The Gap In Monetary and Fiscal Policy

One of the big questions for policymakers is how much of the current downturn represents of temporary cyclical fluctuation and how much of it is a permanent reduction in out productive capacity. If the downturn is mostly temporary, then we will eventually bounce back to the old output trend line. Something like this:

But if it's mostly permanent, i.e. if the trend has fallen to a lower value and will stay there, then the picture is different:

In the first case, highly stimulative policy is appropriate to help the economy get back to the long-run trend as soon as possible. There's still a lot of ground to cover, and policy can help. But in the second case the economy is already back to it's long-run trend at most points in time, or nearly so, and there is no need for policymakers to do much of anything at all. At least that's what we're told.

However, I think this misses part of the story. What it misses is that AS shocks themselves can be both permanent and temporary, and some people may be confusing one for the other. For example, when there as a large AD shock in the form of a change in preferences, say that people no longer like good A as it has gone out of fashion and have now decided B is the must have good, then there will be high unemployment in industry A and excess demand for labor and other resources in industry B. As workers and resources leave industry A, our productive capacity falls and it stays lower until the workers and other resources eventually find their way into industry B. When this process is complete, productive capacity returns to where it was before, or perhaps goes even higher. Thus, there is a short-run cycle in productive capacity that mirrors the business cycle.

Even a standard business cycle type AD shock will temporarily depress capacity and produce similar effects. Suppose that interest rates go up, taxes go up, government spending goes down, investment falls --pick your story -- causing aggregate demand to fall. When, as a result, businesses lay people off, idle equipment, etc., productive capacity will fall. It can be cranked up again, and will be when the economy recovers, but rehiring labor and taking equipment out of mothballs takes time. In the interim the natural rate of output falls and, just as with a change in the preference for good A versus good B, a negative aggregate demand shock can cause "frictions" on the supply side that temporarily increase the natural rate of unemployment. And there are many other ways this can happen as well.

The point is that there can be short-run cyclical AS effects, and failing to account for these can lead to policy errors. Consider the following diagram:

Up until the point where the line splits into three pieces, assume the economy is in long-run equilibrium with output at the natural rate (we can discuss whether the natural rate actually exists another time, I want to work in the standard model for the moment since that is where the policy discussion is centered). Then, for some reason, aggregate demand falls leading the economy into a recession. As AD falls, people are laid off, equipment is stored, factories are shuttered, and so on and the economy's capacity to produce falls in the short-run as shown by the blue line on the diagram.

But this is a temporary, not a permanent situation. Eventually people will be put back to work, trucks in parking lots will be back on the road, factories will reopen -- you get the picture -- and productive capacity will grow as the economy recovers. I believe many people are treating what is ultimately a temporary fall in capacity as a permanent change, and they are making the wrong policy recommendations as a result.

In fact, there's no reason to think productive capacity can't return to its long-run trend just as fast or faster than output can recover. If so, then it would be a mistake to do as many are doing presently and treat the blue short-run y* line as a constraint for policy, conclude that the gap is small and hence there's nothing for policy to do. Capacity will recover, and policymakers must take this into account when looking at whether additional policy can help the economy. If capacity can grow fast as the economy recovers, then it poses little constraint and policymakers should try to return us to the long-run trend as soon as possible. That is, aggressive policy is still called for even if productive capacity is presently relatively low.

And even if the economy can recover faster than productive capacity can return to its long-run trend, i.e. actual output can "catch" the blue line before it reaches the dotted long-run y* line, it would still be wrong for policymakers to treat the value of productive capacity today is a constraint. Since short-run y* is cycling back to trend, and since it takes time for policy to work, policymakers are shooting at a moving target (a target that might move even faster with effective stimulus). And in any case, there's nothing wrong with catching short-run y* as soon as possible -- in fact that's desirable.

The fear, of course, is that once the economy catches short-run y*, trying to push beyond that constraint would be inflationary. Some argue we are close to that situation already, and additional policy could well cause prices to increase, but I just can't see significant inflation risks at the present time, in part because of my differing views on where the recovery of capacity.

Finally, the discussion about inflation brings up another point. One of the puzzles in the macroeconomic literature about business cycles is that prices don't move anywhere near as much as a gap analysis implies they should. But the gap used in this analysis of often the distance between long-run potential output and actual output (i.e. the difference between the dotted line and the solid black line in figure 1 or figure 3). But if price pressure depends upon the gap between short-run capacity and actual output (the blue and black lines), as you would expect it would, and if output and short-run capacity co-vary positively after a shock (I gave reasons above why this could happen), then the gap and hence prices could be relatively constant throughout the cycle. The gap between the blue and black lines doesn't change much and hence inflation doesn't change much either.

One last point about the diagram. I drew the long-run line so there is a long-run decline in the trend of our productive capacity after the recession (i.e. a permanent shock). However, it's hard to see because, consistent with my beliefs, I do not think the change in our long-run capacity to produce goods and services will be as negative as many others. So the effect is not large in the diagram (I acknowledge I'm more optimistic on this point than many others that I respect). But even if the long-run trend had fallen by more than shown in the diagram, say by 50%, the points above would still hold. If the capacity to produce recovers as the economy recovers, and does so relatively fast, then policymakers should not be constrained by the belief that the natural rate of output is relatively low at the present time. Aggressive policy is still the best course of action.