", but how far below varies from cycle to cycle."
"This is not at all what standard New Keynesian models say. In those models “potential output” is what the economy would produce if prices were perfectly flexible. "
(Leave on one side the question of whether flexible prices get you to full employment in a liquidity trap, especially with problems of debt overhang)."
" In the short run, however, prices are sticky,
so we’re often not at potential;
but the economy can run above as well as below potential
and in fact
there would be no necessary reason why underemployment
should be more common than overemployment."
"Largely thanks to this theoretical conclusion,
it has become standard to describe the job of monetary policy
as one of “stabilization”, rather than the achievement of full employment"
.
"Like Fatas and Mihov, however,
I don’t think this is right."
" Or more accurately, I don’t feel that it’s right."
" What lies behind that feeling?"
"Partly, I think, it’s the historical record:
booms are more similar than busts."
" To take the extreme case,
clearly we’ve never had a period when the economy
was as far above capacity as it was below capacity in the Great Depression."
" And even in the postwar record, if we look at unemployment rates,
troughs – local minima in the rate – are more closely clustered than peaks – local maxima:"
"There’s also the now very clear evidence
that the old notion that wages are sticky downward in a way they’re not sticky upward
is entirely true –"
" and downward nominal wage rigidity eliminates the symmetry
between over- and under-employment."
Here’s the SF Fed data:
San Francisco Fed Percentage of workers with zero wage change
there’s the question of what’s supposed to be going on
when the economy is operating above capacity"
". How do you force people to work more than they would want to in equilibrium? "
"Now, NK models do have an answer of sorts:
they’re always models characterized by imperfect competition,
so prices are above marginal cost,
and there’s a sense in which the economy is always
operating with some excess capacity
in the sense that people are willing to produce more at current prices."
" But my vague sense is that this only gives you a limited amount of wiggle room,
and that really big upward deviations in output can’t happen,
while really big downward deviations can."
"So, why should you care?
Well, Fatas and Mihov have it right:
if the business cycle is a matter of the economy falling below capacity,
rather than fluctuating around potential output,
the costs of recessions are much bigger than often portrayed,
and focusing on “stabilization”
greatly understates the importance of good macro policy"
