Arnold Kling  

Nick Rowe's Continuity Question

Zwolinski, the Drowning Child,... Adaptation and Economics...

He asks,

Assume I am an individual household or small firm, and that I have perfectly flexible prices. How am I affected if all the other households and firms around me have sticky prices, and there is a monetary shock that causes a recession? To what extent can my adjusting my own prices optimally insulate me from the recession around me?

I think that in a world of small, continuous changes, the ability of a small agent (household or small firm) to insulate itself by making small price changes ought to be nearly complete. However, I do not believe that we live in such a world. I think we live in a lumpy world with discontinuous changes. Individuals and firms tend to remain as stable as possible, and then when their actions become unsustainable they make large changes. In some sense, there is under-reaction to small events until problems cumulate and we observe larger actions.

If you are a home builder in Nevada in 2008, a small price cut will not insulate you from the problems that have accumulated. If you are a worker for whom a newly-invented capital good can substitute at much lower cost, a small wage cut will not help you. And so on.

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CATEGORIES: Macroeconomics

COMMENTS (2 to date)
Alex Godofsky writes:

Um, what exactly is "shock" supposed to mean other than "discontinuity"?

Mark Little writes:

I quite agree. (I'm a PSST believer.)

But you didn't mention the rest of Nick's question:

2. Assume my country is a small open economy with sticky prices, and an independent monetary policy with flexible exchange rates. How is my country affected if all the other countries around mine also have sticky prices, and there is a global monetary shock that causes a global recession? To what extent can my country's adjusting its own monetary policy optimally insulate my country from the recession around it?

3. Do questions 1 and 2 have essentially the same answer?

This rather begs the question of what a "global monetary shock" might be. There seems to me to be a broad disconnect between the 'monetarist' perspective (e.g. Sumner), that takes money to be a homogeneous transparent quantity under the firm control of 'monetary authorities', versus the banking/credit perspective that sees debt and liquidity as a heterogeneous, often opaque product of a complex institutional system, subject to sudden changes in confidence and varying "informational insensitivities" (a la Kindleberger, Gorton). I wonder where Nick's "global monetary shock" lives in this spectrum. But never mind that.

Given Nick's assumptions, can't the "independent monetary policy with flexible exchange rates" allow the smooth continuous aggregate price adjustment needed for optimal adjustment to the "global monetary shock"? And so leave the residual loss of aggregate income correctly explained by the pure AD story? (World demand has fallen by assumption, and this is a small open economy. Pending a change in PSST to a less open economy, the country is poorer. This is perhaps one of the few cases of the simple AD deficiency model I find persuasive.)

In other words, the answer to Nick's question 3 is "No", not "Yes" as he suggests.

What am I missing?

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