Tuesday, 18 October 2016
The amazingly nonsensical “sticky price channel”.
It’s quite widely recognized that a significant proportion of the economics profession are not interested in reality: rather, they’re interested in erecting complex theories and models with a view to keeping themselves employed at the taxpayer’s expense. But when it comes to a blatant disregard for reality, the “sticky price channel”, which I stumbled across recently takes some beating.
A guide to the sticky price channel is set out under the heading “The Sticky Price Channel” in a recent CEPR article by Carlos Garriga and Finn Kydland. The article title is “Keeping Policy Rates Persistently Low…”.
The paragraph that claims to explain the sticky price channel runs as follows. (Incidentally I’m not promising that this para is an accurate description of the sticky price channel, but having Googled the phrase “sticky price channel”, this para seems to have got the idea roughly right, far as I can see.)
“The sticky price channel is the central mechanism of monetary policy transmission in the modern macro literature. A number of texts (e.g. Woodford 2003, Galí 2015) describe this channel in detail.1 The key element of this channel is the so-called ‘New-Keynesian Phillips curve’. According to this relationship, aggregate output depends negatively on the expected change in the inflation rate. If today’s inflation is high relative to tomorrow’s expected inflation – that is, the expected change in inflation is negative – aggregate output is relatively high today. The microeconomic foundations for this relationship are driven by the costly adjustment of prices at the firm level. Consider a firm that faces a cost of adjusting its price. When the aggregate price level increases, and thus inflation increases, the firm finds itself with a higher demand, as its products look relatively cheap. If the increase in the aggregate price level is expected to only be temporary, the firm does not find it profitable to incur the adjustment cost of changing its price. Instead, it increases output to satisfy the higher demand. In equilibrium, all firms facing price adjustment costs behave this way and, as a result, aggregate output increases. However, when the increase in inflation is expected to be highly persistent, the cost of changing the price is worth paying and the firm adjusts its price, rather than output. In equilibrium, all firms behave this way and, as a result, aggregate output does not change. The sticky price channel is thus most potent when changes in policy rates, and thus inflation, are only temporary.”
Now if you didn’t fall about laughing at that, here’s why you should have.
First, why would any government implement monetary stimulus (or indeed fiscal stimulus) given a significant amount of inflation? It wouldn’t!! Put another way, when inflation rises above the 2% target, governments and central banks normally turn off the stimulus tap.
Raising prices is costly?
Second, the idea that raising prices is costly is a joke. A supermarket chain can raise all its prices nowadays by pressing a key on a computer keyboard. The cost of doing that is negligible compared to what supermarkets spend on wages, purchasing food to sell and so on.
And in the case of small businesses which are not quite so computerised as supermarkets – e.g. small hotels and restaurants – where they want to adjust prices, they’d have to re-print menus etc. Well shock horror! That’s not going to ruin any hotel or restaurant.
And if there are any small hotels or restaurants out there who don’t know how to set up a desktop printer, I’m happy to offer instructions.
And this ere “sticky price theory” is according to the above paragraph “…the central mechanism of monetary policy transmission in the modern macro literature...”. If that’s the case, most macro-economists should check in with their shrink.
Why expand sales when they’re not profitable?
A third problem is this passage:
“Consider a firm that faces a cost of adjusting its price. When the aggregate price level increases, and thus inflation increases, the firm finds itself with a higher demand, as its products look relatively cheap. If the increase in the aggregate price level is expected to only be temporary, the firm does not find it profitable to incur the adjustment cost of changing its price. Instead, it increases output to satisfy the higher demand.”
Now hang on. Let’s make the not unreasonable and simplifying assumption that the typical firm is making a standard return on capital or a “normal profit” as economists sometimes call that, at the start of the above mentioned inflationary period.
Once that inflation has started, and given that the firm does not raise its prices pro rata, it will then be making a LESS THAN normal profit, or even a loss. Now what’s the point in bothering with extra sales if they’re not profitable? None!
Indeed, why bother selling ANYTHING? Strictly speaking it could make sense for the owner of a business in that situation to simply close down the business temporarily and go on a fishing holiday, till profitability returns.
In practice, nine times out of ten, businesses obviously don’t do that when faced with making low or zero profits for a while because they risk losing regular customers. So what they often do is to keep supplying regular customers, while telling new customers their demands just cannot be met.
Indeed there’s a second reason for ignoring those new customers. It’s a reasonable bet that the new customers have simply been attracted by the artificially low prices the firm is demanding. I.e. when things return to normal, those new customers may vanish. To that extent it makes sense (unless the firm is desperate to buy market share) to politely tell the new customers their orders cannot be met.
A fallacy of composition.
A fourth error in the sticky price theory is in the sentence that follows on from the latter quote. The sentence reads “In equilibrium, all firms facing price adjustment costs behave this way and, as a result, aggregate output increases.”
Now hang on: inflation by definition is a situation where a significant proportion of the country’s firms are increasing their prices!!! I.e. you can’t assume inflation and then in the next breath assume firms are not increasing prices!
To be more accurate, there is no sharp dividing line between what might be called a micro and a macro scenario. We’ve dealt above with the purely micro scenario: i.e. situation where an individual firm faces generally rising prices while it keeps its own prices constant.
At the other extreme there is what might be called a “pure macro scenario”. That’s where inflation is running at X%pa because EVERY firm is raising its prices by X%pa. In that scenario it’s clearly a nonsense to suggest that the typical firm will expand sales and output because its prices have risen less than the general increase in prices.
The whole “sticky price channel” looks to me like a train wreck, or something so near a train wreck that it can be ignored.
So what is the “central mechanism of monetary policy transmission”?
And finally, having ridiculed one alleged “central mechanism of monetary policy transmission”, there is perhaps an onus on me to set out what I think the real “central mechanisms” are. So here goes. But be warned: they’re very boring, simple and straightforward, which is perhaps why some economists don’t like them. To repeat, what many economists want is complexity because complexity keeps them employed. Anyway, I propose the “mechanisms” are as follows.
First, there is interest rate cuts. The result of those cuts is to encourage more borrowing and when money is borrowed and spent demand rises. That’s simple enough.
Second, there is QE. That consists of the central bank printing money and buying sundry safe assets. That leaves the private sector with an excess stock of cash, which induces the private sector to spend in one way or another. That raises demand. That’s also simple enough.
Third, there is helicoptering, which is a mixture of monetary and fiscal policy. Helicoptering consists of having the state print money and spend it and/or give it away to households. When a household finds it has more cash, it tends to spend some of it (gasps of amazement). That increases demand.
Alternatively, if the new money is directed towards public spending, than that extra spending also increases demand. (Incidentally, helicoptering is more common than many people think: that is, when government implements standard fiscal stimulus (government borrows $X, spends it and gives $X of bonds to lenders) and then then central bank prints money and buys back some of those bonds (which the CB is quite likely to do at least to some extent) then to the extent the latter “buy back” takes place, that whole exercise equals helicoptering.