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Saturday, October 12, 2013

'Nominal Wage Rigidity in Macro: An Example of Methodological Failure'

Simon Wren-Lewis:

Nominal wage rigidity in macro: an example of methodological failure: This post develops a point made by Bryan Caplan (HT MT). I have two stock complaints about the dominance of the microfoundations approach in macro. Neither imply that the microfoundations approach is ‘fundamentally flawed’ or should be abandoned: I still learn useful things from building DSGE models. My first complaint is that too many economists follow what I call the microfoundations purist position: if it cannot be microfounded, it should not be in your model. Perhaps a better way of putting it is that they only model what they can microfound, not what they see. This corresponds to a standard method of rejecting an innovative macro paper: the innovation is ‘ad hoc’.

My second complaint is that the microfoundations used by macroeconomists is so out of date. Behavioural economics just does not get a look in. A good and very important example comes from the reluctance of firms to cut nominal wages. There is overwhelming empirical evidence for this phenomenon (see for example here (HT Timothy Taylor) or the work of Jennifer Smith at Warwick). The behavioral reasons for this are explored in detail in this book by Truman Bewley, which Bryan Caplan discusses here. Both money illusion and the importance of workforce morale are now well accepted ideas in behavioral economics.

Yet debates among macroeconomists about whether and why wages are sticky go on. ...

While we can debate why this is at the level of general methodology, the importance of this particular example to current policy is huge. Many have argued that the failure of inflation to fall further in the recession is evidence that the output gap is not that large. As Paul Krugman in particular has repeatedly suggested, the reluctance of workers or firms to cut nominal wages may mean that inflation could be much more sticky at very low levels, so the current behavior of inflation is not inconsistent with a large output gap. ... Yet this is hardly a new discovery, so why is macro having to rediscover these basic empirical truths? ...

He goes on to give an example of why this matters (failure to incorporate downward nominal wage rigidity caused policymakers to underestimate the size of the output gap by a large margin, and that led to a suboptimal policy response).

Time for me to catch a plane ...

    Posted by on Saturday, October 12, 2013 at 11:29 AM in Economics, Macroeconomics, Methodology | Permalink  Comments (16)



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