Output gaps and heterogeneity

What shape is the Short Run Aggregate Supply (SRAS) curve? The question might sound tediously esoteric but it is, in fact, central to current economic policy debate.

In the long run almost all economists agree that the supply curve is vertical. The quantities of factors of production (land, labour, capital) available at a given time are fixed and even combined in the most efficient way can yield only a given amount of output. In this long run analysis the only way to increase the supply of goods and services available, the essence of economic growth, is to shift the vertical supply curve to the right by either increasing the amount of productive factors, or increasing the efficiency of their combination (their Total Factor Productivity).

Some economists think this also applies in the short run. As a result they argue that any attempted expansion of demand via monetary or fiscal policy, shifting the demand curve to the right, will simply result in rising prices. Output and employment will be unaffected.

But does it actually apply in the short run? After all, we see many factors of production lying idle. Unemployment, at 7.7%, is higher than at any time between January 1997 and May 2009. 14.1% of shops were empty in September according to the Local Data Company, barely down from 14.2% in February. Here we are in the ‘output gap’, the difference between current output and what output would be if all those unemployed workers were put to work in all those empty shops.

Couldn’t monetary stimulus bring these unemployed workers and empty shops together to increase employment and output without causing inflation? Monetary expansion will not cause higher prices, on this thinking, because rather than bidding up the wages of workers already employed or rents of commercial premises already occupied, the idle ones will be employed instead. That is what Bank of England governor Mark Carney sees when saying that monetary stimulus will continue at least until unemployment falls to 7%. Isn’t this the economist’s hitherto mythical ‘free lunch’?

A problem with this approach is that it views the factors of production as largely homogenous. Every square foot of empty commercial property, whether boarded up corner shop or out-of-town retail unit, is lumped in with every JCB as ‘capital’. All unemployed workers, whether builders or estate agents, are aggregated as undifferentiated slack in the labour market. What this approach misses, as does much clumsy, aggregative, ‘modern’ macroeconomics, is heterogeneity.

As economist Benjamin Powell points out, “A tractor is not a hammer”. An economy experiencing a tractor boom may find itself with a glut of unemployed tractors when that boom busts. Hammers, on the other hand, would be relatively scarce. As a result the returns on employing each capital good, tractors or hammers, will differ.

Any monetary stimulus attempting to bring these tractors back into employment will not be confined to spending on tractors. Some, probably most, will be spent on hammers which are not currently idle and whose supply will not expand to accommodate this new ‘demand’ immediately. It will simply bid up hammer prices. And if hammer supply does expand, that expansion will be revealed as an unsustainable malinvestment when the monetary stimulus is withdrawn.

And, a tractor not being a hammer (capital goods being heterogeneous in other words), they are not substitutes. An increased demand for one from monetary stimulus need not result in a proportionate increase in demand for the other. Those idle tractors will remain idle as the hammer boom takes off.

Just as a tractor is not a hammer, Mesut Özil is not Miley Cyrus; labour is also heterogeneous. If the economy had overinvested in midfielders during a singing bubble and there were now too many to gain employment as such in a sustainable pattern of demand, any monetary stimulus designed to get these guys back to work would begin driving up the wages of relatively scarce twerking pop stars before a substantial number of those midfielders had found employment.

Those footballers, like the tractors, do not represent ‘slack’ waiting to be picked up by a few more dollars. They are just dead capital and unsuitable labour, the product of malinvestments.

The lesson is that there is no single Short Run Aggregate Supply curve for the ‘the economy’. In each example above, at a given point the SRAS curve for tractors and running backs was horizontal while those for hammers and pop stars were vertical. Attempts to drive the economy along one aggregated economy-wide curve towards full employment will hit choppy waters sooner than monetary policy makers, with their crude view of a few macro variables, think. They might find they have less room for manoeuvre than their models tell them.

This article originally appeared at The Cobden Centre

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