Nick Rowe: When Microfoundations Actually Matter

Nick Rowe:

Worthwhile Canadian Initiative: Sticky prices vs sticky coordination; inflation vs NGDP targeting: Monetary policy matters (mainly) because of nominal rigidities. The simplest story of nominal rigidities is that… [f]irms want to change prices when a shock hits, but there is some cost that makes it hard for them to do so. The object of monetary policy should then be to target the stickiest prices. Monetary policy should respond to shocks to try to ensure that firms don't need to change the prices that are costly for them to change…. An alternative story of nominal rigidities is sticky coordination…. Each firm does not know whether the other firms will change their prices, and each waits for the others to go first…. There is a very small cost to each of us in changing our watches for daylight saving time. But we need someone (like the government) to help us coordinate so we all change our watches at the same time….

If the only shocks hitting an economy were Aggregate Demand (nominal, velocity) shocks, it doesn't matter for monetary policy which one of these two stories is correct. Monetary policy should try to exactly offset those AD shocks…. And if all shocks were AD shocks, it also doesn't matter whether monetary policy targets inflation or Nominal GDP…. When there are AS shocks, it does matter….

If the source of nominal rigidity is sticky prices, then monetary policy should target inflation. (If the sticky prices were sticky nominal wages, then monetary policy should target wage inflation.)… [A]djust monetary policy… so the sticky price is always at the equilibrium level despite being sticky.

But suppose there are AS shocks and the source of nominal rigidity is sticky coordination rather than sticky prices?…

The whole idea behind sticky coordination is that people can solve partial equilibrium problems a lot more easily than they can solve general equilibrium problems…. If its hard for people to solve general equilibrium experiments, monetary policy should try to ensure they don't have to solve general equilibrium experiments…. Under NGDP targeting, the general equilibrium solution to supply shocks is at least qualitatively similar to the partial equilibrium solution. To parallel the idea of targeting the stickiest price, monetary policy should try to make sure that people don't have to do those things that are hard for them to do, and will do badly or not at all…