Friday, September 21, 2012

Eli Dourado on the Short and Long Run

Eli Dourado says he is a fan of Scott Sumner, NGDP level targeting and many of the ideas of market monetarists.  That is good to hear.    Since Market Monetarists don't all agree with one another, I am willing to welcome him to the club.   We could use more Ph.D. students interested in the program.   (OK, it would be nice if they were doing money-macro dissertations.)

Dourado argues that QE3 is unlikely to do much good because the economy has already adjusted to the "long run."   His evidence is that corporate profits are at an all time high and that the mean duration of unemployment has leveled off and remains high.

The high corporate profits are relevant because he supposes that low demand results in lower profits which causes firms to cut production.    While production may be low, this evidence shows that it isn't because low demand has resulted in unusually low profits.

But most other Market Monetarists are arguing is that higher spending on output would cause firms to sell more, and so they would produce more.   We aren't saying that higher spending on output would cause firms to make more profit, and so they would produce more.

What is Dourado arguing?   If spending on output rises back towards (or all the way to) the trend of the Great Moderation, all that would happen is that profits would rise while production would remain on its current low growth path?   For profits to rise with no added growth in output,  firms would need to respond to the added sales solely by raising their prices (more quickly.)   If profits are to rise, their costs can't rise as quickly, which could occur because their debt service costs don't rise.  And, of course, wages might stay on their current growth path too.

That's one scenario.

Consider again the scenario most Market Monetarist suggest instead.   Firms sell more and so they produce more.  To produce more they hire more workers.   Profits don't play a key causal role, though I suppose this scenario  requires that price is above marginal cost for many firms so that if they produced and sold more their profits would be higher.    Well, the current high level of profits are consistent with price being greater than marginal cost for many firms. (Of course, historically high profits only require that prices are greater than usual relative to average costs.   Prices could be equal to marginal costs.)

Dourado also explains that firms have been able to expand production while using fewer workers.  This must be true today since production is above its previous peak while employment is below its previous peak.    However, increased productivity doesn't require reduced employment.    It is perfectly consistent with increased production and constant employment.     In other words, if firms have figured out ways to produce a given level of output with less labor, this just suggests that real demand needs to increase even more.    When employment reaches its growth path from the Great Moderation, production will have surpassed its growth path from the Great Moderation   However, if spending on output only returns to the growth path of the Great Moderation, the added production would require that prices shift down to a lower growth path.

Well, that is another scenario.  By increasing nominal GDP back to the growth path of the Great Moderation and observing whether prices remain below their growth path  from the Great Moderation and real GDP rises above its growth path of the Great Moderation, we will find out how much labor productivity has increased.

Of course, there is also the problem of complementary factors of production.   While more rapid increases in demand could result in the employment of  more workers each producing more output, more of the other factors of production would be needed to produce the added output.   Bottlenecks for these other factors of production could lead to higher costs and higher prices of output.

However, it is hard to imagine that an improvement in labor productivity would cause real output to fall below its existing growth path because of bottlenecks from other factors of production.   It just would not rise as much.   The increase in output would be dampened, at least temporarily.

And, of course, real GDP is about 12 percent below its growth path from the Great Moderation and so speculating about how much it would rise above that path because of added labor productivity versus how much employment would remain below its  growth path of the Great Moderation is very premature.

The typical Market Monetarist perspective is that nominal GDP has shifted to a 14 percent lower growth path.    For real output and employment to remain on its previous growth path, the price level and nominal wages need to also shift to 14 percent lower growth paths.   They haven't.   Instead, they are only about 2 percent lower.

It is possible that raising nominal GDP back to its previous growth path (or even to one 2 percent lower) would have no positive impact on production and employment.   It is possible that if the price level and wages shifted down 12 percent more, the increase in real expenditure would  only result in shortages of output and/or labor.   For this to be true, the productive capacity of the economy must have decreased by about 12 percent.

This is, of course, possible.   Enhanced labor productivity is not something that would tend to have such an effect.

Dourado's version of how shifts in nominal GDP impact real output and employment is based upon an assumption of market clearing.    Prices and wages always adjust so real expenditure is sufficient to purchase everything produced, but when prices and wages shift in unexpected ways, people will work or produce more or less than they would if they understood what was happening to the price level or wages.   These mistaken shifts in supply result in shifts in production, but at each and every point in time, the prices and wages are at levels such that real expenditure is sufficient to purchase all that firms wish to sell or employ all the labor households want to provide.

If there is a surprise decrease in nominal GDP, this will cause the price level and wage level necessary for real expenditure to remain equal to productive capacity to fall.   The falling prices and wages lead to confusion, and firms choose to produce less and households choose to work less.   If the decrease in nominal GDP can be rapidly reversed, then the price level and and wage level rise again and firms will go back to producing the right amount and households will go back to working the right amount.

But it is hard to believe that people are still confused about the lower wages and prices after four years.   They must be producing and working the amount they prefer.   It must be that they prefer producing and working much less.

Most Market Monetarists would say that a decrease in nominal GDP could leave real expenditure unchanged if prices and wages drop in proportion.   If that fails to occur, then real expenditures fall, and firms reduce production and employment to match the lower volume of real sales.   If productive capacity is unchanged, then real output is below productive capacity.      If that is the case, then real output and real income can expand by simply increasing spending on output or lowering prices and wages.  

The puzzle, then, is why haven't firms cut the prices they charge and the wages they pay so that real expenditures recover to the productive capacity of the economy?   They have had four years to make these cuts.    Again, if the problem was a decrease in the productive capacity of  the economy, the lower prices and wages would just lead to shortages of output and/or labor, and do no good.   And so, it would seem that if prices and wages haven't been cut after four years, it must be that the productive capacity of the economy decreased.

If the productive capacity of the economy decreased, then increasing nominal GDP back to the trend of the Great Moderation would solely result in an increase in the growth path of the price level.    Market Monetarists, as advocates of nominal GDP level targeting, believe that if the productive capacity of the economy shifts down to a lower growth path, then the least bad consequences is for nominal income to remain on an unchanged growth path and the price level to shift to a higher growth path.  

Still, even after four years, most of us doubt that there was just a happy coincidence that spending on output fell in near exact proportion to a decrease in productive capacity.   And further, we see substantial evidence that firms would be willing and able to produce more if their sales were to increase.   Few of us ever bought into Dourado's market clearing approach--shifts in supply due to confusion--anyway.   But we see the experience of the last four years as providing evidence that it isn't even a close approximation.  

On the other hand, most of us do believe that firms eventually cut prices and wages in the face of persistent surpluses of output and labor.   Most of us remain puzzled by the slow adjustment.   Personally, I lean to seeing credible inflation targeting as increasing price and wage stickiness as a manifestation of Goodhart's law.   I think credible nominal GDP targeting would worsen wage stickiness for much the same reason, though perhaps lessen price stickiness.   I don't see the sticky wages as much of a problem in that context--rather, it just makes it more important to keep nominal GDP on target.


  1. Why does productive capacity have to have fallen to explain a fall in RGDP?

    If uncertainty (or whatever) on the part of businesses and consumers causes demand for both investment and consumer goods to shift to the left then if the supply of labor curve stays the same (and is relatively flat) won't we end up with a equilibrium with lower RGDP as people choose leisure over lower wages ?

    In this situation QE3 will just have a short term effect before moving back to the current equilibrium unless either:

    1) Money is still overvalued which seems unlikely after 4 years
    2) QE3 can somehow boost confidence and cause the long term AD curve to shift to the right again. I'm not sure by what mechanism QE is going to do that.

  2. Your scenario is a decrease in productive capacity. While a sudden decrease in the desire to work (a shift of labor supply to the left) is one possibility, a decrease in the demand for labor resulting in workers wanting to work less due to lower wages would be another. Of course, what you have described is a decrease in the supply of complementary factors for labor--that is why labor demand falls.

    Anyway, if you assume labor market clearing, then a decrease in supply or decrease in demand for labor doesn't cause higher unemployment. People will say that they can find jobs, but rather just prefer leisure to the wages they can receive.

    Now, if the demand for labor has fallen, then in a real market economy, a surplus of labor is the likely immediate result. And only as wages fall does the quantity demanded rise back some and the quantity supplied fall.

    With nominal GDP targeting, what happens is that nominal wages keep on their growth path, but the price level moves to a higher growth path. Real wages fall, and the quantity of labor demanded recovers and the quantity of labor supplied falls. People drop out of the labor force. Presumably, there would be people quitting because it is just not worth it to work because their wages are not keeping up with the run up in the cost of living.

    As for the long term aggregate demand--what does that mean? Do you mean the level of nominal expenditures in the economy? That can be at any level. Or do you mean real expenditures? In the long run, that is the same thing as productive capacity.

  3. Thanks for your detailed reply.

    I was thinking of a reduction of productive capacity as somehow real resources being eliminated (raw materials running out, or machines being destroyed via disaster etc) but see now that the scenario I was describing can also be seen a a "decrease in productive capacity".

    I agree that in as much as NGDP targeting would eliminate problems associated with sticky prices then its effects will be beneficial even after a decrease in productive capacity. I'm somewhat skeptical though that we can be seeing problems associated with sticky prices 4 years after the sharp NGDP decrease on 2008.

    By "long term aggregate demand-" I mean current expectations about future real demand (sorry about my haphazard terminology). It seems to me that this would be a major determinant in current investment decisions. What I'm wondering is why (if we are indeed not in a situation where money is over-valued) boosting the money supply via QE3 is going to boost expectations about future demand rather than just moving the economy to the same equilibrium but with higher prices.

    I think that the safest policy right now would be a commitment to an NGDP target using 2012 as a base level, bounded only by a upper-inflation limit. I think this would provide a stable environment for business to plan ahead and for productive capacity to find its natural level free of regime uncertainty (which QE3 just adds to).

  4. Speaking of other factors of production, Casey Mulligan has released the first chapter of his new book. I still think the increased level of unemployment is mostly a matter of low demand, but he makes the important point that outside of a few industries (like construction) there doesn't seem to be reduced usage of other production inputs.

  5. So is Major_Freedom correct when he says that NGDPLT exacerbates the very problems it tries to solve?

    1. To some degree, yes. I think the expectations generated by NGDPLT will make the wage trajectory more sticky. But successful NGDPLt will keep real output more stable than a gold standard or fixed quantity of money. Being uncertain about whether shifts in nominal GDP are permanent or temporary will make wages more flexible, but not enough to prevent severe changes in real output and employment.

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