EclectEcon

Every time I look at the data, it seems pretty clear to me that if aggregate demand is pushed upward, then in the short run the economy will experience reduced unemployment rates and (often with a lag) higher rates of inflation. During such a period, the unemployment rate drops below the natural unemployment rate (or the NAIRU), and that seems pretty much like what the North American economies were experiencing during the past few years. We had unemployment rates lower than we had seen for the past 25-30 years. These numbers make it seem that our economies had been pumped up by the spending supported with loose credit conditions.

We learned in the late 70s and 80s that we cannot sustain these low unemployment rates by continuing to inflate aggregate demand. Eventually the unemployment rates rise back toward their natural rates. This process of having our unemployment rates rise as we slide along the short-run Phillips Curve is not the same thing as an inadequate-aggregate-demand-induced recession; rather, it is a reversion to long-run equilibrium. Furthermore, any attempts to head off this reversion to the long-run are likely to be highly inflationary. Both the Fed and the Bank of Canada will have to be very careful not to over-inflate our economies in a futile attempt to reduce or hold unemployment below the natural rates.

Making things worse, it is likely that the long-run vertical Phillips Curve is shifting to the right (increasing the natural unemployment rate), at least temporarily, as the economies suffer some short-run aggregate supply shocks:

1. The liquidity crisis is not just affecting aggregate demand; it is accompanied by a decline in the production of financial intermediation, a supply effect (cf Tyler Cowen, with thanks to Gabriel Mihalache).
2. Rapid growth in the developing economies has led to a tremendous increase in their demand for commodities. This, in turn, means the prices of these goods are higher for North Americans, which has the same effect as any other supply shock in the economy [h/t to BrianF for this one].

Both of these supply shocks will tend to raise the unemployment rate, at least temporarily (for several years?) above what would otherwise be the natural unemployment rate. And the sad thing is that the central banks will try to deal with them by increasing aggregate demand, but their doing so will not help the unemployment picture much, but will put more upward pressure on the rate of inflation.