Arnold Kling  

Nick Rowe vs. Scott Sumner

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The Rest of The Great Stagnati... Great Stagnation or Lousy Data...

Nick Rowe writes,


Monetary disequilibrium theorists will disagree with those Keynesians. We add monetary exchange to the mix. We don't buy and sell output for labour. We don't buy and sell output for bonds. We buy and sell output for money -- the medium of exchange. We buy and sell everything for money -- labour, bonds, and output. If there's an excess demand for money, so the desired stock of money exceeds the actual stock of money, people will be trying to sell more of everything than they buy of everything. An excess of AS over AD means an excess demand for money. It's the real stock of money M/P that must adjust to equilibrate AD and AS.

If I have this right (and the main reason I am writing this post is to get feedback on whether I have this right), then this is a bit different from the Scott Sumner mechanism. In Rowe's world, when the money supply contracts, producers are caught temporarily off guard and prices stay too high. This reduces M/P, leading to lower spending and output. In Sumner's world, when the money supply contracts, price-setters read the situation clearly but nominal wages are sticky. Nominal GDP falls relative to nominal wages, and output contracts.

Going out further on a limb, I would say that in Rowe's monetary disequilibrium world, we would observe output falling first (due to a drop in the money supply or an increase in money demand), leading to disinflation. In principle, we could see output decline without a drop in inflation. In an old-fashioned aggregate-supply world (like the one I use to characterize AS), we would see disinflation first, leading to lower output. The catch is that for Sumner, output drops when expected inflation drops, so that we could observe the output decline before we see the inflation decline. But overall, we would be surprised if output dropped without disinflation.

This might be a good time to bring up the issue of paradigms vs. theories. A theory is something that stands or falls on a single decisive test. You're Ben Franklin, you have a theory that lightning is an electrical phenomenon, so you fly your kite with a key on the end of it, and hopefully you live to tell about the confirmation of your theory.

A paradigm is more like a language. There is no decisive test that tells me that English is "true" and French is "false." Overall, I feel more comfortable blogging in English than in French. A computer programmer these days might feel more comfortable coding in C than in FORTRAN, but that does not refute the latter.

In science, comfort with a paradigm depends in part on empirical issues and in part on the overall "fit" with other theories. The AS-AD paradigm can be made to fit any observed data. If prices and output are moving in the same direction, you call it a shift in AD. If prices and output are moving in the opposite direction, you call it a shift in AS.

One of the reasons that people proclaim the Recalculation Story bogus is that they think of it as an AS shift, and yet we see prices and output moving in the same direction. But that is like running a French sentence through an English translating program, getting a nonsensical result, and pronouncing French a bogus language.

For me, the nice thing about PSST (patterns of sustainable specialization and trade) is that it fits so well with normal economics. Normal economics is about entrepreneurs trying to identify opportunities to exploit specialization of labor and comparative advantage. Normal economics (or normal Austrian economics) does not take equilibrium for granted. Instead, the economy is constantly changing, and individuals and firms are constantly adapting.

One can argue that both AS-AD and PSST are about short-run adjustment in an economy that is far away from a desirable equilibrium. However, the AS-AD approach sees adjustment as being all about getting to the correct aggregate relative prices (the version that I am most used to looks at W/P. but if you prefer M/P that does not ease my concern). The PSST approach sees adjustment as much more complex, requiring a lot of entrepreneurial trial and error to resolve.


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CATEGORIES: Macroeconomics



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The author at Taking Hayek Seriously in a related article titled Arnold Kling — Hayekian of the Day writes:
    Recalculation thinking vs AS-AD thinking. Sort of like the difference between adaptation thinking at the margin in Darwinian biology versus Platonic / Aristotelian thinking about biological kinds. Kling misses the fact that one kind of thinking provide... [Tracked on January 29, 2011 5:09 PM]
COMMENTS (12 to date)
Nick Rowe writes:

I think you have it half right.

Here is an oversimplified way of looking at it:

"What needs to adjust so that AD=AS?"

Arnold: "W/P"
Nick: "M/P"
Scott: "M/W"

Scott is halfway between you and me. Because Scott's sticky wage view is exactly on the boundary between the W/P view and the M/P view, it's hard to tell which camp he belongs to. "Is Scott saying the real wage is too high or the real money supply is too low?" Sort of both.

I'm going to think and try to explain this more clearly.

fundamentalist writes:
The AS-AD paradigm can be made to fit any observed data.

I think that is true of any paradigm, but it's not the fault of paradigms as the fact that historical data is so vast and contradictory that the promoter of a wacky paradigm would have to be an idiot to not find supporting data.

So how does one determine what's true in economics? Observing human nature and using logic. Economics is about how humans behave in the marketplace. It's not about mechanically interacting aggregates.

Bob Murphy writes:

I can't say whether you are right on Rowe vs. Sumner, but other than that this was a great post Arnold.

Artturi Björk writes:
However, the AS-AD approach sees adjustment as being all about getting to the correct aggregate relative prices (the version that I am most used to looks at W/P. but if you prefer M/P that does not ease my concern).

No. It's not all about getting to the correct aggregate relative prices.

No one is saying that relative prices don't have to change, but you seem to be opposed to getting the right aggregate prices and then worrying about relative prices.

It's comes across as you thinking there is harm in getting the right aggregate prices for the recalculation. It comes across as Nick and Scott think it does good for the recalculation to get the right aggregate prices.

Also I've never understood Scott to mean only wages when he writes about sticky wages, but all kinds of sticky nominal prices, which I thought was what Nick meant when he wrote

It's the real stock of money M/P that must adjust to equilibrate AD and AS.

So I don't yet understand how Scott is half way between you and Nick.

Nick Rowe writes:

Assume perfect competition. If firms are able to sell all the output they want, the (notional) labour demand curve is given by W/P = MPL(Ld). Substitute into the production function Ys=F(Ld) and solve for the notional SRAS curve Ys=F(inverse function of MPL((W/P))).

Since Scott assumes that P adjusts very quickly, and W slowly Scott is always on the notional labour demand curve and SRAS curve, but will be off the labour supply curve, and hence off the LRAS curve.

I assume P adjusts at roughly the same speed as W, so firms will be constrained in the output market, and will be off their notional labour demand curves. MPL>W/P. Firms will be on their constrained labour demand curves, which is simply the inverse of the production function. They demand only as much labour as is needed to produce the level of output they are able to sell, given AD and sticky P. Given M and P, a fall in W will not increase the (constrained) quantity of labour demanded.

Bill Woolsey writes:

It isn't really that complicated.

Suppose there are price floors on all product prices.

Wages, on the other hand, can be cut.

The quantity of money falls in half.

Spending falls. Firms cut production to match sales. There is no continuing flow of production beyond the flow of spending. There may be surpluses in the sense that desired sales are greater than purchases, but actual production doesn't exceed purchases.

Firms are producing less so they reduce new hires and layoff people. Employment falls and unemployment rises. There are actually people looking for work.

Assuming money wages didn't rise in the face of this mass unemployment, the real wage is unchanged.

There was no higher real wage to cause higher unemployment.

Suppose money wages f3ll in the face of the massive unemployment. While the firms would have lower costs and would be motivated to sell more, they cannot sell more because people won't buy. (The price floors prohibit them from cutting prices.)

Now, the lower real wages might cause people to want to work less. And, eventually, firms might shift to techniques that use more labor and less other resources. So, employment might actually increase. The unemployment rate might drop.

Monetary disequilibrium theorists would say that the problem was the drop in the quantity of money or the price floor. The problem was never that real wages were too high and needed to drop.

Now, remember that wages are a prices--the prices of labor. We all know that. If we consider a scenario where all prices, including wages, are free to drop, the problem is still that either prices have not fallen enough or the nominal quantity of has fallen and remains low.

If all prices, including money wages were perfectly flexible, then there would be no problem. And at no point would real wages fall. Prices and wages would fall in proportion. There was never a reason for real wages to fall. They were never too high.

If all prices (including wages) were equally sticky, then they would all fall pretty much in proportion. Output would be depressed until they fall enough, but at no point would real wages be too high, despite the unemployment of labor. This could all occur with firms keeping producion matching sales so that there is no inventory buildup.

If some prices are more sticky than other prices, then the relative prices of the more flexible ones will fall. While the normal situation would be that they should contract output, that really doesn't work in this situation. The problem would need to be that their selling prices are falling faster than the prices of inputs. Anyway, these relative prices rise again once the stickier prices catch up, dropping the needed amount.

It is possible that some product prices are more sticky than some types of labor. That some product prices are more flexible than some types of labor. Some wage rates relative to some product prices might might rise and others might fall. And then they will reverse. The relative prices of goods with more sticky prices rise and then fall. The relative prices of goods with more flexible prices fall and then rise.

But the "problem" isn't that goods with sticky prices have high relative prices.

I think it is realistic that most wage rates are more sticky than most product prices, so that the real wages in the adjustment process rise and as wages catch up (in a downward direction) real wages fall.

But the problem isn't that real wages are too high. And, of course, lower money wages with unchanged goods prices (which lowers real wages) would not solve the problem!

The solution is to avoid decreasing the quantity of money to start with. Or, if it does decrease to get it back up as soon as possible.

And, of course, changes in the demand to hold money cause the same problem.

Arnold Kling writes:

Nick,
I certainly understand the sticky-price model, with M/P. It was Barro-Grossman or Malinvaud back in my day. My dissertation was an attempt to explain sticky nominal prices in support of that model.

And I understand the W/P model with sticky W, but I think of that as the M/W model. I am curious if there is really any important difference between those two.

Nick Rowe writes:

Arnold: I wasn't sure if you remembered the B&G and Malinvaud models. So few people do, nowadays. I think the economy is usually somewhere around the B&G "point B" in a recession.

I tend to agree very much with Bill on this stuff. Sometimes I have this strange feeling that Scott is about to wander off the straight and narrow of the monetary disequilibrium story, and Bill (usually) has to gently but firmly bring him back on the true path!

If I were caricature my own position, it's this: there is no important difference between inputs and outputs (for monetary AD/AS questions). The whole economy is just one big barbershop where all of us cut each others' hair. The demand for output *is* the demand for labour (and other inputs), because input and output are the same thing. Y=L. MPL=1. W=P. W/P=1 always. M/P and M/W are the same thing. The notional labour demand curve is horizontal. There is not diminishing marginal product that could make it slope down. Kapital and Land are just as likely to be unemployed in a recession. So there's no real point in distinguishing between the different inputs, and assuming the employment of one varies holding the employment of the others constant.

There's money and haircuts. And bonds too, just to appease the Keynesians and Neo-Wicksellians who keep harping on about interest rates, but they don't really make much difference. It's just a historical accident that central banks do open market operations rather than haircut operations, and talk about manipulating the price of bonds rather than manipulating the price of haircuts.

Yep, that's my paradigm, as opposed to theory.

Chris Koresko writes:

Nick Rowe: Assume perfect competition.

Does that assume away PSST?

Struggling a bit here...

Noah Yetter writes:

An excess of AS over AD means an excess demand for money.

An economist wrote this? AS and AD are not quantities, they are relationships of quantity and price. One cannot "exceed" the other. This is Econ 101 level stuff.

Nick Rowe writes:

Noah: Give me a break. I'm talking about points on the AD and AS functions, obviously. And yes, I have taught more Econ 101 students the difference between demand and quantity demanded than you have had hot dinners. I'm not going to say "Quantity of aggregate output demanded" every time, when Arnold knows I must mean that when I say "AD", rather than "AD curve".

Chris: assuming PC doesn't necessarily assume away PSST (though it comes close). But yes, that simple model was assuming away PSST. All models assume away some stuff to focus on other stuff.

Scott Sumner writes:

I agree with both of you. Nick's monetary disequilibrium story explains why NGDP changes, and the sticky wage and price story tells why changes in NGDP also change RGDP (rather than just prices.)

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