Tag Archives: price changes

To deregulate or not?

An article published at Macroscan on the dilemma of the Indian government about whether to deregulate the price of oil or not, the author argues for not to do so. However, I think he needs more than the analysis he is basing his argument on. The simulation is based on Tinbergen style simultaneous equations model of the Indian economy. So my 5 cents to the debate are as follows:

There are several general equilibrium effects of an oil price shock that have to considered. How are people going to react to the change in price of oil? In the first place, shielding the consumers from oil price shocks has distorted consumer decisions. Combined with shoddy public transportation system, it has lead to a higher demand for private transportation vehicles. If government passes on the oil price changes to the consumer, the consumers might respond to the relative price changes. Over the period of time there will be further demand for efficient public transportation and the reliance on oil for private transportation might actually go down leaving the net effect on GDP close to zero. Also, reduction the oil subsidy will reduce the over fiscal deficit and lower the inflation tax. The government might decide to channel that expenditure somewhere else like better schools or highways! But to account for such kind of changes you will have to simulate a micro-founded general equilibrium model and not a Tinbergen style simultaneous equations one (NIPFP working paper No. 2012-99) which does not allow for equilibrium responses from economic agents (the famous Lucas critique!). I think right assessment of what should be the appropriate policy in the case of oil price deregulation cannot be made till such analysis is undertaken. You still might have a case for not deregulating the price of oil but it would be based on a more robust analysis.

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Filed under current economic issues, indian economy, macroeconomics

New keynesian or New classical?

For quite some time now I have been struggling with the question of what is the appropriate theoretical framework for macroeconomic analysis. The new Keynesian framework assumes that prices are rigid, whereas the new classical framework assumes that prices are flexible and hence markets always clear. Which one is the right assumption?

There has been significant amount of research done about price flexibility in reality starting with the seminal paper by Bills and Klenow (2005). In a more recent paper by Klenow and Malin(2010), the authors summarize this research and try to give us a clear picture on the evidence concerning frequency of price changes. One of their important conclusions is that the prices change at least once a year with temporary price changes and discounts taking up most of this change.  After excluding these short term changes, they conclude that prices change close to once a year. Of course there is significant variation in frequency of price changes across goods with prices of more cyclical goods changing with a higher frequency than others. But more importantly,  there exist strong linkages between price changes and wage changes.

How does this evidence bear on the question of relevant macroeconomic framework? It certainly seems that prices are actually much more flexible than what we would like to believe.  Given the lagged effect of any policy change, be it fiscal of monetary, it would certainly be true that on an average prices would have changed at least once before the effect materializes.  If this holds then prices have to be treated as flexible for policy analysis purposes and hence the appropriate macroeconomic framework would definitely be the new classical one! At least that is how I would like to think about the issue. Any thoughts on it?

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Filed under current economic issues, macroeconomics