Noah Smith has a classically snide rejoinder to Stephen Williamson’s outrage at Noah’s Bloomberg paean to price stickiness and to the classic Ball and Maniw article on the subject, an article that provoked an embarrassingly outraged response from Robert Lucas when published over 20 years ago. I don’t know if Lucas ever got over it, but evidently Williamson hasn’t.
Now to be fair, Lucas’s outrage, though misplaced, was understandable, at least if one understands that Lucas was so offended by the ironic tone in which Ball and Mankiw cast themselves as defenders of traditional macroeconomics – including both Keynesians and Monetarists – against the onslaught of “heretics” like Lucas, Sargent, Kydland and Prescott that he just stopped reading after the first few pages and then, in a fit of righteous indignation, wrote a diatribe attacking Ball and Mankiw as religious fanatics trying to halt the progress of science as if that was the real message of the paper – not, to say the least, a very sophisticated reading of what Ball and Mankiw wrote.
While I am not hostile to the idea of price stickiness — one of the most popular posts I have written being an attempt to provide a rationale for the stylized (though controversial) fact that wages are stickier than other input, and most output, prices — it does seem to me that there is something ad hoc and superficial about the idea of price stickiness and about many explanations, including those offered by Ball and Mankiw, for price stickiness. I think that the negative reactions that price stickiness elicits from a lot of economists — and not only from Lucas and Williamson — reflect a feeling that price stickiness is not well grounded in any economic theory.
Let me offer a slightly different criticism of price stickiness as a feature of macroeconomic models, which is simply that although price stickiness is a sufficient condition for inefficient macroeconomic fluctuations, it is not a necessary condition. It is entirely possible that even with highly flexible prices, there would still be inefficient macroeconomic fluctuations. And the reason why price flexibility, by itself, is no guarantee against macroeconomic contractions is that macroeconomic contractions are caused by disequilibrium prices, and disequilibrium prices can prevail regardless of how flexible prices are.
The usual argument is that if prices are free to adjust in response to market forces, they will adjust to balance supply and demand, and an equilibrium will be restored by the automatic adjustment of prices. That is what students are taught in Econ 1. And it is an important lesson, but it is also a “partial” lesson. It is partial, because it applies to a single market that is out of equilibrium. The implicit assumption in that exercise is that nothing else is changing, which means that all other markets — well, not quite all other markets, but I will ignore that nuance – are in equilibrium. That’s what I mean when I say (as I have done before) that just as macroeconomics needs microfoundations, microeconomics needs macrofoundations.
Now it’s pretty easy to show that in a single market with an upward-sloping supply curve and a downward-sloping demand curve, that a price-adjustment rule that raises price when there’s an excess demand and reduces price when there’s an excess supply will lead to an equilibrium market price. But that simple price-adjustment rule is hard to generalize when many markets — not just one — are in disequilibrium, because reducing disequilibrium in one market may actually exacerbate disequilibrium, or create a disequilibrium that wasn’t there before, in another market. Thus, even if there is an equilibrium price vector out there, which, if it were announced to all economic agents, would sustain a general equilibrium in all markets, there is no guarantee that following the standard price-adjustment rule of raising price in markets with an excess demand and reducing price in markets with an excess supply will ultimately lead to the equilibrium price vector. Even more disturbing, the standard price-adjustment rule may not, even under a tatonnement process in which no trading is allowed at disequilibrium prices, lead to the discovery of the equilibrium price vector. Of course, in the real world trading occurs routinely at disequilibrium prices, so that the “mechanical” forces tending an economy toward equilibrium are even weaker than the standard analysis of price-adjustment would suggest.
This doesn’t mean that an economy out of equilibrium has no stabilizing tendencies; it does mean that those stabilizing tendencies are not very well understood, and we have almost no formal theory with which to describe how such an adjustment process leading from disequilibrium to equilibrium actually works. We just assume that such a process exists. Franklin Fisher made this point 30 years ago in an important, but insufficiently appreciated, volume Disequilibrium Foundations of Equilibrium Economics. But the idea goes back even further: to Hayek’s important work on intertemporal equilibrium, especially his classic paper “Economics and Knowledge,” formalized by Hicks in the temporary-equilibrium model described in Value and Capital.
The key point made by Hayek in this context is that there can be an intertemporal equilibrium if and only if all agents formulate their individual plans on the basis of the same expectations of future prices. If their expectations for future prices are not the same, then any plans based on incorrect price expectations will have to be revised, or abandoned altogether, as price expectations are disappointed over time. For price adjustment to lead an economy back to equilibrium, the price adjustment must converge on an equilibrium price vector and on correct price expectations. But, as Hayek understood in 1937, and as Fisher explained in a dense treatise 30 years ago, we have no economic theory that explains how such a price vector, even if it exists, is arrived at, and even under a tannonement process, much less under decentralized price setting. Pinning the blame on this vague thing called price stickiness doesn’t address the deeper underlying theoretical issue.
Of course for Lucas et al. to scoff at price stickiness on these grounds is a bit rich, because Lucas and his followers seem entirely comfortable with assuming that the equilibrium price vector is rationally expected. Indeed, rational expectation of the equilibrium price vector is held up by Lucas as precisely the microfoundation that transformed the unruly field of macroeconomics into a real science.
Uneasy Money 
Wonderful post, I agree with every word. Tobin was one of the few prominent economists to insist that price flexibility could be destabilizing:
“Keynes tried to make a double argument about wage reduction and employment. One was that wage rates were very slow to decline in the face of excess supply. The other was that, even if they declined faster, employment would not – in depression circumstances – increase. As to the second point, he was well aware of the dynamic argument that declining money wage rates are unfavorable to aggregate demand. But perhaps he did not insist upon it strongly enough, for the subsequent theoretical argument focused on the statics of alternative stable wage levels.”
That’s from his 1975 AER Proceedings paper, which has a model of corridor stability in the sense of Leijonhufvud. My post on the paper is here:
http://rajivsethi.blogspot.com/2009/12/on-consequences-of-nominal-wage.html
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Since you touched upon the issue of wages as inputs briefly…I have a question for you, Dr. Glasner. Have you read David Card and Alan Krueger’s paper on the minimum wage and the fast food industry in New Jersey and Pennsylvania?
http://www.jstor.org/stable/2118030
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David,
Another way out of requiring sticky micro prices is that if there are millions of prices, it is simply unlikely that the millions of (non-sticky) adjustments will happen in a way that brings aggregate demand into equilibrium with aggregate supply.
Imagine that each price is a stochastic process, moving up or down +/- 1 unit per time interval according to the forces in that specific market. If you have two markets and assume ignorance of the specific market forces, there are 2^n with n = 2 or 4 total possibilities
{+1, +1}, {+1 -1}, {-1, +1}, {-1 -1}
The most likely possibility is no net total movement (the “price level” stays the same) — present in 2 of those choices: {+1 -1}, {-1, +1}. However with two markets, the error is ~1/sqrt(n) = 0.7 or 70%.
Now if you have 1000 prices, you have 2^1000 possibilities. The most common possibility is still no net movement, but in this case the error (assuming all possibilities are equal) is ~1/sqrt(n) = 0.03 or 3%. In a real market with millions of prices, this is ~ 0.1% or smaller.
In this model, there are no sticky individual prices — every price moves up or down in every time step. However, the aggregate price p = Σ p_i moves a fraction of a percent.
Now the process is not necessarily stochastic — humans are making decisions in their markets, but those decisions are likely so complicated (and dependent e.g. on their expectations of others expectations) that they could appear stochastic at the macro level.
This also gives us a mechanism to find the equilibrium price vector — if the price is the most likely (maximum entropy) price though “dither” — individuals feeling around for local entropy gradients (i.e. “unlikely conditions” … you see a price that is out of the ordinary on the low side, you buy).
This process only works if the equilibrium price vector is the maximum entropy (most likely) price vector consistent with macro observations like nominal output or employment.
http://informationtransfereconomics.blogspot.com/2015/03/entropy-and-walrasian-auctioneer.html
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I would like to add that a panic or other sources of pessimism about economic growth can easily coordinate all the demand curves to fall together, causing prices to fall together. It is hard to coordinate optimism across several sectors (you usually get booms in particular sectors … dot-com, housing, tulip bulbs).
It is then hard for uncoordinated (stochastic) price movements to get back to equilibrium from that disequilibrium moving only a fraction of a percent at a time.
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I have a somewhat different take. I like Lucas’ insistence on equilibrium at every point in time as long as we recognize two facts. 1. There is a continuum of equilibria, both dynamic and steady state and 2. Almost all of them are Pareto suboptimal.
The Arrow-Hahn distaste for RBC models was as much a distaste for the policy implication as it was for the method. At least that’s what I gleaned from conversations with Frank. Perhaps Ken Arrow reads blogs and will jump in and prove me wrong.
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Excellent blogging.
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This isn’t directly on the point of your post, but it is something I’ve always wondered about price flexibility.
If prices were fully flexible, wouldn’t that tend to make business ventures *more* risky? A business needs to buy inputs and then produce and sell its output. If prices are fully flexible, isn’t their greater risk that the market-clearing price of the final product will fall below the cost of the inputs?
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David, Sorry, but that’s not what Lucas means by “rational expectations.” I would encourage you to read Bennett McCallum’s explanation of what rational expectations actually means, as opposed to the misleading description used by many of its critics. A model with rational expectations is one where if the model says the world is X, you don’t assume the public believes “not X.” That is, expectations are not inconsistent with the model. Nonetheless, it allows for an almost infinite amount of uncertainty about the world, and indeed Lucas often assumed a substantial amount of ignorance—arguably an implausibly high level of ignorance.
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While not disagreeing with David and much of the posts that follow, I would like to offer a different explanation of price stickiness, one that is only a slight elaboration of the explanation developed in the 1950s by Keynesians who sought empirical underpinnings of the General Theory.
Referring to “price stickiness” implies that the normal theoretical expectation is that prices should fluctuate to clear markets more or less continually. This is the expectation that follows from the model of (1) a perfectly competitive market with (2) a positively sloped supply curve derived from positively sloped marginal cost curves of the individual firms. But neither of these are typical characteristics of firms in manufacturing and service industries, where firms are typically price setters, not price takers, and marginal cost curves are typically horizontal up to full capacity. Full exposition of these points requires a full length article so I must be brief and refer to other published work.
First, price taking in competitive markets is rarely if ever found in manufacturing and service industries. Many are oligopolistic and of those that have a larger number of competitors, almost all sell differentiated products and so must set the price of each and let fluctuations in sales, not in impersonally determined market prices, signal how their demands are fluctuating in the short run.
Second, the relevant theory of many production processes does not give rise to positively sloped supply curves for individual firms. There has always been strong empirical evidence that the short run marginal cost curve of the typical manufacturing firm is horizontal and the correct interpretation lies in the nature of the firm’s fixed factor. The standard text book talks of spreading more or less of the variable factor, usually taken to be labour and materials, over a given quantity of a fixed factor, usually taken to be capital equipment in the case of manufacturing, or land in the case of agriculture. It then appeals to the law of diminishing returns to explain a U-shaped SRMC curve, the most important part of which is the upward sloping part. But this only applies if the fixed factor is subject to a strong equality: K=K* (where K* is the fixed amount available in the short run and K is the amount actually employed). In most situations, the fixed factor is subject to an inequality constraint: one can use less but not more than the fixed amount available in the short run, K less than or equal to K* (I cannot get the relevant sign to print here). Firms can then vary output up to full capacity by altering the amount of all factors used, thus keeping their ratios at their optimal values. Consider, for example, a building containing 100 sowing machines with one hundred operators. If the firm’s demand falls cyclically and it desires to reduce output by 10 percent, it does not have 90 operatives running around trying to tend 100 machines; instead it lays off 10 operatives and leaves 10 machines idle. This holds the ratio of labour to machines constant allowing the firm to produce at the same unit cost as when output was at full capacity. (In many of today’s modern service industries there is no constraining fixed factor and virtually all inputs can be varied so that again the law of diminishing returns is irrelevant to the shapes of their short run cost curves. Also with many industries in the new electronic economy most of the costs are associated with developing new products and improving old ones, while the marginal cost of producing another unit of current output is at, or close to, zero and so does not vary significantly with output.)
Finally we need to ask why, even if firms are price setters and faced with constant short run marginal cost curves, prices should stay constant as output fluctuates over the short term. As far back as the 1930s a substantial amount of direct questioning showed that firms claimed to follow a full cost pricing rule, calculating full cost, adding a markup, then selling whatever was demanded at that price. This seemed implausible to those who believed in a positively sloped SRMC curve, but it was eminently plausible given a horizontal SRMC curve. All that was then required was, first, that the markup at normal capacity was at or near the profit-maximising markup and, second, either that the elasticity of demand did not change significantly as demand varied cyclically or that the benefit gained from constantly changing prices by small amounts as the profit-maximizing markup changed cyclically was less than the cost.
Selected References
“IS-LM, Keynesianism and the New Classicism”, in Macroeconomics and the Real World, Volume 2: Keynesian Economics, Unemployment, and Policy, Roger E. Blackhouse and Andrea Salanti (eds), (Oxford: Oxford University Press), 2000, 57-82.
“The History, Significance and Policy Context of The Phillips Curve,” (with William Scarth), Introductory essay to Inflation and Unemployment: The Evolution of the Phillips Curve (3 Vols.) (Richard Lipsey and William Scarth, eds.) (Cheltenham: Edward Elgar), 2011, xii-xxxvii.
“The Phillips Curve and the Tyranny of an Assumed Unique Macro Equilibrium”. Simon Fraser University Discussion paper first presented at the 40th annual meeting of the History of Economics Society, Simon Fraser University
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This is a very nice post, but as always the question is what do we give up by adding some ad-hoc price stickiness to a GE model and going from there, rather than modelling the price-setting process explicitly? I don’t know the answer to this question, but it does seem that we can learn a lot from the traditional approaches.
Also, regarding nominal rigidities — while it is true that they are not necessary for AD effects, macro-level evidence (e.g. from exchange rates) suggests that they are very significant by themselves, making them a natural candidate.
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Richard Lipsey’s remarks are great; they are tied to the practice of running a business.
An additional point about pricing based on knowing your costs – businesses are always mindful of new entrants, and new entrants will face much the same costs when producing if they are in the same market-geography but new entrants will tend to use price as a way to establish a presence in the marketplace. So businesses not only know to cover costs, but are made sensitive to the setting of their prices so they do not invite in too much new competition.
Note how the digital-world brings in the potential for many more new entrants, all untied to the geographic factors that apply to current businesses in the targeted area.
Thanks, great blog. I’d appreciate a whole lot more on “pricing” as I do not think that the setting of prices is well understood by macro-eonomists, imho.
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David Glasner: “rational expectation of the equilibrium price vector is held up by Lucas as precisely the microfoundation that transformed the unruly field of macroeconomics into a real science.”
That’s how I understand Lucas also. But Scott Sumner says we’re wrong, that’s not what Lucas means by rational expectations. Can anyone point me to a clear statement, by Lucas himself, of how he understands the concept?
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I wish that any argument about rational expectations would begin with the recognition that a rational expectations equilibrium is a *fixed point* of a mapping from subjective beliefs to objective probabilities. If individuals have private information that can’t be deduced from public prices then beliefs can differ, but you still have strong restrictions *across individuals* on what they can each believe. Marcet and Sargent’s papers on the convergence of learning to RE equilibrium provide a clear statement (JET 89, JPE 89).
Franklin Fisher was absolutely right to insist that any equilibrium concept (including rational expectations) ought to have firm disequilibrium foundations.
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in reply (at least partially to ) to Kevin Donoghue):
The new classical economists accused Keynesian economics of having no micro underpinnings and asserted that their new underpinnings, including rational expectations, made economies for the first time into a genuine science. In fact, Keynesian economics had a full set of micro underpinnings based on theory and evidence, as detailed in my paper on IS-LM, Keynesianism and the New Classicism”, referred to in my previous comment on this blog. One may disagree with them, but to deny their existence is to deny history.
The problem was the these fact-based underpinnings of oligopoly and price-setting rather than price-taking firms and labour markets that were not auction markets (and who can seriously assert otherwise about labour markets?) cannot be aggregated into stable macro relations.
So in retrospect, the charge of inadequate micro underpinnings did not refer to the extent to which Keynesian underpinnings were absent or unrealistic. It referred instead to the fact that the Keynesian underpinnings were developed piecemeal and could not be formally aggregated to yield precise macroeconomic behaviour.
The new classical model accomplished this aggregation by employing a series of strong assumptions, some of the most important of which were market clearing under perfect competition, rational expectations and representative agents who can be blown up to become the aggregate of all producers and consumers.
Keynesians argued that the world is irretrievably one of price setting, not price taking in virtually all manufacturing and service industries (plus a number of other non-competitive facets). They agree that no one knows how to aggregate from such micro economic behaviour to stable macro relations. But, they say, if that is the way the world is, there is no point in pretending that it fulfills the empirically false competitive conditions needed for New Classical aggregation.
Thus to many of we Keynesians, the New Classical program replaced messy truth by precise error.
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Kevin, Here’s an abstract from a Lucas and Woodford paper:
“We study the effects of monetary disturbances in an economy in which sellers must deal with potential buyers in sequence, rather than being able to sell their goods in a Walrasian auction market. Because of the structure of trading assumed, the current state of demand is not revealed to sellers until after the process of sequential transactions has concluded. As a consequence, unanticipated changes in nominal spending flows induce less-than-proportional responses in nominal transaction prices, and changes in the same direction in real output. These effects are similar to those obtained if sellers must commit themselves in advance to money prices, but do not depend upon any cost of changing prices. We fully characterize the stationary intertemporal equilibrium of an economy subject to i.i.d. money supply shocks. We show how the ex ante distribution of monetary shocks affects sellers’ pricing strategies, and hence the equilibrium relation between the money supply, the distribution of transaction prices, and the degree to which available productive capacity is utilized.”
Sounds quite Glasnerian. 🙂
Seriously, I’d strongly recommend McCallum’s work on this. He’s spent a lot of time trying to explain to people that the rational expectations assumption was much less than most people assumed, it’s basically “consistent expectations.” The expectations of the agents in the model should not be inconsistent with the model. That’s all. But Lucas emphasized decision-making under limited information, as with his “archipelago” models of the 1970s. Agents make educated guesses, and when there are monetary shocks they often guess wrong. That’s why monetary shocks have real effects (in his view, not mine.)
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Here’s Mike Woodford on the need to go beyond rational expectations in macroeconomics and finance:
“The macroeconomics of the future… will have to go beyond conventional late-twentieth-century methodology… by making the formation and revision of expectations an object of analysis in its own right, rather than treating this as something that should already be uniquely determined once the other elements of an economic model (specifications of preferences, technology, market structure, and government policies) have been settled.”
Source: http://ineteconomics.org/blog/inet/michael-woodford-response-john-kay
Rational expectations, being a fixed point or equilibrium property of a model, is not, in fact, a theory of expectations at all. Under RE, expectations are pinned down by equilibrium conditions once “the other elements of an economic model” have been specified.
There was a conference at Columbia in 2011, organized by Woodford and Ricado Reis, the entire purpose of which was to explore alternatives to rational expectations. I blogged about it here:
http://rajivsethi.blogspot.com/2011/02/belief-heterogeneity.html
The explicit study of expectation formation and revision is an exciting and active area of frontier research in economics. Pretending that the rational expectations hypothesis is an innocuous assumption and an adequate theory will do nothing to further this agenda. Scott’s views on rational expectations are, dare I say, entirely backward-looking.
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Rajiv, You need to be more careful. Are you talking about my views on what other people mean by rational expectations, or my views on how the public forms expectations. I haven’t said anything here about my views on how people form expectations. And yet I fail to understand how my views on what Lucas meant by rational expectations could be “entirely backward-looking.”
Can you be more specific? After all, I do believe people suffer from money illusion, as you might have gathered from the name of my blog.
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Scott, I was responding to your claim that critics of rational expectations don’t know what it “actually means”. I didn’t mean to suggest that you endorse the hypothesis, but I did get the sense that you think it’s a weak or innocuous assumption. It’s not. An RE equilibrium is a fixed point of the mapping from subjective beliefs to objective probabilities. I don’t think any of the leading practitioners would dispute that (see, for instance, Marcet and Sargent JPE 89, p.1309). This is an extremely strong assumption when there is no private information, and even stronger when there is.
I think we are a long way from having an adequate theory of expectations. Three essential ingredients in my view are (i) heterogeneity of beliefs not just due to differences in private information but also to differences in the interpretation of public information, (ii) forward-looking behavior, and (iii) the possibility of mutually inconsistent plans. RE gives us the second, which was an important advance over earlier approaches, but it rules out the other two. The literature on heterogeneous priors is grappling with the first. Hayek, as David has often mentioned, was very concerned with the third.
I was a discussant on a panel on information and expectations at the INET meetings in Paris last week, and there’s some really interesting work going on in this area these days. But we have only just started to scratch the surface.
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The points I’m trying to make are these (i) RE is not a theory of expectations at all, since beliefs are pinned down by equilibrium conditions once other variables are given, and (ii) the constraints on beliefs are highly restrictive in multi-agent systems that are self referential (objective probabilities depend on subjective beliefs).
On the former point, see the Woodford quote above, which I think is spot on. On the latter, think for a moment about the “jump variable technique” that is sometimes used to solve RE models. This involves a distinction between slow moving variables (like the capital stock) and fast moving variables (like prices, interest, or exchange rates). An unanticipated shock to the former leads to a jump in the latter, precisely calibrated so that the economy lands on a saddle path leading to a new steady state. How is this coordinated and calibrated jump justified? By arguing that if one maintains the hypothesis of rational expectations, then any other jump (or no jump at all) would eventually lead to the violation of a transversality condition. This is as circular a defense of a method as you are likely to encounter.
In order for this method to give a determinate outcome, the steady state in the model must be characterized by saddle point stability. If it is not, then once can get multiple RE paths for a given history, as in the sunspot literature. Roger Farmer (who has commented above) has developed some of the most interesting and compelling models of this type.
The RE issue is quite separate from arbitrary assumptions about price-stickiness, and on this point I find myself very much on the side of Lucas and Farmer. Even though prices may be slow to adjust in reality, it’s well worth exploring models of flexible prices (without insisting on rational expectations), because the destabilizing forces in market economies appear in clearest form. Like Tobin and Keynes, I think that price stickiness is actually a stabilizing force. But this is just instinct and conjecture, I don’t have a model.
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Rajiv, Again, I would strongly encourage people to look at Bennett McCallum’s work on rational expectations, which is the best I have seen. Especially his critique of critics of rational expectations. As is clear in the abstract I quoted from, rational expectations does not assume that agents have a high level of knowledge about the economy. Massive ignorance is completely consistent with rational expectations. Rather the assumption is that agent’s expectations (whatever they are) do not conflict with the model itself.
I happen to believe that 99% of Americans have pathetically irrational beliefs about all sorts of economic topics, yet find the ratex hypothesis to have been extremely valuable for my own empirical work. It’s a tool, which may be more useful in some contexts than others. In that respect it reminds me a lot of the EMH. For me, it’s been extremely useful.
Here’s one example. I saw 2008 as a huge triumph for the ratex/EMH view of the world, where the wisdom of the crowds simply blew away so-called “expert” forecasts. But everything I read says that most people think 2008 somehow refutes ratex/EMH. I conclude that most people must be defining these theories very differently than I do.
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looking back at the mankiw ball paper is useful to me today for research purposes…but if i had been at the conference i am sure i would have been very annoyed…i hate it when people waste my time telling me what i already know…best i can tell that is what lucas was expressing…
other than that, awesome article…maybe try expanding it into a fuller history tracing back the history of the walrasian auctioneer? i would read it and recommend
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Rajiv, Thanks, as always, for your comment, and the link to your post. There are many subtleties in the argument about whether wage adjustments are stabilizing or destabilizing, but I think the important point is that the usual presumptions, based on Marshallian partial equilibrium analysis, about eliminating an excess supply via a price reduction don’t apply. I am hesitant to say that price and wage adjustments are destabilizing, but it is certainly the case that relying on price and wage adjustments to restore equilibrium is a very bad idea.
Blue Aurora, I don’t remember if I read the paper or just read about it. I remember that it generated a lot of controversy when it was published and that there were some subsequent studies that called the results of Card and Krueger into question, but I don’t have a strong opinion about their study.
Roger, I think equilibrium at every point in time is ok if we distinguish between temporary and full equilibrium, but I don’t see how there can be a continuum of full equilibria when agents are making all kinds of long-term commitments by investing in specific capital. Having said that, I certainly agree with you that expectational shifts are very important in determining which equilibrium the economy winds up at. I would certainly be curious to know what Arrow makes of RBC theory, but it would be shocking to me if he had anything positive to say about it. I thought that he always tried to emphasize the ways in which the assumptions of the Arrow-Debreu model deviated from real world conditions.
What did you make of Krugman’s post last week about multiple equilibria in which you received an ambiguous shout out?
Benjamin, Thanks.
Michael, One of the important microeconomic studies (actually a whole series of studies) of price flexibility has been by Dennis Carlton who argues that suppliers treat steady customers differently from occasional or anonymous customers. Steady customers get preferential pricing and terms in the sense that in periods of limited supply they get priority over occasional customers without paying a premium.
Scott, You certainly know Lucas better than I do, but I think that rational expectations has more substantive meaning than you are suggesting. A model doesn’t just say the world is X, because what the model says the world is depends on what agents expect the world to be. A consistent model has the property that if people expect the X and the model cannot be in equilibrium unless X is the solution. That is the limited sense in which we can all accept rational expectations. It is a property of a model, not a property of the world. As I understand Lucas and others, they say that people have rational expectations which means that their expectations are such that the world, aside from purely stochastic variables, generates the data that agents expected.
Richard, Thanks for your comment and the references, which adds an important, and often neglected, dimension to the discussion of price flexibility. As we are taught in introductory or intermediate micro, there is no supply curve unless suppliers are price takers. So under your assumptions, either the supply curve is horizontal, because the short run marginal cost curves are horizontal, so that price doesn’t change in response to changes in demand, or there is no supply curve at all because firms are price setters not price takers. Price adjustment in that context is not necessarily a feature of the adjustment process to a disequilibrium.
Jonathan, Thanks. I am not saying that price stickiness shouldn’t be allowed in models, just pointing out that there is lots of other stuff to be concerned with.
JF, Yes, it’s great to have someone of his eminence as a visitor here. Well, if I think of any more stuff about pricing, I’ll try to share it with you.
Kevin, Just guessing, but I think that rational expectations can take on a range of meanings depending on the context. It can be a test of the consistency of a model, or it can be an assertion about the substantive context of expectations in the real world. I don’t think that Lucas has ever denied that rational expectations are not an empirically meaningful concept, but that’s just my impression.
Rajiv, I think that’s right.
Richard, Your comment raises the question in my mind, which you may have gone into in your papers, but I don’t recall, of where these microfoundations relying on constant marginal costs and imperfect competition, are to be found. Keynes did not mention them, though perhaps constant marginal costs are implicit, and I don’t think Hicks used those assumptions, and certainly they weren’t part of the neoclassical synthesis. But I do agree with your assessment of New Classicism, though I’m not sure that I would give them that much credit for precision either.
Scott, Interesting abstract, do you have a reference for the paper? My comment on your exchange with Rajiv is the following. My naïve interpretation of rational expectations is that it is a tool by which to solve a DSGE model by saying that the expectations of agents in the model are those that will support an equilibrium of the model. If the model has a unique equilibrium there is only one set of expectations that is consistent with the equilibrium and the modeler posits that agents share that set of expectations. A technique for solving a model is thus confused with the process by which agents form expectations.
LAL, Annoyance is one thing, but Lucas got so annoyed that he couldn’t figure out what the point of the paper really was. Glad you like the post, and thanks for your suggestion for expansion. I will keep it in mind.
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That Lucas paper: Yikes.
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Thanks to all for interesting comments. David, the Lucas & Woodford paper Scott cites is at the link below. I haven’t read it yet.
https://ideas.repec.org/p/nbr/nberwo/4250.html
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David
I am comfortable with temporary equilibrium as the guiding principle, as long as the equilibrium in each period is well defined. By that, I mean that, taking expectations as given in each period, each market clears according to some well defined principle. In classical models, that principle is the equality of demand and supply in a Walrasian auction. I do not think that is the right equilibrium concept.
Hicks wanted to separate ‘fix price markets’ from ‘flex price markets’. I don’t think that is the right equilibrium concept either. I prefer to use competitive search equilibrium for the labor market. Search equilibrium leads to indeterminacy because there are not enough prices for the inputs to the search process. Classical search theory closes that gap with an arbitrary Nash bargaining weight. I prefer to close it my making expectations fundamental.
Once one treats expectations as fundamental, there is no longer a multiplicity of equilibria. People act in a well defined way and prices clear markets. Of course ‘market clearing’ in a search market may involve unemployment that is considerably higher than the unemployment rate that would be chosen by a social planner. And when there is steady state indeterminacy, as there is in my work, shocks to beliefs may lead the economy to one of a continuum of steady state equilibria.
That brings me to the second part of an equilibrium concept. Are expectations rational in the sense that subjective probability measures over future outcomes coincide with realized probability measures? That is not a property of the real world. It is a consistency property for a model. And yes: if we plop our agents down into a stationary environment, their beliefs should eventually coincide with reality. If the environment changes in an unpredictable way, it is the belief function, a primitive of the model, that guides the economy to a new steady state. And I can envision models where expectations on the transition path are systematically wrong.
The recent ‘nonlinearity debate’ on the blogs confuses the existence of multiple steady states in a dynamic model with the existence of multiple rational expectations equilibria. Nonlinearity is neither necessary nor sufficient for the existence of multiplicity. A linear model can have a unique indeterminate steady state associated with an infinite dimensional continuum of locally stable rational expectations equilibria. A linear model can also have a continuum of attracting points, each of which is an equilibrium. These are not just curiosities. Both of these properties characterize modern dynamic equilibrium models of the real economy.
There are still a number of self-professed Keynesian bloggers out there who see the world through the lens of 1950s theory. They have some catching up to do with the literature.
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Superbe, superbe, mon ami
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1st paragraph: should be “Mankiw” not “Maniw.”
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