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Noah Smith

Magic Fairies Cause Recessions

Saying that something akin to magic fairies causes recessions isn't a very satisfactory explanation.
Close your eyes and make a wish.                                                  
Close your eyes and make a wish.                                                  

Here's how recessions work. Sometimes, for whatever reason, the Federal Reserve decides to raise interest rates. That's expected to cause deflation, so companies want to lower their prices to avoid being outcompeted when all the other companies lower their prices. But here's the problem -- some of them can't. Because every quarter, a magical fairy taps a certain percentage of them on the shoulder and says "Sorry, you're not allowed to change your prices this quarter." Since they can't drop their price, companies that get cursed by the fairy end up just producing less. Voila -- a recession!

Actually, I'm just kidding. I don't really think this is how recessions work. But, like the Real Business Cycle theory I described in a previous article, this is a real, honest-to-God macroeconomics model. In fact, more complicated versions of it are the dominant theory used by central banks all over the world. It's called the New Keynesian model, and it was the major challenger to RBC theory back in the 1990s. Its inventors, who include Greg Mankiw, Mike Woodford, Jordi Gali, Olivier Blanchard and others, haven't won Nobel prizes yet, but you can bet they're in the pipeline.