Bryan Caplan delivers what I would think of as the standard critique of PSST

  1. Without wage-stickiness you need Zero Marginal Product workers to make PSST work. This is kind of crazy notion to begin with and further would explain unemployment under any model so that means PSST is not really a model of unemployment.
  2. With wage-stickiness you have AD-AS so why do we need PSST?

Arnold responds

Obviously, there must be some impediments to adjustment in order for unemployment to persist. If you think that the only impediment is nominal wage rigidity, then of course monetary expansion and inflation are the cure for any adjustment problem.

The PSST story is that a major impediment to adjustment is that entrepreneurs must come up with new uses of labor to employ workers released from sectors where they are no longer needed. This requires imagination, experimentation and evolution. It takes time.

Once you are here though I think that you can just think of PSST as an expansion on the notion of matching.

So, unless you really are running up against subsistence wages, then SOME fall in the real wage would clear the market, implying SOME amount of inflation would cure the recession.

What Arnold could add is this – look that’s all true but its not optimal.

The reason that workers are holding out for higher wages is that they rationally expect entrepreneurs to come up with useful ways to employ them. Because there is a cost to matching, you basically want to look as wide and as far as you can for such an entrepreneur.

This encourages you to keep looking for work rather than lower your reservation wage.

However, what can happen is that in a sudden shift in economic fundamentals entrepreneurs cannot think of ways to employ workers fast enough. The ideal waiting time rises rationally. This would then be exacerbated by increases in Unemployment Insurance, etc.

The important thing to remember though – and this applies to all Austrian-esque stuff I think – is that you have got to have some sort of information or market imperfection or else relative prices will do all of the work for you.

A competitive economy with no frictions can be hit by an arbitrarily large shock – nominal or real – and will readjust instantly. There is just no possible way to screw it up. It doesn’t matter if there is lack of imagination or the government is shooting people at random or anything.

A frictionless market will simply readjust. It might readjust to an extremely low wage, if all of these bad things are happening, but it will readjust.

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