Monetary policy with excess capacity

Here is some simple evidence of excess capacity and its relevance for unemployment.  I’ll give it more debate another time, and don’t too rapidly infer causal linkage from that graph behind the link, but at the very least it is not a crazy hypothesis.  Now that the gdp numbers have been revised downwards, and we see the U.S. economy has not reattained pre-crash output levels, the hypothesis that excess capacity is driving some of current unemployment is more plausible.

In one standard model, excess capacity renders nominal wage flexibility moot.  Workers could lower their reservation wages without it helping much.  Firms don’t want to produce any more, or they could produce more by working their current capital assets more heavily, rather than by hiring another worker.

Now let’s say there is a burst of inflation.  It might lower the real reservation wages of the unemployed, but employers still don’t bite, at least not until the excess capacity is worked off.  That can take a long time, especially if aggregate demand is low and the rate of innovation is sluggish.

There might be a stimulative effect if the nominal shock induces employers to expand output and, sooner or later, expand employment.  In other words, monetary policy must rely on the employers having money illusion.  Nonetheless employers are more likely to read financial news than are workers and arguably employers are less likely to be tricked by monetary policy.  Even if the employers are tricked, that just means they expand output, using spare capital, and work their way through the excess capacity more quickly; it doesn’t mean they hire more workers now.  Much will depend on capital-labor substitutability.  There is also the risk that employers will cut back on output once they see they were tricked by monetary policy; in contrast, workers who took a job under money illusion are not so likely to quit just because they pick up the WSJ and see that the nation has been suffering from hyperinflation or something like that.

Excess capacity is one reason why monetary policy isn’t always so effective, even when labor resources are unemployed.

Fiscal policy with excess capacity deserves a post of its own.  For now I’ll note there is a difference between hiring people to work directly for the government, contracting with firms to use some of their excess capacity, and contracting with the highest quality firms which perhaps do not have much excess capacity at all.

I again stress that microfoundations matter.  And please don’t read this post the wrong way.  I still favor looser monetary policy, but I view myself as lacking in real influence on the world and thus I am “working through the available variations” rather than propagadizing for my favorite policy.  If I were President of the United States, my blog posts would read somewhat differently.