Beyond 1950's Economic Theory: Nonlinearity, Multiple Equilibria and Sticky Prices

David Glasner has a very nice post on Price Stickiness and Economics with great comments from Rajiv Sethi,  Richard Lipsey and Kevin Donoghue among others. David reacts to a post from Noah Smith: this is all classic stuff

 

Here is David

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.

This is my response, first posted as a comment on David's blog,

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.

David replies...

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.

I agree with much of this. My response to David, which I have also posted on Uneasymoney....

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 by 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.