Monday, January 18, 2010

Nominal Shocks and the Price Level

Arnold Kling is puzzled about the relationship between nominal expenditure, the price level, and nominal wage and debt contracts. In response to my post, he writes:

I guess the idea is that there was a downward shock to monetary growth, and lower inflation would have insulated real GDP from that shock. But if you believe that deflation would have kept real GDP on track, then I do not see how you can explain the drop in real GDP on the basis of locked-in debt contracts and wage contracts. If you believe in locked-in debt contracts and wage contracts, then deflation should have made real GDP worse, not better.

Assuming "a downward shock to monetary growth," means a decrease in the growth path of nominal expenditure on final goods and services, then this is correct. If the price level fails to adjust in proportion to the decrease in nominal expenditures, real expenditures fall. Less real expenditure results in firms selling fewer goods and services. Firms selling fewer goods and services respond by producing fewer goods and services. If firms produce fewer goods and services, then real output and real income fall. Firms that produce fewer goods and services employ less labor. And so, employment falls.

This would occur even if there were no increase in real wages or the real value of debts. Nominal expenditures are about 9 percent below trend. The price level is about 1% below trend. Real expenditures and real output are about 9% below trend. Employment is about 9% below trend.

But why don't prices fall in proportion to nominal expenditure? Why doesn't the price level decrease enough to leave the growth path of real expenditure unchanged? Why isn't the price level 9 percent below trend with real expenditure, real output, and employment all growing on their trend growth paths?

That is a bit of a puzzle. Lower nominal expenditure implies a decrease in the demands for various goods and services. This should result in surpluses of those goods and services. Each firm facing a surplus should lower its price to try to dampen the negative impact on sales. As many firms lower prices, the price level should fall below its trend growth path.

However, even if there is no solution to that puzzle, if the firms don't lower their prices significantly, the decrease in real expenditure caused by the decrease in nominal expenditure is sufficient to explain the decrease in real output and employment.

Nominal wage contracts and nominal debts provide possible explanations for why prices drop less than in proportion than the decrease in nominal expenditure. There is value in those explanations. However, it isn't that suddenly real wages or real debts have risen and this has caused a disruptions in production.

As explained above, if the price level doesn't decrease at all, so that fixed nominal wage contracts result in unchanged real wages, and real debts are unchanged, real expenditure still decreases and real output and employment fall because firms will not produce what they cannot sell and they will not employ workers to producing nothing.

Further, if nominal expenditure is unchanged, and somehow the price level falls, real wages might rise and real debts increase, but the shortages of products at those lower prices will result in firms raising prices rather than lowering output.

It is likely that if product prices are flexible, and fixed nominal wage contracts and nominal debt are all that prevent prices from falling in production to the drop in nominal expenditure, the impact of real output would be less than if final goods prices didn't decrease at all.

The more prices that are flexible (and that includes wages and debt contracts,) the less disruptive will be a change in nominal expenditures. The notion that the problem is that the flexible prices fell, and that even with nominal expenditures depressed, getting the flexible prices back up would help, is a serious error. Isn't that exactly the error made by both the Hoover and the Roosevelt administrations, the errors that motivated their efforts to restrict competition and production?

Is it possible that deflation could result in further decreases in nominal expenditure? Yes, especially if people project past deflation into the future. Similarly, it is possible that expected inflation, even if caused by restrictions on competition, could cause increase in nominal expenditure.

But given nominal expenditure, a lower price level results in more real expenditure, real output, and employment. And, more importantly, a sufficiently large increase in the quantity of money can increase nominal expenditure to any growth path.

1 comment:

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