Tuesday, 3 January 2012

Keynesian Economics, Price Rigidity and Demand Denial

Something prompted from revising my second year undergrad lecture notes, and so mainly for economists.

In mainstream macro today, Keynesian economics is synonymous with the macroeconomics of price rigidity. Most of the time I have no problem with that. All the evidence suggests there is significant inertia in aggregate prices, and it is very difficult to tell realistic stories about how inflation moves without taking this into account. Price inertia and imperfect competition are probably essential in understanding why output tends to follow aggregate demand in the short term.
My problem with identifying Keynesian economics with the macroeconomics of price rigidity is that it allows those who would like to ignore Keynesian theory with too easy an opt out. They can argue that, despite appearances to the contrary, prices are in fact pretty flexible. They then conclude that Keynesian economics is irrelevant. Unfortunately far too many academic macroeconomists appear to implicitly or explicitly take this view.
                Is it logically the case that if prices are flexible Keynesian economics can always be ignored? The answer is simply no. Price flexibility alone does not ensure demand always moves quickly towards supply: it is the combination of price flexibility and monetary policy that does this. And when something goes wrong with monetary policy, price flexibility alone may not work.
We are living through exactly such a situation. It is not just the zero lower bound for nominal interest rates that is important here. It is also the fact that monetary policy has an inflation target rather than a price level target. After a large negative demand shock, demand can only be restored in the short term (for a given fiscal stance) by a large reduction in real interest rates. Real interest rates are nominal rates minus expected inflation. The zero lower bound stops nominal rates falling enough, and inflation targeting stops inflation expectations rising enough. No amount of price flexibility can change this. (For a more detailed discussion see here.)
                Students often think that price flexibility must imply that output is supply determined, because if any workers were unemployed, nominal wages would continue falling until they were employed. But just imagine an economy made up of monopolistic competitors where production was linear in labour. In that economy firms would ‘determine’ a constant real wage through their mark-up, and no amount of nominal wage cutting would reduce real wages or increase employment. 
Demand denial is the belief that we can always ignore aggregate demand when analysing short term movements in output and employment. It sometimes seems to be based on a view that price flexibility alone always ensures demand is sufficient for supply. It does not.


  1. Wouldn't the real balance effect restore equilibrium if prices were flexible? If prices fall due to inadequate demand, the value of real money balances should increase. This increase in wealth should stimulate demand, until demand equals supply at the initial interest rate.

    1. Good question. I think one answer is that in the standard intertemporal consumption model, where the welfare of future generations is internalised and therefore the rate of interest is equal to the rate of time preference, if an individual receives a gift of additional wealth, only its annuity value (the interest received from it) is consumed. Anything different would violate consumption smoothing. Now the interest on money is zero ... But there is a lot more that could be said here - maybe in another post.

    2. I'm not familiar with the details of that result, but my sense is it must be misleading in this case. Suppose that the interest rate on assets is zero, and that gifts of assets don't affect consumption because only the interest on the assets (zero by assumption) is consumed. That would seem to imply that consumption is unrelated to wealth! Adding assets has no effect on consumption, and presumably by the same logic taking assets away would not affect consumption (the agent only reduces consumption by the amount of the loss in interest payments, which is zero).

      Of course, the interest rate in question needn't be zero, because the real interest rate on money can be positive or negative depending on inflation. But in any case it seems to me that an increase in wealth should lead to higher consumption, regardless of the rate of interest. This should follow from utility-maximization: a household with assets can increase total consumption by exchanging them for goods (I thought this was ensured mathematically by the "transversality condition").

      If we accept that gifts of wealth must increase consumption, and that "outside" money represents wealth, then a falling price level should stimulate demand.


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