Currencies, Prices, and Mike Mussa (A Bit Wonkish), by Paul Krugman, in NY Times: Michael Mussa died yesterday. I didn’t know him well, but like everyone in international economics, I was greatly informed by his work.
Probably his most influential paper — certainly the one that had the biggest impact on me — was his 1986 paper (pdf) on currency regimes and the behavior of real exchange rates. This bore on the question of whether exchange rate changes make adjustments in relative costs and prices easier; it bore more broadly on the question of whether prices are flexible, as fresh-water economists like to assume, or instead sticky in nominal terms.
Mussa had a simple but powerful insight: if prices were flexible, then all relative prices should be determined by “real” factors, and their behavior shouldn’t change if, say, a country goes from a fixed exchange rate to a flexible rate or vice versa. As he pointed out, this proposition could be tested using a natural experiment, the breakdown of Bretton Woods and the move to floating rates. Did the behavior of real exchange rates — relative price levels expressed in a common currency — change?
And how. Here’s one of the figures from his paper, with all variables expressed in natural logs:
With the end of fixed rates, relative prices became much more variable, with real exchange rates tracking nominal rates.
By the way, there was a second natural experiment with Europe’s move back to fixed rates, and then eventually to the euro. Once again real exchange rate behavior changed markedly.
All this amounts to the single most compelling demonstration that prices are indeed sticky, with all that follows from that observation — in particular, the case for activist monetary and fiscal policies to fight slumps.
I suspect that evidence like this is one reason international macroeconomists have been less likely than domestic macro types to march off into the dreamworld of real business cycles and all that.
Anyway, Mussa was a fine economist, and will be missed,