Must-Read: A key factor Krugman omits in which standard Hicksian-inclined economists’ predictions have fallen down: the length of the short run. The length of the short run was supposed to be a small multiple of typical contract duration in the economy — perhaps six years in an economy characterized by three-year labor contracts, and perhaps three years in an economy in which workers and employers made decisions on an annual cycle. After that time, nominal prices and wages were supposed to have adjusted enough to nominal aggregates that the economy either would be at or would be well on the road to its long-run full-employment configuration. Moreover, the fact that price inertia was of limited duration combined with forward-looking financial markets and investment-profitability decisions to greatly damp short-run shortfalls of employment and production from full employment and sustainable potential.
It sounded good in theory. It has not proved true in reality since 2007:
Paul Krugman: Demand, Supply, and Macroeconomic Models: “If you came into the crisis with a broadly Hicksian view of aggregate demand…
…you did quite well… [arguing] that as long as we were at the zero lower bound massive increases in the monetary base wouldn’t be inflationary [and would have near-zero effects on broader aggregates]… budget deficits would not drive up interest rates… large multipliers from fiscal policy…. What hasn’t worked nearly as well is our understanding of aggregate supply… the absence of deflation… [of] the “clockwise spirals”… in inflation-unemployment space as evidence for… Friedman-Phelps…. The other big problem is the dramatic drop in… potential output… correlated with the depth of cyclical slumps….
[The] policy moral[?]… Central banks focused on stable inflation may think they’re doing a good job… when they are actually failing…. Fiscal contraction in a liquidity trap seems… absolutely terrible for the long-run as well as the short-run, and quite possibly counterproductive even in purely [debt burden] terms…. I don’t think even Hicksian-inclined economists have taken all of this sufficiently into account.