Morning Must-Read: Simon Wren-Lewis: Sticky Prices and Teaching Macroeconomics: How We Confuse Students, and Sometimes Ourselves

Simon Wren-Lewis: Sticky prices: How We Confuse Students, and Sometimes Ourselves: “In week one I talked about time periods in macro, and how the ‘short run’ was the length of time ‘it takes prices to fully adjust’….

[This] is at best highly misleading… the short run is the length of time it takes… monetary policy to achieve the real rate of interest implied by the RBC, or Classical, model.  Calling this the time period it takes prices to fully adjust only makes sense when monetary policy involves some kind of nominal anchor…. The big danger in equating Keynesian economics with sticky prices is that students forget about the crucial role monetary policy is playing…. Yet the linking of the short run with sticky prices is ubiquitous…. Mankiw… says:

In the long run, prices are flexible and can respond to changes in supply or demand. In the short run, many prices are sticky at some predetermined level. Because prices behave differently in the short run than the long run, economic policies have different effects over different time horizons.

This kind of statement makes sense in a fixed money supply world, but it makes much less sense in the real world. (Mankiw uses the term ‘long run’ where others would use ‘medium run’, but let us not worry about that.) Compare it with this alternative statement:

“In the long run, monetary policy adjusts to achieve steady inflation, which means output goes to its ‘natural’ or Classical level. In the short run, monetary policy fails to achieve this, so we need to look at movements in aggregate demand to explain output.”

This works for any sensible monetary policy….

One of the problems some people have with understanding that we are still in a situation of deficient demand is that it is five years after the recession ‘and surely prices should have adjusted by now’. There is also a rather more profound point. Many anti-Keynesians use this misunderstanding about price adjustment to dismiss Keynesian economics. When they say ‘I ignore Keynesian economics, because I think prices adjust rapidly’ they are really saying ‘I ignore Keynesian economics because I think monetary policy is very successful’. And in the real world, monetary policy can only be very successful by understanding Keynesian economics!