Real Adjustment Costs
By Arnold Kling
I am disappointed by some of the reactions to my macro play. People are not being deliberately obtuse, but they are being obtuse. That is what happens when you are committed to one paradigm and someone tries to suggest something different.
One way to articulate the difference between the AS-AD paradigm and the PSST paradigm is in terms of the barriers to adjustment. In the AS-AD paradigm, the problem is price adjustment. If nominal wages and prices move quickly enough, you can never have a recession. But because they move slowly, you can have excess aggregate supply, which you can alleviate by printing more money to boost aggregate demand.
In the PSST paradigm, the adjustment costs are real. The problem that Leroy and Bao have is not that they have failed to adjust the price on their menu. The problem for Leroy and Bao is that their experiment in Tex-Vietnamese cooking is a lousy idea. But it takes time and effort for them to figure out that instead they should partner with Esteban and Marcel, respectively.
An intermediate case is the DMP story, which won the most recent Nobel Prize in economics. Diamond, Mortensen, and Pissarides describe a real cost of adjustment, in which workers and firms must search for matches. However, a lot of AS-AD types look at the DMP model and focus on how this search process arrives at the equilibrium nominal wage.
Moreover, the DMP model assumes that the jobs are just sitting there, waiting to be filled. In the PSST model, there are costs to figuring out the patterns of sustainable specialization and trade. There is trial and error. There are up-front investments. There is training (which is an up-front investment). Because of these real adjustment costs, appropriate prices are necessary but not sufficient for the economy to be able to reach full employment. In the PSST model, all the price signals can be correct, but entrepreneurs have not yet done the right experiments and invested in the right business models to create the patterns of trade that will result in full employment.
Go back and read the play without trying to ask what is going on with the real money supply. Read it for what it is. It is a story in which people try a configuration of activities and it is not profitable. Their marginal products in that configuration are so low that the characters end up not engaged in market activity (unemployed, in other words). Then they figure out a configuration in which their marginal products are high.