New Monetarist Economics
Paul Krugman seems worried that Noah Smith has been bitten with a zombie, or thrown into a discombobulated condition otherwise. Noah’s sin is to have suggested that what is going on in a New Keynesian model may not shed much light on what is going on in Japan. The basic Woodford construction confines attention to sticky prices as a friction that creates inefficiency that can be corrected by monetary policy. Competitive companies can change prices infrequently – say Monopolistically, through a Calvo prices mechanism – and unanticipated shocks can lead to relative price distortions that financial policy can work to mitigate. But, those comparative price distortions shall vanish in the long run as prices adapt.
Noah seems to think that twenty years (in japan case) gets us quite near to full modification, and I agree with the fact. Indeed, with the frequency of price changes we see in the data (e.g. Klenow et al.), the same debate would seem to use to our current predicament. It has been five years because the shock hit that produced the last tough economy in the United States. Krugman is certainly sold on the idea that AD-AS and Woodford macroeconomics will be the same thing.
According to Krugman, we can do effectively with AD-AS, though sometimes we would have to “check” what we should are doing by heading to the full-blown New Keynesian model. In the case of Noah’s post, Krugman considers Noah’s analysis is flawed because of his failing to take accounts of the liquidity trap, and otherwise falling short in adhering to Krugman’s talking points.
= $ =p>Krugman has two models he likes about. The first is AD-AS, and the other is within his paper with Eggertsson. But he desires to think about those as a similar thing. So let’s take the AD-AS route, as that’s easier. What is Krugman trying to say? Set the wayback machine, Sherman, and off we go. I’m now imagining myself in a macro class in 1975, where I discovered that which was in the first release of Branson’s publication. This is something similar to using an 8-monitor player you within your basement.
The thing works – in the sense that you can make it do what it was created to do – nevertheless, you know while using it that you are wasting your time and effort. Figure 1 teaches you the IS-LM, AD-AS right part of the model. This is the liquidity trap case.
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The LM curve is toned. Equilibrium output Y0 is significantly less than full employment result YF. How come the AD curve vertical? That’s because changes in prices don’t do anything in the IS-LM portion of the diagram, as real money demand is elastic at the zero lower bound perfectly. So, in the lack of some type of intervention, this economy remains permanently stuck below full work.
The fix is fiscal policy – increase G, shift the IS curve, and we go to full work output. But, as I had been taught in my own intermediate macro course, Pigou acquired a fix for this. But Figures 1 and 2 aren’t what Krugman has at heart. He’s barking up Kalecki’s tree, apparently. Kalecki argued that a deflation would increase the real value of obligations denominated in nominal terms, and that the wealth effect would go the other way.