Grasping Reality on TypePad, by Brad DeLong

Extreme economic events have often challenged existing views of how the economy works and exposed shortcomings in the collective knowledge of economists.... Both the Great Depression and the stagflation of the 1970s motivated new ways of thinking about economic phenomena. More recently, the financial crisis and its aftermath might well prove to be a similar sort of turning point....

The Influence of Demand on Aggregate Supply: The first question I would like to pose concerns the distinction between aggregate supply and aggregate demand: Are there circumstances in which changes in aggregate demand can have an appreciable, persistent effect on aggregate supply? Prior to the Great Recession, most economists would probably have answered this question with a qualified "no."... Post-crisis experience suggests that changes in aggregate demand may have an appreciable, persistent effect on aggregate supply--that is, on potential output.... Recent studies present cross-country evidence indicating that severe and persistent recessions have historically had these sorts of long-term effects, even for downturns that appear to have resulted largely or entirely from a shock to aggregate demand. With regard to the U.S. experience, one study estimates that the level of potential output is now 7 percent below what would have been expected based on its pre-crisis trajectory, and it argues that much of this supply-side damage is attributable to several developments that likely occurred as a result of the deep recession and slow recovery....

If we assume that hysteresis is in fact present to some degree after deep recessions, the natural next question is to ask whether it might be possible to reverse these adverse supply-side effects by temporarily running a "high-pressure economy," with robust aggregate demand and a tight labor market.... Hysteresis effects--and the possibility they might be reversed--could have important implications for the conduct of monetary and fiscal policy. For example, hysteresis would seem to make it even more important for policymakers to act quickly and aggressively in response to a recession, because doing so would help to reduce the depth and persistence of the downturn, thereby limiting the supply-side damage that might otherwise ensue. In addition, if strong economic conditions can partially reverse supply-side damage after it has occurred, then policymakers may want to aim at being more accommodative during recoveries than would be called for under the traditional view that supply is largely independent of demand. More research is needed, however, to better understand the influence of movements in aggregate demand on aggregate supply....

Heterogeneity: My second question asks whether individual differences within broad groups of actors in the economy can influence aggregate economic outcomes.... Prior to the financial crisis, these so-called representative-agent models were the dominant paradigm.... However, a disaggregated approach seems needed to understand some key aspects of the Great Recession.... I am glad to now see a greater emphasis on the possible macroeconomic consequences of heterogeneity, including in work by economists at the Federal Reserve. Nevertheless, the various linkages between heterogeneity and aggregate demand are not yet well understood, either empirically or theoretically.... Even though the tools of monetary policy are generally not well suited to achieve distributional objectives, it is important for policymakers to understand and monitor the effects of macroeconomic developments on different groups within society.

Financial Linkages to the Real Economy: My third question concerns a key issue for monetary policy and macroeconomics that is less directly addressed by this conference: How does the financial sector interact with the broader economy?... Consider the influence of balance sheet conditions and noninterest credit terms on spending and overall activity--an area where it is important to take account of differences across individual households and firms, as I just noted. Research on this topic has, of course, been ongoing for some time, and it has expanded greatly in the wake of the financial crisis. But I believe we have a lot more to learn....

Inflation Dynamics: My fourth question goes to the heart of monetary policy: What determines inflation?... The standard framework for thinking about inflation dynamics used by central bank economists and others prior to the financial crisis remains conceptually useful.... Questions about some of its quantitative features have arisen in the wake of the Great Recession and the subsequent slow recovery.... The influence of labor market conditions on inflation in recent years seems to be weaker than had been commonly thought.... Whether this reduction in sensitivity was somehow caused by the recession or instead pre-dated it and was merely revealed under extreme conditions is unclear.... Another gap in our knowledge about the nature of the inflation process concerns expectations.... Perhaps most importantly, we need to know more about the manner in which inflation expectations are formed and how monetary policy influences them....

With nominal short-term interest rates at or close to their effective lower bound in many countries, the broader question of how expectations are formed has taken on heightened importance. Under such circumstances, many central banks have sought additional ways to stimulate their economies, including adopting policies that are directly aimed at influencing expectations of future interest rates and inflation. The unusually explicit and extended guidance about the likely future path of the federal funds rate that was provided by the FOMC from 2011 through 2014 is an example of such a policy, as is the Bank of Japan's upward revision to its official inflation objective in 2013....

International Linkages: Before closing, let me mention one additional area where more study is needed--the effects of changes in U.S. monetary policy on financial and economic conditions in the rest of the world and the ways in which those foreign effects can feed back to influence conditions here at home.... This issue is far from settled, as are a host of other related questions, including the following: Do U.S. monetary policy actions affect advanced and emerging market countries differently? Do conventional and unconventional monetary policies spill over to other countries differently? And to what extent are U.S. interest rates and financial conditions influenced by easing measures abroad?..