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A Basic Mistake in Krugman's post

Gustavo Lucas (Guest Blogger)

In a recent post Paul Krugman says the following about the AS-AD model with a Taylor Rule:
"a rising price level doesn’t reduce demand through its effect on the real money supply, it reduces demand through its effect on the mind of Ben Bernanke."
Does it make sense? An increase in the price level, positive inflation, implies a decrease in the real interest rate and hence an increase in the AD through consumption and/or investment:

i – p = r
I´(r) < 0
C´(r) < 0
Y = C0 – ar
Where r is the real interest rate, i the nominal one (the one used by the Central Bank), I'(r) means that the investment is negatively related to the interest rate, C'(r) is the same for consumption and Co represent the autonomous expenditures and a is the sensitivity of the output to the interest rate (that is, the IS equation).

I am supposing that the inflation is increasing. If inflation does not increase, we do not have any effect on the economy. So, in any case, when Krugman says that the increase in the price level ‘reduces demand through its effect on the mind of Ben Bernanke’ actually means ‘the increase in price level reduces demand through the IS-LM model’ – that does not have monetary policy rule. However, he is explicitly talking about the AD-AS model with monetary policy rule... So, in the end it should be re-stated as ‘the increase in price level reduces demand through the mind of Paul Krugman, since it actually increases demand.’

Comments

  1. I actually think that his position is the same as Dumenil & Levy. There's an inflation rate at which the central bank does react and rises interest rate. I think he has the same idea in mind.

    ReplyDelete
  2. I don't think this is correct.

    Here is what Krugman is thinking.

    1. Y = Y(r), Y' < 0
    2. P = P(Y), P' > 0, P(Y*) = P-bar
    3. r = i - P
    4. i = r* + P + g(P - P-bar)

    1 is the IS curve -- output is a declining function of interest rates.
    2 is the Phillips curve -- inflation is an increasing function of output. (We would typically add expectations here, but for the present purpose that doesn't matter.)
    3 is the Fisher equation -- the real interest rate is the nominal interest rate minus the rate of inflation.
    4 is the monetary policy rule -- in this case, the central bank targets a *real* interest rate which it adjusts upward or downward based on the deviation of inflation from the target. (It could just as well be Y instead of P, or a weighted combination of the two as with the taylor rule.)

    So a risig rate of inflation is passed more than one for one to the nominal interest rate, so real rates and inflation move in the same direction, moving output back to Y*. The only reason this would not happen is if the central bank fails to follow the rule given by equation 4, for instance because of the ZLB.

    Krugman is explicitly saying that the right model of the economy is one with a monetary policy rule, and that this rule is what maintains equilibrium. Given that, and given that he is writing about economies in general and not the special conditions of the ZLB, the quoted passage is perfectly sensible.

    The real problem with the Krugman column is that he does NOT teach this to his students. Instead, he teaches them a model where Y returns to Y* automatically, without the need for central bank action. And he does this for explicitly ideological reasons -- because he wants them to think that flexible prices make capitalism a self-equilibrating system, even though his own preferred model says just the opposite.

    It's a shocking and shameful admission on his part. This column should make us all lose whatever respect we have for him as an economics teacher. (He's still fine as political polemicist.) But as far as the logic of his preferred model goes, there is nothing wrong with it on its own terms. Krugman is perfectly consistent here. The claim in this post, that Krugman is mistaken about the effect of inflation in standard macro models, seems to be simply wrong.





    ReplyDelete
    Replies
    1. Jason, i perceived the same today in the morning. He is not very clear in the argument but he is right. He wants to mean that Bernanke applies the Taylor Rule when he sees increasing in price level. The problem is that the passage is not so clear, at least for me and i always thought that he used the traditional version of AD-AS, with self-stabilizing flexibility. Thanks for the comment. I am wrong!

      Delete
    2. No problem. You're right, he is not very clear. Glad we agree!

      Delete

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