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." They would have broadly agreed with Robert Solow that economic output over the longer term is primarily driven by supply--the amount of output of goods and services the economy is capable of producing, given its labor and capital resources and existing technologies. Aggregate demand, in contrast, was seen as explaining shorter-term fluctuations around the mostly exogenous supply-determined longer-run trend.1 This conclusion deserves to be reconsidered in light of the failure of the level of economic activity to return to its pre-recession trend in most advanced economies. This post-crisis experience suggests that changes in aggregate demand may have an appreciable, persistent effect on aggregate supply--that is, on potential output.
It seems likely that demand shocks have at least a transitory impact on aggregate supply, if only because they impact investment. But I think Yellen is making a mistake here, which could lead monetary policy astray if we are not careful.
There are good reasons why most economists have viewed AS and AD shocks as being independent, at least as a first approximation. Deep recessions such as 1907-08, 1920-21, 1929-33, 1937-38, 1981-82, etc., are usually followed by fast recoveries. The recent 2007-09 recession is of course an exception. But should we re-evaluate the basic model based on a single exception?
Suppose the model is revised, and we now assume that deep recessions lead to a long period of sluggish growth as aggregate supply is depressed. In that case we will have not one mystery to explain (2007-09), but dozens. A more plausible explanation of the recent period is that the Great Recession just happened to coincide with a slowdown in trend growth. The unemployment rate did recover, which is exactly what you'd expect if my theory were correct. Instead, other factors not usually linked to AD seem to explain the slowdown. These include a slowdown in the growth rate of the working age population as well as a slowdown in productivity growth. Could the Great Recession have caused the sharp slowdown in productivity growth? I suppose anything is possible, but in that case why didn't previous deep recessions lead to slowdowns in productivity growth?
There's another, and in my view even more persuasive argument against Yellen's theory. The models that try to explain why AD might depress AS tend to predict lower levels of RGDP, but no permanent reduction in the growth rate of RGDP. This might reflect discouraged workers retiring or going on disability, as well as a slightly smaller capital stock. Neither factor should reduce the long run trend rate of growth in RGDP--it's one-time level reduction.
Now admittedly it's too soon to say the long run trend rate of growth has slowed. But this leads to the biggest problem with Yellen's hypothesis: long-term interest rates are extremely low, both in nominal and real terms. The overwhelmingly most likely explanation of the lower than normal long-term real interest rate is that the market expects sluggish RGDP growth to be the new normal. If that's the case, then there is really no plausible AD model to explain this slowdown. It's just barely possible that the 2008 recession depressed output by 5% today (although I doubt it) but it's completely implausible that it would depress output by 20% in the year 2030.
More likely, the US is being impacted by the same factors that have slowed growth throughout the developed world. We don't fully understand those factors, but they include a slower growth rate in the working age population, and a shift to a service-oriented economy where productivity gains are harder to achieve. Those problems cannot be fixed by "making the economy run hot" to boost aggregate supply.
Rather than trying to solve supply-side problems with monetary policy, I'd like to see central banks concentrate on refraining from causing problems by refraining from policies that generate unstable NGDP. Let other policymakers try to undo the tangle of taxes and regulations that are preventing our economy from reaching its full potential.