Why is this a problem? For real expenditures, and the real volume of sales, to return to the growth path of the Great Moderation, the price level must also fall 13 percent below its growth path from that period. Since it is now only about 2 percent below that growth path, there is 11 percent to go. While an immediate 11 percent deflation of prices (and wages) would rapidly solve the problem, and then allow for a resumption of 5 percent growth of money expenditures, 2 percent inflation, and growth of real expenditures of 3 percent, the most likely consequence of 5 percent growth in money expenditures starting from the current, depressed level, would be slow inflation or even mild deflation for an extended period of time. Only a very gradual return of real expenditures to its past growth path would be possible. Output and employment would remain depressed for an extended period.
An alternative approach would be more rapid growth of money expenditures--faster than the past trend growth rate--to return to the old growth path, after which 5 percent growth of money expenditures would resume. To return to the growth path of the Great Moderation one year from now, a 21 percent growth rate would be necessary. A two year adjustment path would require roughly 12.5 percent growth in money expenditures each year.
What about inflation? If the return of the money expenditures to its growth path of the Great Moderation simply returns the price level and real output to their previous growth paths, then the inflation rate would be about 4.6 percent. Of course, after a year of readjustment, the inflation rate would return to 2 percent.
However, the logic of that approach suggests that real expenditures (and real output) would increase at a 14.6 percent annual rate. That would be a happy result if possible. Unfortunately, even if the entire decrease in output was due to depressed sales, such a rapid recovery of production may be impossible. Even higher inflation might occur, resulting in the price level rising above its long term growth path. As production catches up, then inflation would again slow, this time moving down to the long term growth path.
There is reason to believe that the productive capacity of the economy has been reduced. Part of this is temporary--a need to shift labor and build capital goods appropriate to a new pattern of production, one that includes less residential investment. However, part of the shift will be permanent reflecting the loss of capital, including the skills of workers, specific to home construction.
The Congressional Budget Office estimates potential income--the productive capacity of the economy. Assuming their estimates are correct, potential output in the third quarter of 2010 is 3.8 percent below the trend growth path of real GDP for the Great Moderation. While real output is currently nearly 10 percent below the trend growth path of the Great Moderation, it is only 6.4 percent below the CBO estimate of potential output.
If money expenditures returned to its trend value of the Great Moderation in one year ($17,652 billion in the third quarter of 2011,) and real output returned to the CBO forecast of potential output, ($14,399 billion) the market clearing price level would be 122.6, which implies a 10.3 percent inflation rate and 8.6 percent growth in real output over the coming year. Again, assuming the CBO's estimates of potential income are correct, thereafter, the 5 percent growth path of money expenditures would be consistent with real output growing with capacity at approximately 2 percent a year and inflation running at 3 percent a year. If the return to the growth path of money expenditures is spread over 2 years, and the inflation rate over those two years would need to average 7 percent and real growth would be 5 percent per year.
(If the CBO estimate of potential income is correct, then there is no need for real expenditures to return to the growth path of the Great Moderation. Since potential income has fallen nearly 4 percent below that growth path, and with the price level already 2 percent below its growth path, the price level (including wages) need only drop 6 percent. )
I have long favored a noninflationary growth path for money expenditures and have proposed shifting to a new 3 percent growth path. My proposed growth path shifts to the lower growth rate at the third quarter of 2008, which is when money expenditures began to drop. With this alternative growth path, money expenditures are currently 8.4 too low, and would need to grow 12.4 percent over the next year to reach the targeted level--$16,415 billion.
If the price level remained at its current value of 111, the resulting increase in real expenditures would remain 2.6 percent below the growth path of the Great Moderation. For real expenditure and real output to return that growth path, the price level would need to fall to 108, which would require 2.6 percent deflation.
However, if the CBO estimate of potential income is correct, then the price level consistent with the real expenditures equal to potential output ($14,399.6 in third quarter of 2011,) would be 114. This would imply about 2.6 percent inflation over the coming year. After that point, the 3 percent growth in money expenditures would result in an inflation rate of about one percent--at least if the CBO estimate of continued slow growth in productive capacity is correct.
In my opinion, the Great Recession began in the third quarter of 2008. While I have no complaint with the NBER dating the recession as beginning in December of 2007, the first three quarters of recession where similar to the two recessions during the Great Moderation. Only in the third quarter was there a break, with a sharp decrease in money expenditures. In the third quarter of 2008 the Great Recession began.
However, suppose the shift in growth paths--the initial point of the new 3 percent growth path-- occurs at the official start of the recession, first quarter 2008. This slightly lower growth path would imply a target of money expenditures of $16,119 billion for the third quarter of 2011. It is currently (third quarter of 2010) 6.7 percent below the target and to reach the target in one year, it must grow 10.4 percent.
In the diagram below, the trend of Final Sales of Domestic Product during the Great Moderation (2004-2008) is shown in black. Adjusted trend one shifts to a 3 percent growth rate starting in the third quarter of 2008. Adjusted trend two shifts to a 3 percent growth rate in the first quarter of 2008.
If the price level remained at its current value, real expenditures (and real output) would be more that 4 percent below the trend growth path of the Great Moderation. The price level necessary for real expenditures to be back to that growth path is 106, which would require deflation of 4.4 percent. However, if the CBO estimates of potential income are correct, then the price level necessary to keep real expenditure equal to the productive capacity of the economy is slightly less than 112. The implied inflation rate would be one percent. This would imply that happy result of real expenditure and real output rising 8.6 percent, closing the output gap between the current value of real GDP and the CBO estimate of potential one year from now. After that point, real output would presumably grow at the anemic levels estimated by CBO, approximately 2 percent, and the inflation rate would remain at approximately 1 percent.
In the diagram below, the price level consistent with the CBO estimate of potential income and the 5 percent growth path of the Great Moderation is shown in black at labled P (trend.) During this period, the inflation rate is approximately 3 percent. That is because the CBO estimate of potential output grows at the rather anemic 2 percent. P (adj. 1) shows the price level consisent with a 3 percent growth path of money expenditures starting in the third quarter of 2008 and P (adj. 2) shows the price level consistent with the 3 percent growth path starting at the first quarter of 2008.