Saturday, January 15, 2011

Unemployment and Aggregate Demand

Tyler Cowen writes:
When will people move away from pure AD theories of unemployment?
My short answer is when money expenditures return to the growth path of the Great Moderation.  In the third quarter of 2010, Final Sales of Domestic product were 13 percent below that growth path, and would need to rise about 21 percent to return to the level of that growth path by the first quarter of 2012.

My long answer is--who has a pure AD theory of unemployment? Frictional, structural, technological, and institutional unemployment combine to make up the natural unemployment rate.   Each of those types of unemployment have causes, and those causes are subject to change.   I think the overproduction of homes 5 years ago implies an increase in structural unemployment. Labor and other resources need to be shifted to the production of other things.   (Unemployment due to there no longer being scarcity is not "structural.")

I don't believe that if money expenditures return to the trend of the Great Moderation, employment and output would return to their trends from that period. I also think that the price level would be on a higher growth path, and probably the inflation rate would be higher.  I still favor targeting money expenditures.

But I am very confident that employment, output, and real would be much higher than today!

When money expenditures have returned to that growth path, and employment continues more or less unchanged from its trough, and output remains on an approximate 6 percent lower growth path, I will admit that aggregate demand wasn't the problem.

But don't tell me about growth rates from radically lower levels. The economy is growing. If the economy is on the equilibrium growth path, staying there requires that the real quantity of money grow with the demand for money. It requires that real expenditure grow with real output.   However, just because these growth rates match doesn't imply the economy is in equilibrium.   If you are on the wrong growth path, then having the growth rates balance means you never shift to the equilibrium growth path.

Cowen quotes:

Friday showed that total sales in 2010 were up 6.8 per cent from 2009, marking the sharpest such increase in more than a decade... Industrial output is up by 5.9 per cent year-on-year.
See, just growth rates.   Where are these relative to the growth paths of the Great Moderation?

Of course, if you assume that all changes in real output must be due to productivity shocks, and that growth just resumes from the changed level, then levels don't matter. If you assume that the price level always adjusts each "period" to clear all markets, and that output is only impacted by a misperception of this period's inflation rate, or even sticky prices this period, with prices always fully adjusting before the beginning of the next "period."   then levels don't matter. I think the Great Recession shows that there is something fundamentally wrong with this model.    You know, models that seemed to work quite well in the Great Moderation, when money expenditures remained very close to a 5 percent growth path.   When maybe most of the shocks were small productivity shocks.   When there wasn't a 13 drop in the growth path of money expenditures!


  1. Exactly!

    Monetarists like you, Sumner, Beckworth, etc. are probably not clear enough on this point: nominal income targeting is the least bad monetary rule regardless of what else is occurring in the economy. These ideas are not just monetary "fine tuning" or "counter-cyclical policy", because it turns out that the best policy during normal times is also the best policy during abnormal times.

  2. Bill
    This one was along the same line of argument:

  3. It is very tough to see these things happening; I really hate the unemployment rates. As a Forex trader, I need to be seriously keeping eye on these rates, as we know how much it can make the economy weak or strong. I don’t worry too much given my broker OctaFX takes care of all these stuff, as they got great service that’s providing us with daily market news and analysis, it is really helpful and allows me to work smoothly.