A simple parable of price stickiness and international externalities

Olivier Blanchard and Nobuhiro Kiyotaki published a famous "Keynesian" paper in 1987 and it remains a well-cited piece in macroeconomics.  One central result is that prices and wages can get stuck too high, above market-clearing.  Market participants who produce more and lower prices and wages confer a strong large and positive externality on other individuals (or regions) in the market.  Of course in the absence of such adjustments, activist monetary policy is recommended, but the point about externalities remains.

Yet often, today, we are told that the individuals (or regions) which produce (i.e., export) more are imposing negative externalities on other individuals or regions.

Of course the Blanchard and Kiyotaki model had its limitations.  It did not, for instance, incorporate open economy considerations.  It could be that the star producers impose an unfavorably high exchange rate on the broader region and hurt the ability of the broader region to export to the larger world economy.

When the open economy considerations are relatively strong, that coincides with…the conditions under which a coordinated fiscal policy will prove counterproductive, for reasons shown by the Mundell-Fleming model.  In other words, if you think the strong Eurozone countries are hurting the Eurozone weakies, you also should be skeptical about coordinated European fiscal policy.  This paper surveys some key issues.

In many open economy versions of the B-K model, or variants, looser monetary policy simply exports the problems of the region to other parts of the world.  So why advocate such policies, especially if you are an outsider?  Maybe the EU determines its own economic destiny (fine by me) but then we're back to German production and prosperity helping Spain rather than hurting it, for the reasons given by B-K.

In this well-regarded model, the international spillover effects from the monetary expansion can be either positive or negative.  But it takes work to get those effects into the positive category.

Here is a survey of some literature which extends the sticky price model to open economy and policy coordination settings.

It is commonly suggested that German exports damage (or help) Spain without considering the broader implications of that proposition.

Overall, the results may depend on whether wage rigidity is real or nominal in each currency, the degree of capital mobility, the currency of invoicing in which sticky prices are set, and how much market participants look forward and consider stocks in addition to flows.  This paper surveys some issues.  There are many permutations, to the point where they are perhaps no longer very useful.

I wish to emphasize the broader point that not all combinations of views here are mutually consistent.

Comments

Wouldn't the price rigidness be much lower if the state hasn't fought against the effects of the price rigidness for the last 70 years?

The paper by B and K is described as " well regarded" and "well cited". These are terms of literary criticism. Would it be too much to ask that it also pass some kind of scientific test?

I know exactly what you mean about high wages getting stuck without readjustment---just look at tenured faculty salaries during an enrollment downturn or shift in demand.

That is why the Virginia legislature has accepted the offer of the GMU economics faculty to abandon tenure and Ui and return to the free market!

Bill,

People make comments about the free market. Universities are almost as far from free markets as banks are. Doing away with tenure would not bring universities closer to the free market. If universities suddenly were brought to the free market tenure would still be fine because it's just a contract. However, as with bond rates, there should probably be a clause for adjustable pay in the event of deflation.

Coordinated fiscal policy is counterproductive for open economies? How does that come out of the Mundell-Fleming model?

Under flexible exchange rates, individual fiscal policy is ineffective (and therefore coordination difficult to enforce), but coordinated policy works (provided that enough of the world is involved and that the nations abide by their commitments). Under fixed exchange rates, individual fiscal policy is effective, and coordination is largely irrelevant but certainly not counterproductive.

In the 30s, FDR's technocrats set up industrial policy that focused on the international externalities of raw materials. The fear was a war would starve US industry of the raw materials needed to produce the weapons of war. The primary method was the strategic stockpiles.

This system has been generally opposed by conservatives, instead preferring a system where the US military controls the US access to these raw materials. That is the core of Persian Gulf politics, but has also driven policies in other places.

Well, China has of course set up industrial policy to insure access to raw materials, but in recent weeks have made it clear they are going to use their raw material policies to implement economic warfare, creating "externalities" that hobble the economies of the US and Europe and Japan and Korea.

China has subsidized the mining and refining of the rare earths, or shall we say, favored the local production of these rare earth in order to take over 50-90% of world rare earth production. It freely exported these rare earths using low labor costs to bankrupt rare earth mining in most of the rest of the world.

(A few nations, like South Africa, based their economy on rare mineral production with tight control of the international trade, and of course, OPEC.)

So the future of the US economy is constrained by China's refusal to export the rare earths needed for US firms to compete with China, but because of China's well developed rare earth mining and the purposely decayed US rare earth mining by ending the US industrial policy adopted by China, US manufacturers can't compete with China in order to support the free market development of US rare earth production.

China has priced rare earths in finished goods below the rigid free market price of rare earths to US manufacturers.

Comments for this post are closed