A Lesson in Mainstream Macro
By Arnold Kling
From Narayana Kocherlakota,
The impact of any macroeconomic shock can be divided into two components. One component is the effect of the natural demand and supply adjustments that would occur if prices and their expectations were to adjust continuously. Monetary policy cannot be used to offset this natural consequence of the shock without creating inflation that is either too high or too low. The other component is the consequence of what economists call nominal rigidities–the sluggish adjustment of prices (including wages, the price of labor) and price expectations. Monetary policy can be used to offset this latter component of the shock’s impact without creating undue pressures on inflation. The challenge for monetary policymakers is to figure out how to divide the observed movements in the unemployment rate into these two components.
…In this essay, I’ve argued that data on aggregate labor market variables like unemployment rates and vacancies are insufficient to reach a sharp answer. Other information, including survey responses and inflation data, suggests that nominal rigidities are having a substantial impact. This conclusion, combined with the low level of inflation itself, implies that it is appropriate for monetary policy to be highly accommodative–as indeed it was at the end of 2010.
Pointer from Timothy Taylor.