The Wages Debate

I comment on this Bryan Caplan post, in which he says that, in a liquidity trap, reducing wages increases Aggregate Demand if labor demand is elastic and that this is what Paul Krugman said back in 1999. I asked where PK says this, am still waiting for a response.

My response was:

"If labor demand is elastic" -- In a steep recession, w/ interest rates at zero?

OK, so prices would tend to fall. We're in a situation w/ nominal interest rates pinned at zero, and we more in a deflationary direction. So real interest rates up. (Caplan considered nothing about interest rates, and seems to have forgotten the the liquidity trap assumption)...

Real interest rates up shifts Aggregate Demand which way?

Sumner then wonders why wages must fall for Spain.

Wages down for small-open economy Spain means Net Exports up. (To an extent, this would mitigate impact of lower wages in US case too.) Spain's prices won't decrease 1 for 1 w/ wages b/c much of Spain's products are purchased elsewhere, so the real interest rate rises less in the Spanish case. However, the rest of Europe has Net Exports down and downward pressure on prices, which means AD is definitely down for the "rest of Europe" and that for Spain it "depends on the elasticities", although likely the net export effect will dominate. Overall, European AD falls (perhaps some crazy elasticities would overturn this...)...

If Spain devalues, it's not the same thing though, and here's why: in Peseta's, products from Germany and France would cost more, spain's own products, at least initially, would have the same price, increasing demand for Spanish goods at the expense of foreign goods, as in the normal case. Before, prices in spain were deflating, but w/ a devalued currency, they are inflating. So now we have Spanish AD unquestionably up. It's still beggar thy neighbor for the rest of Europe, except this increase in Spanish AD from reduction in the real interest rate will increase its demand for products from the rest of Europe. Now AD for the rest of Europe is uncertain, and for Europe inclusive of Spain also uncertain, but more likely up...

I cannot wait until my Mankiw textbook arrives so that I can check my intuition about how the economy operates in a liquidity trap.