Putting sticky-price DSGE lipstick on the RBC pig

27 Dec, 2018 at 11:49 | Posted in Economics | 1 Comment

‘New Keynesian’ macroeconomists have for years been arguing (e.g. here) about the importance of the New Classical counter-revolution in economics. ‘Helping’ to change the way macroeconomics is done today — with rational expectations, Euler equations, intertemporal optimization and microfoundations — their main critique of New Classical macroeconomics is that it didn’t incorporate price stickiness into the Real Business Cycles models developed by the New Classicals. So — the ‘New Keynesians’ adopted the methodology suggested by the New Classicals and just added price stickiness!

6a00d8341c652b53ef01630539828a970d-800wiBut does putting a sticky-price DSGE lipstick on the RBC pig really help?

It sure does not!

I have elaborated on why in my On the use and misuse of theories and models in mainstream economics, and David Glasner gives some further reasons why a pig with lipstick is still a pig:

The real problem is not that prices are sticky but that trading takes place at disequilibrium prices and there is no mechanism by which to discover what the equilibrium prices are. Modern macroeconomics solves this problem, in its characteristic fashion, by assuming it away by insisting that expectations are “rational.”

Economists have allowed themselves to make this absurd assumption because they are in the habit of thinking that the simple rule of raising price when there is an excess demand and reducing the price when there is an excess supply inevitably causes convergence to equilibrium …

I regard the term “sticky prices” and other similar terms as very unhelpful and misleading; they are a kind of mental crutch that economists are too ready to rely on as a substitute for thinking about what are the actual causes of economic breakdowns, crises, recessions, and depressions. Most of all, they represent an uncritical transfer of partial-equilibrium microeconomic thinking to a problem that requires a system-wide macroeconomic approach. That approach should not ignore microeconomic reasoning, but it has to transcend both partial-equilibrium supply-demand analysis and the mathematics of intertemporal optimisation.

David Glasner

1 Comment

  1. Economists have a lovely theory of how market price in a system of markets can coordinate a highly decentralized economy and the rest of us have an actual economy in which there are very few “markets” in which a market-clearing equilibrium price is even possible, given actual cost structures.
    As long as economists insist on “hand-waving” in place of studying the actual economy, instead of building operational models of price formation by administrative processes for example, then silly ad hoc dodges like “price stickiness” are inevitable substitutes for knowledge.
    David Glasner takes one gentle step in the direction of an operational model by asking, if current markets are trading at disequilibrium prices, how will adjustment of prices proceed toward a presumptive general equilibrium? Where, implicitly, is there a practical means of tatonnement? How do market players learn? I would go half-a-step further: what if there are markets for which no market-clearing equilibrium price is possible? I think this is a common enough microeconomic reality, accounting for ubiquitous administrative pricing. By Walrasian standards, a single “market” with no market-clearing equilibrium would imply the failure of general market equilibrium. Why can’t this be accepted as the nature of reality, of the actual money economy? That is, that there is no self-regulating market economy?

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