Will stimulating nominal aggregate demand solve our problems?

In which I join the ongoing debate on how much we should expect fiscal and monetary stimulus to accomplish.

Arnold Kling has proposed a “recalculation” theory of macroeconomics:

My claim (which is not original with me– it is recognizably Austrian) is that a recession can be thought of as a recalculation. Imagine a central planner who decides to radically change plans. He has a huge recalculation to make in order to figure out where to allocate labor and capital. He says to some people, “Wait a minute. I am thinking. Some of you just have to stand idle while I figure this out.”

The market economy is like that central planner. We are undergoing a Great Recalculation….

In conventional, hydraulic macro, we think in terms of this one good called GDP, and the output gap is the difference between how much of this GDP stuff we could produce if everybody were working and how much we are actually producing with all the unemployment over and above “normal.” We assume that “normal” unemployment, which is structural and frictional, is some roughly constant fraction of the labor force.

The way I look at things, we have a huge amount of structural and frictional unemployment these days. There is very little cyclical unemployment–limited to autos and household durable goods. If you measure the output gap using my definition of cyclical unemployment, then the output gap is tiny.

Paul Krugman finds this unconvincing:

the whole notion falls apart when you ask why, say, a housing boom– which requires shifting resources into housing– doesn’t produce the same kind of unemployment as a housing bust that shifts resources out of housing.

It is not clear whether Paul is intending his observation as a refutation of all models that attribute a fall in potential output to sectoral imbalances, though Tyler Cowen seems to read his statement that way. To their discussion I’d like to add a paper I published in 1988. There I presented a model in which unemployment arises from a drop in the demand for the output of a particular sector. The unemployed workers could consider trying to retrain or relocate, or might instead decide to wait it out in hopes that the demand for their specialized skills will come back.

If instead of a drop in the demand for sector A there was a boom in the demand for sector B, it is true that some workers in sector A might choose to retrain or relocate, and be temporarily unemployed as a result. But the key kind of unemployment that I think this sort of model describes– waiting for an opening in the particular area in which you’ve specialized– is caused by drops in demand, not increases.

Insofar as the frictions in that model are of a physical, technological nature, increasing the money supply would simply cause inflation and not do anything to get people back to work. I should emphasize that I built that monetary neutrality into the model not because I think it is the best description of reality, but in order to illustrate more clearly that there is a type of cyclical unemployment that stimulating nominal aggregate nominal demand is useless for preventing.

My personal view is that real-world unemployment arises from the interaction of sectoral imbalances with frictions in the wage and price structure of the sort documented by Truman Bewley and Alan Blinder. The key empirical test, in my opinion, is at what point inflationary pressures begin to pick up. If Krugman is correct, we could have much bigger monetary and fiscal stimulus without seeing any increase in inflation. If the sectoral imbalances story is correct, it would be possible for inflation to accelerate even while unemployment remains quite high.

I would also emphasize that even with a sectoral-imbalance interpretation, there is a clear potential for fiscal policy to have made a positive contribution by preventing job losses caused by state and local government spending cuts. Under the “hydraulic macro” view, as long as the federal government increases spending by the same amount that state and local governments decrease spending, we’d be OK. Under the “sectoral imbalances” view, a $1 increase in federal spending combined with a $1 decrease in state spending is on balance contractionary, and that downturn would have been preventable by a simple fiscal transfer from the federal to the state level. I note that
one-fifth of the seasonally adjusted job losses in September came from a decrease of 47,000 in the number of state and local government employees. I am still persuaded that the nation would have been better served with the stimulus bill I proposed in January in place of the American Recovery and Reinvestment Act. Whatever your position on that, I’m presuming we could all agree that things have not developed so far in the way that we would have hoped.

Source: Greg Mankiw

You can find more discussion from Arnold Kling ([1],
[2]),
Ryan Avent,
Robert Waldmann, and
Matthew Yglesias.

Read more….