Tyler Cowen poses this question:

Why is there still inflation in Greece?

He thinks this puzzle is hard, but it is in fact easy. Let’s model this more simply:

There are three countries in the world, Productoland, Moderatia, and Dysfunctiony. In this model there are a few rules:

· All money is gold.

· All goods and money can be teleported and traded freely across national borders.

· There is a universal legal prohibition from a resident of any country from relocating to any other country for non-leisure purposes.

· Wages are sticky.

· The equation of exchange accurately describes these economies.

In the initial state all three economies are performing well, even though “fundamentals” (mainly institutions) are much stronger in Productoland and significantly stronger in Moderatia. However, after some unexpected shock (say, a surprising report about the economic state of Dysfunctiony), there is a “panic” about the economy of Dysfunctiony. Very rapidly money, ie gold, begins to flee Dysfunctiony.

What would we expect to see happen? Primarily, we would expect to see a substantial negative shock to AD in Dysfunctiony. Wages are sticky; and more importantly, the law of one price means that prices of all goods (since there are zero transaction costs in this model) must remain equal in all three nations. Therefore, the decrease in MV would result in a reduction in QP; but because both Plabor and Pgoods are sticky, we would expect to see most of the commensurate decline occur in Q. We would expect to see some slowdown in Productoland and Moderatia, since presumably the market for imports in Dysfunctiony is slower, and overall global NGDP would probably fall, but if labor markets remained relatively tight in Productoland and Moderatia, we may in fact see the increase in MV in those countries (due to the influx of gold, ie money) lead to an increase in P, since Q is probably nearing its upper-bound; and an increase in P in those countries would of course result in a further increase in P in Dysfunctiony to the extent it affected teleportable goods. This would of course result in a further commensurate decline in Q, which would cause MV to further flee.

Basically, if transaction costs and barriers to trade are low, we should expect to see consumer prices move in unison within a currency union, and we should expect monetary shocks to result in severe real declines in output but continued price stability. This, I believe, sufficiently explains why Greece saw massive unemployment even as prices continued along the ECB’s chosen path, for the same reason Nevada saw unemployment increase from 4.2% to 14% over the course of the Great Recession even as there is no evidence that consumer prices diverged wildly in Nevada from other parts of the United States.

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