Sunday, July 11, 2010

Economist's View: The "Obama Shock" Hypothesis "Seems Ridiculous"

Prescott isn't alone in pushing the "Obama shock" idea. The claim is that the recession is due to a labor supply shock where workers collective decide to work less due to one government program or another, or some type of technology shock. So good to see there's some pushback against the silly claims being made by adherents to the RBC model.

But there are also those who think the New Keynesian model is, well, silly. On this topic, see David Andolfato's criticism of the New Keynesian model and Nick Rowe's response.

One of the points David Andolfatto raises is the evidence for the sticky price assumption, but the discussion of the evidence for and against the sticky price assumption is a bit slim. I haven't had time to write up a response to David and Nick due to deadline pressure, but let me try to add to the discussion by repeating a summary of some of the evidence from a post from 2007 (this is also very far from an exhaustive accounting of the work on this issue, but hopefully it's representative):

...[This is] from a paper I read not too long ago. According to this work, the degree of rigidity in prices depends upon the level of aggregation examined, the degree of monopoly power, and the type of shock hitting firms:

Sticky Prices and Monetary Policy: Evidence from Disaggregated U.S. Data, by Jean Boivin, Marc Giannoni, Ilian Mihov , NBER WP 12824, January 2007 [open link]  Abstract This paper disentangles fluctuations in disaggregated prices due to macroeconomic and sectoral conditions using a factor-augmented vector autoregression estimated on a large data set. On the basis of this estimation, we establish eight facts: (1) Macroeconomic shocks explain only about 15% of sectoral inflation fluctuations; (2) The persistence of sectoral inflation is driven by macroeconomic factors; (3) While disaggregated prices respond quickly to sector-specific shocks, their responses to aggregate shocks are small on impact and larger thereafter; (4) Most prices respond with a significant delay to identified monetary policy shocks, and show little evidence of a "price puzzle," contrary to existing studies based on traditional VARs; (5) Categories in which consumer prices fall the most following a monetary policy shock tend to be those in which quantities consumed fall the least; (6) The observed dispersion in the reaction of producer prices is relatively well explained by the degree of market power; (7) Prices in sectors with volatile idiosyncratic shocks react rapidly to aggregate monetary policy shocks; (8) The sector-specific components of prices and quantities move in opposite directions.

The main contribution of the paper is to divide shocks into two types, economy-wide shocks that hit all sectors, and sector specific shocks that hit individual sectors, and to do so in an econometrically defensible manner.

In previous results, when shocks were not disentangled to separate economy-wide and sector specific shocks, empirical results tended to find a large degree of price stickiness at both the aggregate and sectoral levels lending support to sluggish-price, menu-cost* type models.

This paper follows in the path of previous work showing that individual prices, or at least highly disaggregated prices, are far more volatile, i.e. flexible, than typically assumed in sluggish price models.

Restating the results, when the authors separate shocks into aggregate and sector specific shocks, they find that:

1. Most of the price volatility at the sectoral level is due to sectoral shocks, not aggregate shocks.

2. Differences in price-setting behavior across sectors are mostly due to differences in the response to sector-specific shocks, most sectors respond similarly to aggregate shocks.

3. There is persistence (stickiness) in the response of disaggregated prices, but this is due to the response to aggregate shocks. There is little persistence in the response of disaggregated prices to sector specific shocks. In addition, the response of disaggregated prices to sector specific shocks is more immediate than the response to aggregate shocks.

4. The differences in the responses across sectors is explained by differences in market power. More monopoly power implies more stickiness.

5. There is no longer a price puzzle (the annoying tendency for prices to rise after the Fed tightens in empirical models used for policy analysis).

Overall, then, what this paper finds is that firms exhibit considerable flexibility in responding to sector specific shocks - there is not much price stickiness on display - but a much more sluggish response to aggregate shocks.

One thing that is needed is to explain these results theoretically. The paper outlines some recent attempts in this direction, but there is much more work needed on both the empirical evidence about price stickiness and on the supporting theoretical models.

The sluggish price to aggregate shocks is still present, so this doesn't rule out aggregate fluctuations driven by aggregate shocks. That is, I don't think the evidence against the sticky price hypothesis is quite as strong as David implies (though he is very careful to note that there is evidence for the assumption). That is from:

See also

Finally, this is a different topic, but since the wonkiness door is open, Paul Krugman posted a discussion of monetary policy earlier today:

I discuss Krugman's here, in particular why we shouldn't place too much faith in the Fed's ability to stimulate the economy through further reductions in long-term interest rates.

Posted via email from Jim Nichols

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