The prevailing macroeconomic textbook wisdom is that aggregate demand shocks determine short-run cyclical fluctuations around an equilibrium GDP (potential output) and an associated equilibrium unemployment rate or NAIRU. These are determined by supply factors and, in New Keynesian models, by the institutional setting causing some real rigidities; they are independent of aggregate demand fluctuations, and are viewed as ‘attractors’ towards which the economy tends to return (Solow 1997; Taylor 2000; Blinder 2004). However, the long stagnation after 2008 has increasingly called this conventional view into question, so much so that Janet Yellen has recently very explicitly put it in doubt:
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?
Actually, several papers have recently shown that after the 2008 recession, estimated potential output has declined and the estimated Nairu has increased in most countries, and several others have provided evidence based on the experience of many countries over a long time period (from the 1960s to the present) that it is generally true that recessions have persistent effects on the path of GDP, questioning the notion that it would return to an independent, supply determined trajectory (Ball et al. 1999; Ball 2009, 2014; Blanchard et al. 2015; Cerra and Saxena 2009; Fatàs and Summers 2016; Haltmaier, 2012; Martin et al. 2015; Reifschneider et al 2015).
Moreover, already in the past there had been empirical findings suggesting that fluctuations in output tend to be associated with rather persistent changes in GDP trajectories.
One such strand, stemming from Nelson and Plosser (1982), is the literature on unit roots in GDP series. Empirical testing has proved controversial and to some extent inconclusive (Cushman 2016), but econometric research along these lines appears on the whole to conclude that fluctuations tend to be associated with persistent changes in GDP trajectories, and that if there is at all a return to an independently determined GDP trend, this must be extremely slow, much beyond the commonly assumed horizon for cyclical fluctuations and economic policy (Diebold and Rudebush 1989; Martin et al. 2015, p. 3). The ‘real business cycle’ literature has interpreted this as evidence that cycle and trend are determined by the same factors, i.e., supply determined. However, this evidence could be interpreted the opposite way: if aggregate demand drives (most) fluctuations, as many economists believe and as pointed out by empirical evidence (see for example Gali 1999), then both cycle and trend would be driven by aggregate demand (Fatàs and Summers 2016, p. 16).
Evidence of GDP unit roots and path dependency of ‘equilibrium’ unemployment (the Nairu) (Blanchard et al, 2015, and for a comment, Stirati, 2016) are, from the conventional viewpoint, puzzling phenomena still in search of a widely shared explanation (Ball 2009, p. 3; 2014, p. 8). The ones most commonly provided in New-Keynesian literature are: i) models according to which negative shocks interact with ‘rigid’ labour market institutions which tend to render the higher unemployment persistent over time (Blanchard and Summers 1986; Lindbek and Snower 1985; Krugman, 1994); ii) the increase in long-term unemployed, who then lose their skills and/or become detached from the labour market and hence do not exert a competitive pressure on wages (Blanchard and Diamond 1994; Ball et al. 1999; Ball 2009); and iii) the effects of aggregate demand on capital formation (Rowthorn 1995; and more recently Haltmaier 2012, p. 1; Ball 2014, p. 1; Fatàs and Summers 2016, p. 16; Martin et al. 2015, p. 8).
However, a typical conclusion in this literature is that persistence only results from negative shocks, which generate higher equilibrium unemployment and lower potential output. Once the economy has reset, attempts to increase output and lower unemployment by means of aggregate demand management would result in high and accelerating inflation (Martin et al, 2015; Duval et al 2011).
In a recent paper (Girardi, Paternesi-Meloni, Stirati, 2017) we have been willing to critically assess this latter view. The relation between our research and the literature on hysteresis is thus two-sided. While in line with the above literature we assess the persistence of aggregate demand effects on GDP and other key macroeconomic variables, in contrast with much of that literature our main purpose in the paper is to test whether ‘persistence’ is also detected in instances of expansion of aggregate demand, and specifically of its autonomous components. Also, unlike much of the hysteresis literature we look at the effects on actual, observable variables rather than on indirectly estimated ones such as potential output and the Nairu.
In order to investigate the effects of positive demand shocks, we have singled out 94 episodes of demand expansion in a panel of 34 OECD countries between 1960 and 2015. We identify demand expansions by looking at the sum of primary public expenditure (comprising public consumption, transfers except interest payments and capital formation) and exports, a variable we call ‘autonomous demand’. We define an expansion as a large yearly percentage increase in autonomous demand, ‘large’ meaning higher than the country mean by more than a standard deviation. We then employ local projections (Jordà 2005) to analyze the impact of these expansions on GDP and other key macroeconomic outcomes in the subsequent ten years. Of course, a key challenge associated with our analysis is that demand expansions could be partly endogenous. Indeed, we find that country-years associated with an expansion are different from the others. However, we show that observable differences between ‘expansion episodes’ and ‘control group’ observations are eliminated by controlling for a full set of country and year fixed effects, which we thus include in all our empirical specifications. We employ two main approaches to estimate our effects of interest: a two-way fixed-effects model, analogous to a standard difference-in-differences estimation, and a propensity score-based specification which explicitly models selection bias.
We find a highly significant and strikingly persistent level effect on GDP. A one-off increase in the level of our autonomous demand variable, relative to the control units, by (an average of) 5% is associated 10 years later with a (log) GDP level 3% higher than in the control group, with no sign of mean reversion. This GDP expansion is associated with a non-statistically significant, small (about half percentage point) and short-lived rise in the inflation rate. Expansions also persistently reduce unemployment and increase labour participation, employment and the capital stock. Effects on productivity are strong and quite persistent, although evidence regarding their permanence is more mixed. Long-term unemployment diminishes in the medium run (the effect lasting 4 to 5 years after the expansion). Our empirical analysis also makes it clear that these effects are not driven by productivity increases or real interest rate declines taking place before the expansion episodes.
Thus, in contrast with the conventional wisdom, our empirical results suggest that production, employment and unemployment are not independent of aggregate demand even in the long run. In addition to this, they suggest that elements typically regarded as ‘supply side’ factors such as labour participation, capital and productivity are also not independent from it.
In important respects, our results concerning the persistent effects of aggregate demand expansions also run counter the logic of hysteresis models, given that we do not find that expansions cause, along with a persistent level effect on GDP, accelerating inflation. In addition, the fact that expansions (similarly to recessions, as shown by the literature quoted above) are shown to have persistent effects in general, i.e. looking at many countries and several episodes of expansion over a very long time span, along with our results concerning the changes in unemployment and long-term unemployment, are not consistent with hysteresis models based on the role of institutions or long-term unemployment.
On the other hand, our findings about the effects on the capital stock are consistent with much empirical literature showing that aggregate private investment largely depends on lagged GDP, and little, if at all, on interest rate. Already in 1986 Blanchard wrote:
The discrepancy between theory and empirical work is perhaps nowhere in macroeconomics so obvious as in the case of the aggregate investment function. […] The theory from which the neoclassical investment function was initially derived implies that one should be able to specify the model equally well whether using only factor prices or using output and the user cost of capital. We all know that this is not the case. […] It is very hard to make sense of the distributed lag of output on investment. […] Finally, it is well known that to get the user cost to appear at all in the investment equation, one has to display more than the usual amount of econometric ingenuity, resorting most of the time to choosing a specification that simply forces the effect to be there
Since then, much additional evidence has accumulated against the conventional view and supporting the effect of GDP growth on private investment.[1] Hence, there is much evidence to support the explanation of hysteresis based on the effect of aggregate demand on capital formation, with the extremely important qualification that such effect holds after expansions too, and without inflationary effects.
These results have some relevance in connection with the recent debate on secular stagnation. One of the issues addressed by the literature is why recovery has been very slow since the 2008 crisis, and there is no sign of a return to the GDP forecasts made prior to 2008 (despite the expansionary stance of monetary policy). The literature has attributed this to three (separate or interlinked) factors: i) a negative equilibrium real interest rate; ii) slow (or even negative) growth due to structural factors, such as demographic and technological trends; and iii) hysteresis. As mentioned however a number of recent papers, such as Blanchard et al. (2015), Martin et al. (2015), Cerra and Saxena (2009), Guajardo et al. (2014); Jordà and Taylor (2015), among others, show that persistent effects of recessions or fiscal consolidations are not a peculiarity of the current situation (hence, of supposedly negative equilibrium interest rate, or relatively new structural phenomena) but are very pervasive. Therefore ‘hysteresis’ or, as we would prefer to call it, ‘persistence’ appears to be the best line of interpretation of the current situation within the ‘structural stagnation’ literature. In addition, although we deal with level effects and not with trends and growth rates, our results support the view that stagnation of some major components of aggregate demand explains the slow post-2008 recovery, as well as relatively slow growth in the earlier period (see Cynamon & Fazzari, 2017, concerning the US case). Thus, the peculiarity of the current situation would lie in the size of the 2008 shock, and in a number of concurrent factors, such as private debt deleveraging, high and increasing inequality in income distribution, stagnant wages, contractionary fiscal policies, large trade imbalances, which all negatively affect aggregate demand. Our results hence support the view that fiscal stimulus would be the most appropriate policy response (Summers 2015; Turner 2015).
Our empirical results lead to the question of what the economic mechanisms working behind them are, and which analytical framework would be consistent with them. Clearly, a positive link between non-investment autonomous components of aggregate demand, GDP and capital accumulation in the long run is inconsistent with macro models in which an increase in public spending, or any other autonomous components of demand, causes a crowding out of private investment and/or private consumption. More generally this is inconsistent with the view that an increase in the autonomous components of demand will cause rising inflation while only temporarily, if at all, an increase in output, which in the medium to long run must be regarded as determined by factor endowments, technology and institutions – all of them independent of aggregate demand.[2]
However, the outline of a reasonable analytical framework consistent with the findings can be traced by linking and bringing to their logical conclusions a number of observations and analyses that are shared by many scholars and empirically supported. Its essential interconnected ingredients appear to be the following:
- In any given period, with given capital stock, aggregate demand can differ persistently from the aggregate output that would be forthcoming if the existing fixed capital was normally utilized (that is, was utilized in the degree planned by firms when installing the equipment). This is in fact simply a restatement of Keynes’s principle of effective demand, while the conventional countervailing feed-back effects, based on changes in the interest rate (owing to Central Bank’s policy or endogenous changes in the price level) and their effect on investment, have not proven to be empirically relevant.
- Persistent underutilization or overutilization of plants induces firms to adjust their capital equipment, as envisaged by the flexible accelerator principle. Accordingly, the existing capital stock in any given period may not be sufficient to employ the entire labour force,[3] and hence labour reserves can generally be available, either in the form of involuntary unemployment or discouraged labour, even when the planned degree of capacity utilization prevails – quite independently of institutional ‘rigidities’.
- It must generally be possible, even when fixed capital is used in the degree initially planned by firms, to increase output simultaneously in investment goods and consumption goods sectors. This requires not only that labour availability is normally not a binding constraint (point b above) but also that even firms that are using capacity in the planned degree have some margin for increasing production, i.e. the planned (average) degree of utilization does not coincide with the maximum. This is a fact much discussed in the literature and confirmed by statistical surveys (Corrado and Mattey, 1997).
As capital and employment adjust to increased production, inflationary pressures that might arise from increasing costs associated with overutilization of fixed capital or labour (overtime, night shifts, increased maintenance costs, bottlenecks in some branch of production, etc.) would fade away. The only remaining inflationary tensions would be those that may be brought about by an intensification of wage pressure and distributive conflict resulting from lower unemployment and faster employment growth (Stirati 2001; 2011; 2016). Our results (along with those of the literature cited in the previous section, and particularly Blanchard et al. 2015; Ball et al. 1999; Ball 2009) however, suggest that this does not in general lead to accelerating inflation.
On the basis of the above points, autonomous demand changes can be said to have long-run effects on GDP in two senses. First, with given capital stock, as long as the change in autonomous demand persists, there are no feed-back mechanisms (i.e., offsetting changes in private investments or consumption) that will systematically drive total aggregate demand back to the output associated with the planned degree of utilization of the existing capital equipment. Second, the changes in autonomous demand and capacity utilization will affect aggregate private investment and hence installed productive capacity, i.e., they will affect ‘potential output’, redefined here as the output forthcoming at the planned degree of utilization of the existing fixed capital stock. Employment will tend to vary in the same direction, and may accordingly stimulate changes in labour force participation.[4]
Overall, this broad framework of analysis is consistent with our empirical results as well as those presented in several papers concerned with persistent effects of recessions and fiscal consolidations.
Summing up and policy
The dependence of capital formation on aggregate demand growth appears to be the most convincing and empirically supported explanation of the persistent effects on GDP resulting from shifts in aggregate demand.
The policy implications of our results (viewed along with the literature concerning the persistent effects of recessions and fiscal consolidations, and the weakness of the relationship between unemployment and inflation) are rather interesting and at variance with the prevailing official wisdom, particularly in European institutions. The conventional trade-off in macroeconomic policy is reversed: aggregate demand expansions bring about persistent effects on GDP, the capital stock, participation and employment at the cost of an extremely short-lived and moderate increase in inflation. Accordingly, neither productivity nor labour supply and capital endowment can be regarded as entirely independent of aggregate demand.
As noted, to some extent similar conclusions have been reached by recent literature on hysteresis; but while hysteresis conveys the idea of a distortion in the normal functioning of the system, caused by some obstacles to the return to what would have been in some sense the natural outcome of free market forces, our results, covering a long period of time and many countries, and the underlying process described above, suggest that the persistence of the effects of aggregate demand changes are indeed the results of the normal functioning of market forces.
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Footnotes
We are grateful to Michael Ash, Thomas Ferguson, Fabio Petri, Servaas Storm and the participants in a seminar organized by Roma Tre Economics Department and Centro Sraffa for helpful comments on earlier drafts of this paper. Any remaining errors are of course our own. Financial support from INET is gratefully acknowledged.
[1] Chirinko (1993), Ford and Poret (1990), Girardi and Pariboni (2017); Khotari et al. (2014), Onaran and Galanis (2012), Sharpe and Suarez (2014) Schoder (2014), Wen (2007). The empirical problems in turn are, in our view, connected to underlying analytical ones. For a critical survey, see Girardi 2017.
[2] We do not address here real business cycle versions of macroeconomic theory – however, our findings that increases in productivity follow and do not lead our expansionary episodes is clearly at variance with that approach.
[3] As was for example the case in Europe in the 1990s, according to Gordon (1995) and Rowthorn (1995) among others.
4 The analytic premises and consequences of the above propositions for the analysis of accumulation were discussed in pioneering research carried out by Garegnani in the early 1960s (Garegnani, 1962 [2015]; see also Garegnani, 1978–79), and have since then stimulated research on the role of demand in accumulation processes; for a survey, see Cesaratto (2015); see also various contributions in Cesaratto and Mongiovi (2015, eds) and Levrero, Palumbo and Stirati (2013, eds, vol. 2). The stability conditions for growth processes with autonomous components of demand and induced investment are discussed in Freitas and Serrano (2015), and essentially rely on the endogenous changes in the average propensity to save associated to the existence of autonomous components of demand and on the graduality of the adjustment of capital to changes in demand and expected output. Empirical research explicitly assessing the usefulness of the approach for the understanding of actual accumulation processes has recently begun to develop: see Freitas and Dweck (2013) on Brazil, and Girardi and Pariboni (2016) on the US; Fazzari et al, 2017 for simulation exercises. In the 1990s a seminal paper by Badhuri and Marglin (1990) also stimulated research on demand-led growth, albeit in a different analytical framework; recently, however, there has been a degree of convergence between these two streams of research (see Cesaratto 2015; Lavoie 2016).
