Endogenous Aggregate Supply
A recent Federal Reserve paper makes the case that potential GDP is to some extent endogenous to aggregate demand shocks:
The recent financial crisis
and ensuing recession appear to have put the productive capacity of the
economy on a lower and shallower trajectory than the one that seemed to be
in place prior to 2007… [We]
argue that a significant portion of the recent damage to the supply side of
the economy plausibly was endogenous to the weakness in aggregate
demand—contrary to the conventional view that policymakers must simply
accommodate themselves to aggregate supply conditions. Endogeneity of supply
with respect to demand provides a strong motivation for a vigorous policy
response to a weakening in aggregate demand.
Up until the point where the line splits into three pieces, assume
the economy is in long-run equilibrium with output at the natural rate…Then, for some reason, aggregate
demand falls leading the economy into a recession. As AD falls, people
are laid off, equipment is stored, factories are shuttered, and so on
and the economy’s capacity to produce falls in the short-run as shown
by the blue line on the diagram.
But this is a temporary, not a permanent situation. Eventually people
will be put back to work, trucks in parking lots will be back on the
road, factories will reopen — you get the picture — and productive
capacity will grow as the economy recovers. I believe many people are
treating what is ultimately a temporary fall in capacity as a permanent
change, and they are making the wrong policy recommendations as a
result.
In fact, there’s no reason to think productive capacity can’t return
to its long-run trend just as fast or faster than output can recover.
If so, then it would be a mistake to do as many are doing presently and
treat the blue short-run y* line as a constraint for policy, conclude
that the gap is small and hence there’s nothing for policy to do.
Capacity will recover…
There are, though, potential drags on the aggregate supply that could prove more lasting. For example, the ACA may have non-trivial effects on the labor supply according to Casey Mulligan. The question is how big of an effect developments like these will have on trend growth. Even if large, they still could be offset by further productivity gains. Ultimately, this is an empirical question.
Source: http://macromarketmusings.blogspot.com/2013/11/endogenous-aggregate-supply.html
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