28 February 2016

How Easy is it to Raise LRAS?

There's recently been quite a bit of talk about greatly increasing the growth rate of GDP in the US over the next decade or so. The only way big aggregate demand stimuli could achieve this goal is if 1) output is currently far below potential in the US or 2) demand side stimulus can raise the long run level of output.

The first option is evidently not the case, given the fact that the labor market is reasonably tight -- the employment rate for Americans between the age of 15 and 64 has recovered most of what it lost in 2008, so output is clearly close to where it would be at full employment. By basically any reasonable account, output is pretty close to potential, so not much in the way of aggregate demand stimulus would have any effect other than increasing inflation. There are no credible models that I have ever seen that suggest that aggregate demand has any effect over the long run level of output, so it's almost fair to simply reject the hysteresis hypothesis simply based on its lack of theoretical reasoning. If this isn't enough, simply taking it to its logical conclusion should reveal some of the absurdity. If central banks, by increasing aggregate demand, could increase potential GDP, then they essentially have the power to decide the equilibrium level of employment, irrespective of demographics. Alternatively, they could be fueling innovation by printing loads of money and causing TFP growth to increase. Both options strike me as completely absurd; personally I see LRAS as completely deterministic to the Federal Reserve.

I will not, however, completely discount the role of fiscal policy. Certainly the Federal Government has the capability to engage in policies that have real effects. For instance, the government could permanently increase government spending as a percentage of GDP and induce everyone to work more by making them feel poorer. Also, the government could invest in a bunch of infrastructure, which could be treated as 'government capital' in all our Cobb-Douglas production functions and would, as such, be stimulative. Basically, the government could very well be boosting potential output, just not with anything that should be labeled 'demand' stimulus. In fact, this is probably true about any fiscal expansion that is ever undertaken -- we should only ever talk about the real effects of fiscal stimulus because everything else is the product of monetary-fiscal interaction. For example, any fiscal expansion will raise the 'natural rate of interest' in a New Keynesian model and the only reason the 'fiscal multiplier' will be any higher than that of a similarly calibrated RBC model is that the central bank refuses to raise the nominal interest rate one for one with the increase in the natural rate. In this sense, fiscal stimulus can almost have demand-side effects at the zero lower bound, but what is really happening is that the central bank fails to tighten monetary policy in the event of stimulus.

Basically, the only way for the government to increase potential output is by taking advantage of the real effects of fiscal policy -- people should stop preoccupying themselves with aggregate demand.

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