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What Causes Recessions?

Author(s): Noah Smith

How did sticky price models come to be.

From Bloomberg:

One time, at a dinner, I asked a famous macroeconomist: “So, what really causes recessions?”

His reply came immediately: “Unexplained shocks to investment.”

We really just don’t know the answer. Some people -- the types who think the market is self-adjusting and wonderful and doesn’t need any government help -- believe that recessions are a natural, even healthy process. Maybe recessions are responses to changes in the rate of technological progress, or to news of future progress, or even bursts of creative destruction. Others -- the people who tend to think the market needs a little helping hand -- believe that there’s something blocking the market from adjusting to the shocks that buffet it.

The market adjusts by the price mechanism. If the cost of something goes up, the price goes up to match. If demand falls, the price drops until the market clears. So if you want to show that the market doesn’t naturally self-regulate, the simplest and easiest way is just to show that prices themselves can’t adjust in response to events. This phenomenon is called “sticky prices.” If prices are sticky, then someone -- the Federal Reserve, or perhaps Congress and the Treasury -- needs to nudge markets back into their long-run equilibrium after a big shock.

In 1994, economists Greg Mankiw and Lawrence Ball wrote an essayfor the National Bureau of Economic Research entitled “A Sticky-Price Manifesto.” Sticky prices might sound like a strange thing to write a manifesto about (did the prices spill Coke all over themselves?), but the essay heralded the beginning of a macroeconomics mini-revolution. It was a direct threat to the line of research that had been dominant in the 1980s, which tried to explain recessions without sticky prices.

The economic establishment reacted harshly to the upstarts. “Why do I have to read this?" fumed Robert Lucas, the dean of macroeconomics. "This paper contributes nothing.” He went on to accuse the sticky-pricers of being opposed to science and progress.

But Lucas fumed in vain. During the following decade, the sticky-price models went from strength to strength. New math was developed to make them easier to use. Possible reasons for price stickiness were investigated -- for example, “menu costs,” in which the seemingly trivial costs of changing prices add up to a big problem across the broader economy.

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