# Tag Archive for 'Lucas critique'

### Glenn Stevens is not quite God

Alan Kohler has a piece on Crikey talking about electricity prices in Australia.  It’s an interesting piece and well worth a read, but it’s got a crucial economics mistake.  After talking about the politics and such, Alan gets down to brass tacks, telling us that:

• Over the last two years, electricity prices in Australia have risen by 48% on average; and
• Indeed, over the last five years, electricity prices have risen by more than 80% on average; but
• Over the last twelve months, overall inflation has only been 1.5%, the lowest in three years.

He finishes by explaining:

That’s because the increase in power prices has been almost entirely offset by the high Australian dollar, which has produced tradeable goods deflation of 1.4% over the past year. In other words, thanks to the high Australian dollar we are getting a big improvement in energy infrastructure without an overall drop in living standards.

And thank goodness for fast rising power prices — without that, we’d have deflation. It’s true!

But it’s not true, and it’s not true for a very important reason.

Back in 1997, in the guts of of the Great Moderation (the time from the mid ’80s to the start of 2007 when US aggregate volatility was low) and before the real estate boom that presaged the financial crisis of 2007/2008, Paul Krugman famously wrote (this Economist piece is the best reference I could find in the two minutes I spent looking on Google) that unemployment was whatever Alan Greenspan wanted it to be, “plus or minus a random error reflecting the fact that he is not quite God.”

It’s popular to argue that Ben Bernanke lacks that power now that America has interest rates at zero. I disagree (see here and here), but I appreciate the argument.

Australia has no such problem. Interest rates are still strictly positive and the RBA has plenty of room to lower them if they wish.

So I have no qualms at all in saying that inflation in Australia is whatever Glenn Stevens (the governor of the RBA) wants it to be, plus or minus a random error to reflect the fact that he’s not quite God.

If the various state grids had all been upgraded a decade ago and electricity prices were currently stable, then interest rates would currently be lower too. They would be lower because that would ensure faster growth in general and a lower exchange rate, both of which would lead to higher inflation, thereby offsetting the lower inflation in electricity prices.

There’s a famous argument in economics called the Lucas Critique, named for the man that came up with it, that points out simply that if you change your policy, economic agents will change their actions in response.  It applies in reverse, too, though.  If economic agents change their actions, policy will change!

Alan Kohler ought to know this. Indeed, I suspect that Alan Kohler does know this, but it’s a slippery concept to keep at the front of your mind all the time and, besides, it would make it hard to write exciting opinion pieces. 🙂

### Deriving the New Keynesian Phillips Curve (NKPC) with Calvo pricing

The Phillips Curve is an empirical observation that inflation and unemployment seem to be inversely related; when one is high, the other tends to be low.  It was identified by William Phillips in a 1958 paper and very rapidly entered into economic theory, where it was thought of as a basic law of macroeconomics.  The 1970s produced two significant blows to the idea.  Theoretically, the Lucas critique convinced pretty much everyone that you could not make policy decisions based purely on historical data (i.e. without considering that people would adjust their expectations of the future when your policy was announced).  Empirically, the emergence of stagflation demonstrated that you could have both high inflation and high unemployment at the same time.

Modern Keynesian thought – on which the assumed efficacy of monetary policy rests – still proposes a short-run Phillips curve based on the idea that prices (or at least aggregate prices) are “sticky.”  The New Keynesian Phillips Curve (NKPC) generally looks like this:

$\pi_{t}=\beta E_{t}\left[\pi_{t+1}\right]+\kappa y_{t}$

Where $y_{t}$ is the (natural) log deviation – that is, the percentage deviation – of output from its long-run, full-employment trend and $\beta$ and $\kappa$ are parameters.  Notice that (unlike the original Phillips curve), it is forward looking.  There are criticisms of the NKPC, but they are mostly about how it is derived rather than its existence.

What follows is a derivation of the standard New Keynesian Phillips Curve using Calvo pricing, based on notes from Kevin Sheedy‘s EC522 at LSE.  I’m putting it after this vile “more” tag because it’s quite long and of no interest to 99% of the planet.