Accelerating output and prices equals additional stimulus?

The Fed made a mistake last year. No doubt the Fed chairwoman 70 years from now will give a speech admitting fault for the “Great Recession”. Fine.

It does NOT follow from this that we need more aggregate demand stimulus now. Obvious, right?

Now, unemployment is high. Empirically, we know two things about unemployment. It goes down when output is increasing (the so-called Okun’s law) and it lags output. We have increasing output and inflation. If those empirical regularities rear their ugly heads this time around, we know that unemployment will decline eventually, too.

Politically, I get why presidents react to bad-sounding headlines and hold “job summits” when unemployment goes above magic numbers. I don’t get the argument from economists for more stimulus. What theory, what mechanism of lagging unemployment would suggest we need increased stimulus even though output and inflation are rising?

I can think of a few things:

  1. Laid off workers are just waiting to be rehired by their former employers
  2. There wasn’t enough stimulus and we’re moving towards long-run equilibrium too slowly
  3. Variant: policy makers were too concerned about inflation and they should put more weight on unemployment going forward

It seems the internets are discovering the fact that this recession hasn’t been characterized by a large number of job losses. Instead, unemployment has been increasing because its harder for people who would have lost their job anyway to find new jobs. The JOLTS data, in other words, suggests that even in the recession laid off workers weren’t temporarily let go. They were fired and no amount of stimulus will get their old employer to hire them back. I’m willing to wager most fired employees have no expectation that they’ll be rehired by the same employer that fired from. In fact, I’m looking at data that suggests they shouldn’t even expect to be rehired in the same occupation; they’re going to have to go out and acquire new skills and find a whole new line of work.

Number one is bunk. What about number two? The problem with the “recovery is too slow” argument is that we don’t know what “too slow” means. Looking at the model I shared the other day, even under the optimal policy that makes the proper trade-off between unemployment and inflation, it takes two years to get half way back to normal unemployment rates. If you believe in the “too slow” theory, then you have to write down a model that would generate faster decreases in unemployment (and not just increases in inflation).

Number three? According to the Gali/Blanchard model, if the Fed is heartless and only cares about inflation, then unemployment is much worse at the time of the shock. This is true. However, as the first graph I showed indicates, the decline in unemployment is much faster. From the peak of unemployment it takes less than two years for unemployment to get half way to its normal level.

Under the third scenario, you might say the Fed should switch to the optimal policy. It should put more weight on unemployment and so it should ease policy. Well, according to the Taylor rule that approximates the optimal policy in the Gali/Blanchard model, interest rates should be about 0.5% 0%. Even under optimal policy where both inflation and unemployment are targeted, no further easing is necessary (and current policy might even be slightly inflationary).

UPDATE: as always I got my arithmetic wrong… post updated with strikes to show what changed.

15 thoughts on “Accelerating output and prices equals additional stimulus?”

  1. Um, it seems to me that the fact that there is still an output gap (and will be for some time to come) implies that more stimulus would be good. The economy is adjusting to the new lower expected AD path (output is rising), but it has not finished adjusting (if it had there wouldn’t be any output gap or at least it would be disappearing very quickly), if we boost the expected AD path closer to it’s old level the economy will have to do less adjusting. Sure additional stimulus would now would not be as good as it would have been at the start of the recession, but that doesn’t imply that it would do *no* good.

  2. Does the “optimal tradeoff” scenario takes into account that higher inflation lowers the burden of government debt? Now that Debt/GDP is…. well, unusual, that might be important.

  3. jsalvatier, I’m not saying we don’t need “easy money” or that we should increase interest rates or whatever… I’m asking why we need to make money easier or do the equivalent of lower interest rates.

    AC, I don’t think B/G model the government (besides the money authority). I’d have to look at the paper.

  4. I suspect that issues related to fiscal-monetary interactions are far more important during this recession than usual.

    Also, Mulligan might have a point in that there’s taxation at work too, or at least distortions/wedges.

  5. “MP” = Monetary Policy? Then no… Here’s why:

    While I’m not 100% in agreement with the fiscal theory of the price level people, they did show that it matters a lot that the government budget constraint is one and that fiscal constrains and is constrained by monetary. So you ought to look at both for optimal policy.

    On the factual side, I take recent events as a cold shower for the “central bank independence” mantra and the “inflation targeting” groupies. — Bernanke co-edited volumes (literally!) on inflation targeting and the monetary policy orthodoxy right before the fudge hit the fan. I’m not sure if recent events are consistent with what was preached at those conferences.

    I also expect (or rather wish) to see the Taylor rule dying a slow but sure death, since a lot of the arguments on which that literature was built are now painfully under question, but then again people have conveniently short memories and if you just need one more equation in your equilibrium block to close your Calvo abomination, some people will still do it.

  6. MP is “main post” or “my post” referring to the post we’re commenting about. What would the fiscal theory of the price level have to say about lagging unemployment?

    In any case, I agree with all that you say but you have to go to war with the models you have. Calvo abominations are what we have.

  7. It will probably take close to a generation to get unemployment down to 4%. That’s a massive welfare loss. It was clear 9 months ago that unemployment was headed for over 9%, and that the Fed should have been doing more. It was even more clear six months ago, and still more clearer three months ago. Now we are over 10%, and unemployment is still on the way up/not recovering. Meanwhile the last CPI for past 12 months is -.2%. The expectation according to the Fed for Q4 is inflation at a 1.4% annual rate. For next year the Fed expects 1.6% inflation. W/ a 2% inflation target, this implies that even if the Fed was heartless, and cared only about inflation, there’s a solid case for more action.

    So, I think its the combination of low inflation and high (and growing) unemployment which is leading people to push for the Fed to do more. Totally standard-textbook AS/AD logic implies no less.

  8. No doubt the Fed chairwoman 70 years from now will give a speech admitting fault for the “Great Recession”.

    Ah, but what will have been the mistake? Sumner says: not expanding the money supply. John Taylor says: not tightening the money supply in the runup to the crisis. Brad de Long would say: letting Lehman fail. Dean Baker would say: by ignoring the housing bubble. Not all of these can be theoretically consistent with each other.

  9. ssendam, that’s right.

    TV, just so I’m clear about what you claiming: you say standard models tell us we need to have *increasing* levels of stimulus when output is below potential? In Taylor rule terms you’re suggesting *changes* in interest rates are a function of output gaps. What standard model gives that form of the Taylor rule?

  10. Output is not expanding nearly fast enough to put a dent in unemployment. Re: number 2, we do know what too slow means- unemployment above 7% until at least 2011. Like TV said, these high rates of unemployment means a huge loss in welfare. Unemployment will fall eventually, sure. Why shouldn’t it fall faster? TIPS spreads aren’t showing very high future inflation. Saying that “things will recover eventually” puts you dangerously close to the classical view circa 1930.

    Regarding GB, I wouldn’t rely so heavily on it- it’s just a working paper. Having interest rates rise by 5% for every 1% increase in the inflation rate is ridiculous at best. Even a forward looking standard Taylor Rule predicts negative rates. The economy needs more stimulus until unemployment is far lower than it is now. Inflation under 2% with shockingly high unemployment, and you say to let off the accelerator? I don’t get it.

  11. gabe, my challenge to folks like you that subscribe to the “too slow” theory is to produce a model that has unemployment as a lagging indicator AND that lag is responsive to fiscal or monetary stimulus. I don’t know of such a model, but I’ve already admitted that my views of unemployment are clouded by models and data that suggest its caused by real search-like frictions. Do you have a model that suggests unemployment lags would be responsive to AD stimulus?

    You misread GB’s Taylor rule. They have a coefficient of 1.5 on inflation. And for the hundredth time I’m not saying let off the accelerator. I’m saying we’re already going the right speed.

    Delong’s rhetoric about the Treasury View, etc, does not help to move the conversation forward and its only purpose is to smear. This issue is more important to me than who ever wins next year’s Congress or whether or not I can make the proper signals that will get me another appointment at the Treasury department. This post and this string of posts isn’t about whether or not there should be stimulus… a point I’ve made explicitly many times. There’s a macro geek version of Godwin’s Law in there somewhere. In other words, please refrain from using that rhetoric.

  12. You are absolutely right about the Taylor Rule, I sincerely apologize.

    Re: let off the accelerator- I meant “to stop accelerating”, not “to slow down”, but anyway

    I admit I know of no modern model that includes unemployment as a lagging indicator other than GB. But I also find modern macro’s treatment of the labor market to be it’s weakest feature. Incorporating search models would be helpful, but it doesn’t seem to be a common feature yet at least. GB seems like a step in the right direction, but I don’t know about some of the features like real wage rigidity. Is there any room for “slack” in modern macro? It seems like it would in a search model, but I need to read more on it. Is there any modern macro model that adequately explain says the post-war experience of the USA with respect to unemployment?

    But isn’t this really about views on potential output? If nominal output is growing at relatively normal rates lately, that does not get one closer to a linear potential output line. Output would need to grow much faster to absorb the large amounts of surplus labor. If these are real shocks and potential output is lower, then real wages would have to fall until equilibrium is reached right? Isn’t higher inflation a faster way to get there? If productivity is increasing rapidly as it has recently, then doesn’t output have to rise faster to match it?

    I don’t totally understand why acceleration of output matters. Most interest rate rules are stated in terms of levels, as you said. The Taylor rule should be negative now, but is the current monetary stance equivalent to a low enough interest rate? At a zero-bound with QE it’s hard to tell.

    When I said the classical view circa 1930, I meant to spare everyone the “in the long-run we’re all dead”, but I should have been clearer I guess. I have never seen you espouse the Treasury View, but I find a view that opposes measures to reduce the length of high unemployment to be a blast from the past. I meant no disrespect, but I think it’s far from Godwin’s law. And I think it’s completely legitimate to call out respected economists that make major errors in their public pronouncements, and completely reasonable to tie it to flaws in reasoning that were made before.

    Given the balanced nature of the American growth path policies that return real GDP to trend faster are worth it. Just because we are getting back to normal doesn’t mean that we couldn’t get there faster. I guess it boils down to how “fast” we’re getting there- push thinks it fast enough, TV and I think not fast enough.

    [wa, thanks gabe for your reply. I think you’ve nailed where we disagree.]

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