Arnold Kling  

PSST and Recovery

Nominal GDP and Employment... Nominal GDP and PSST...

Bryan asks,

without nominal rigidities, why doesn't the PSST model specifically predict that prices will adjust to restore full employment?

Suppose that a bunch of mortgage underwriters get laid off. There are two possible full employment equilibria.

(a) They can be instantly employed as dishwashers at 20 cents an hour.

(b)They can be employed as health insurance claims processors at a salary close to what they were making as mortgage underwriters.

The reason that we don't observe (a) is that wages are not perfectly flexible, if for no other reason than minimum wage laws. Point conceded to Bryan.

But the PSST story is focused on why we do not observe (b). The answer is that it takes time for entrepreneurs to figure out that there is a need for more health insurance claims processors, for the mortgage underwriters to seek and obtain retraining, etc.

Part of the reason that wages are sticky is that unemployed expect that the "right" equilibrium looks like (b) rather than (a). But more wage flexibility does not get you to (b). Instead it gets you to (a). That is why I do not think of wage flexibility as being a solution to problems of finding PSST.

To put this another way, suppose that policy makers, observing the correlation between nominal GDP and employment, try to exploit this correlation by raising nominal GDP. If there is enough money illusion, they will move the economy to (a). But I think instead all that happens is that the economy takes its own sweet time moving to (b), and in the mean time nominal wages and prices are higher than they would have been had the government done nothing.

Just as Milton Friedman predicted that the Phillips Curve would break down of policy makers tried to exploit it, I predict that the correlation between nominal GDP and employment will break down if policy makers try to exploit it. They will get mostly higher prices for their troubles. I may be wrong, and things are so bad that I would be willing to try the experiment for a while, but I predict that it will not turn out well.

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CATEGORIES: Macroeconomics

COMMENTS (7 to date)
MichaelM writes:

I do enjoy the notion that markets adapt to policy regimes, leading to a break down in formerly stable relationships that policy makers might exploit. It makes perfect sense when you look at markets as complex adaptive systems which react to changes in stimuli in order to maximize some variable or set of variables.

Markets are most like an organism which learns by millions of different trial and error processes at once, eventually overwhelming any attempts to pen it in.

Ryan writes:

More wage flexibility will get us to (a), I agree, but I don't see how more wage flexibility would prevent us from getting to (b).

Entrepreneurs are always figuring things out in a dynamic economy and we're always moving towards a new (b). The story of a recession is high unemployment, because we no longer get to (b) by going through (a).

I think PSST is happening all the time, but sticky wages cause recessions.

Arnold Kling writes:

Ryan, if people are working as dishwashers, they never get trained to do anything else

Maurizio writes:

I think there is a distinction to be made:
more wage flexibility produces (a) in the short term and allows to get to (b) in the long term, while monetary inflation might produce (a) but prevents to get to (b) because it impedes recalculation.

MMJ writes:


One can make the argument (as others have) that the UK is trying to "exploit...the correlation between nominal GDP and employment". I would be interested in your thoughts on what's happening there.

John B. writes:
if people are working as dishwashers, they never get trained to do anything else

When I was in college I had a part-time job as a dishwasher. Not only was I going to college, but the manager of the restaurant asked me if I'd take a full-time job as an assistant pastry cook with on-the-job training.

Don't forget evening courses, part-time work, shifting between activities within one job and self-study. "Dead-end jobs" don't have to be dead-end.

Lee Kelly writes:

To borrow a line from Sowell: there are no dead-end jobs, just dead-end people.

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