prices and wages with unchanged output and employment. According to Nick’s interpretation, the Krugman/Barro dispute is seemingly reduced to a verbal dispute about the meaning of the word “cause.” But, presumably, Krugman wants to say that a reduction in AD, must, for reasons deeper than mere “price stickiness,” have output and employment effects, not just price effects.
Then Scott weighed in with the following comment.
If wage and price stickiness aren’t needed for the Keynesian model, do the model without them. I don’t see how it can be done. I’ve never seen a Keynesian model with complete wage and price flexibility. If NGDP falls 99%, and so do wages and prices, how is there unemployment?
I responded to Nick and Scott as well as to further comments by Anon and Wonks Anonymous, but my comments may have been too terse to have been comprehensible. At any rate, there was no response to my comment, so I don’t know if readers came away nodding or shaking their heads.
At the risk of boring even those who have made it this far, let me try to make a couple of crucial, but rarely noted, distinctions about terms like “price stickiness,” “price inflexibility,” or “price rigidity.” On the one hand, “rigid prices” can mean that, even though supply and demand have shifted in a way that implies that the price should change, the price doesn’t change. On this interpretation, “price stickiness” is a kind of (perhaps externally imposed) market failure. The virtue of the price system, as Hayek taught us, is that it transmits information about alternative uses for and supplies of resources, leading to efficient resource allocation with no need for central direction, purely through voluntary responses to price signals.
On this interpretation, “sticky” prices constitute a fundamental failure; prices and wages, either because of direct government intervention or monopoly privileges, do not adjust in the “normal” or “proper” way to changes in demand and supply; the price mechanism doesn’t function as it is supposed to. Well, then, the argument goes, if the price mechanism is malfunctioning, because prices are “stuck” at levels too high for markets to clear, of course output and employment will contract. If that is all there is to what Keynes was saying, what’s the big deal? Everybody knew that.
I interpret this to have been Barro’s point about which Krugman complained. And, Scott Sumner seems to agree with Barro that Keynesian economics is nothing other than the economics of sticky prices. Nick Rowe, however, if I understand him correctly, at least wants to leave open the possibility that Keynesian economics is about more than just the assumption that the price mechanism is malfunctioning.
Here is where my UCLA training, and my seemingly fruitless efforts nearly 40 years ago, may give me (but certainly not just me) some added insight into the problem. Let me ask the following question. When aggregate demand drops, would we really expect workers immediately to take wage cuts and businesses immediately to reduce prices, the decline in aggregate demand being entirely reflected in instantaneously falling prices and wages, with no reduction in output and employment? I doubt it. At the moment aggregate demand falls, how many people are even aware of what has just happened? It’s not easy to distinguish between a general decline in demand and a decline limited to just your own product. If you are a worker told by your employer that you are being laid off because his sales are down, would it be more rational for you to ask how big a wage cut would allow you to hang on to your job, or to assume that some other employer would be willing to pay you a wage close to what you had been earning. (And if there was none, why was your old employer paying you a much higher wage than anyone else was?)
This is the search rationale for unemployment developed at UCLA in the early 1960s and discussed in the classic introductory text University Economics by Alchian and Allen, later developed by others like Peter Diamond into a theory for which Diamond, not undeservingly, did win a Nobel Prize. Axel Leijonhufvud, who came to UCLA while turning his own Ph. D. dissertation into a wonderful book On Keynesian Economic and the Economics of Keynes, used the search-theoretic explanation of unemployment to suggest an interpretation of Keynes that didn’t rely on wage and price rigidity in the first sense.
Another UCLA luminary, Earl Thompson, restated the same basic point more elegantly in a Hicksian temporary equilibrium framework. In temporary equilibrium, as understood by Hicks, individual supply and demand decisions depend on the possibly incorrect and conflicting price expectations of each transactor. Only in full general equilibrium are all price expectations correct, but in temporary equilibrium prices do adjust to clear markets despite incorrect price expectations. Suppose price expectations are too high, as they are after a decline in aggregate demand, then the quantities offered for sale by transactors will be less than would have been offered if expected prices were lower. Given that expected future prices are too high, the price mechanism is working as well as it can. Prices are not sticky; no price adjustment would induce a mutually beneficial transaction given the price expectations held by the transactors. But those incorrect price expectations, nevertheless, cause a cumulative contraction of output, with shrinking aggregate demand. Even though price expectations may be revised downward, the fall in aggregate demand may prevent restoration of full equilibrium with correct price expectations.
That is how you can have declining real output and employment even with fully “flexible” prices in the only sense of the term that I can conceive of. If someone wants to call this Keynesian or involuntary unemployment, it is fine with me. However, I don’t think that the formal apparatus of what is commonly understood to be Keynesian economics is at all necessary to understand the mechanism. I am not even sure that the Keynesian model is even helpful in understanding the nature of the dynamic at work in this situation.
Those were the days.