Exchange Rates and Wages

24/12/2011

By Paul Krugman

A followup to my post about modern Chicago economists forgetting what Milton Friedman knew: recent events have actually given us a dramatic demonstration of the reality of nominal wage stickiness. Here’s a graph I’ve shown before:

It shows wages in domestic currency for three crisis economies, Ireland, Latvia, and Iceland; it also shows Icelandic wages converted into euros at the market exchange rate. What you see here is that despite crushing unemployment, wages in Ireland and Latvia have come down only slightly — but Iceland, by letting its currency devalue, achieved a quick 30 percent fall in wages relative to the euro zone.

And international macroeconomists know that the behavior of real exchange rates — exchange rates adjusted for relative inflation — is a prime piece of evidence for price stickiness. Not only do real rates move very closely with nominal rates, but the behavior of real rates changes dramatically when you move from floating to fixed rates or vice versa.

It would be one thing if people like Cochrane had a serious critique of all this evidence, and of the decades-long research agenda that has confirmed the importance of price stickiness. But what’s clear in this discussion is that these guys are simply unaware of all this work, and feel entitled to make proclamations a priori.

What went wrong with the economics profession?

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