Why aggregate demand stimulation becomes less effective as a recession continues

Megan McArdle raises some doubts about the idea of a four percent inflation target, as has been suggested by Olivier Blanchard and others.  I would stress the point that the optimal inflation target falls as a recession proceeds.  Whatever you think of four percent inflation in absolute terms (I have favored two percent, though not four), it would have done much more good a year or two ago than it can do today.

There is an asymmetry between layoffs and rehires.  If an economy starts heading into recession, robust aggregate demand may limit the number of layoffs.  But once those workers are laid off, robust aggregate demand won't necessarily lead to their rehiring.  The employer already has figured out how to do without those workers and the production process has "moved on," so to speak.  Few employers are looking to recreate the status quo ex ante.

Even a shock which was originally one hundred percent "nominal" becomes increasingly "real" as time proceeds.  The laid-off workers have to find new and different jobs, which often means cross-sectoral adjustments.  Laid-off workers become frustrated, lazier, less healthy, and so on — hysteresis – which also makes for required real adjustments, since now they are less productive.

As time passes in the recession, nominal wages also adjust to some extent, perhaps in a painful manner, but that too limits the value of inflation or reflation.

Repeat after me: "Even a shock which was originally one hundred percent "nominal" becomes increasingly "real" as time proceeds."  Again, that means the case for significantly higher inflation — whether strong or weak in absolute terms — becomes weaker every day. 


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