From the CEA’s report “The Economic Impact of Recent Temporary Unemployment Insurance Extensions” released earlier today.
…CEA estimates that in December 2011, without a year-long extension:
- Employment would be 593,000 lower than if there were an extension;
and- GDP would be 0.6 percent lower than if there were an extension.
These conclusions are depicted in Figure 5 from the report.
Source: CEA, “The Economic Impact of Recent Temporary Unemployment Insurance Extensions,” (December 2, 2010).
For a discussion of the implications of UE on unemployment and employment, see the analysis here.
Here’s another great analysis by a recent winner of the John Bates Clark medal:
http://elsa.berkeley.edu/~saez/landais-michaillat-saezNBER10UI.pdf
Abstract:
This paper analyzes optimal unemployment insurance over the business cycle in a search model in which unemployment stems from matching frictions (in booms) and job rationing (in recessions). Job rationing during recessions introduces two novel effects ignored in previous studies of optimal unemployment insurance. First, job-search efforts have little effect on aggregate unemployment because the number of jobs available is limited, independently of matching frictions. Second, while job-search efforts increase the individual probability of finding a job, they create a negative externality by reducing other jobseekers’ probability of finding one of the few available jobs. Both effects are captured by the positive and countercyclical
wedge between micro-elasticity and macro-elasticity of unemployment with respect to net rewards from work. We derive a simple optimal unemployment insurance formula expressed in terms of those two elasticities and risk aversion. The formula coincides with the classical Baily-Chetty formula only when unemployment is low, and macro- and micro-elasticity are (almost) equal. The formula implies that the generosity of unemployment insurance should be countercyclical. We illustrate this result by simulating the optimal unemployment insurance over the business cycle in a dynamic stochastic general equilibrium model calibrated with US data.
Do we not want the economic impact of UI to be going down? Ideally everyone on UI will find a job and its impact will be zero. Now I know this is not likely, but one should not see that dropping red line and think “something must be done”!
2slugs,
This is exactly what we have done. UI benefits have become more generous during the downturn. The economy is starting to turn the corner. If countercyclical UI benefits are optimal, then the current level of generosity should be the peak.
So paying people not to work leads to more jobs? Seems counter intuitive. Given the great projections that the WH made of unemployment with and without the stimulus, why should I trust these projections? I don’t.
Oh my, this is economics here, not partisan politics or Fox News. Let’s just keep this simple…if you cut off unemployed people’s benefits they lost their ability to spend right? How man people will fall from the rolls overs the time indicated on the graph? How much would they have spent, vs. how much now that they are not getting anything? What does that do to the economy? If you take the dollar total of the benefits away from the economy in general, what does that do to demand/employment? Not hard to figure out.
And if you think you are “paying people not to work” let me suggest that you live on around $500 MAXIMUM or so a week for a family of 4. Let’s see if you agree that is “paying someone not to work”. I don’t know about you, but even the lowest skilled workers tend to make more than this. So giving people UE, keeps them spending and paying their bills, not defaulting on debt (driving up the cost of credit etc because SOMEONE is going to pay for it and it’s the rest of us…just like health care).
Honestly, what’s happened to the basic education system that people don’t even intuitively know this? Oh right, blinded by ideology. Then if you see facts, you just dispute them, sort of like fundamentalists with bible mistakes and contradictions.
econominium: You make good points. Out of curiousity, what would need to happen for you to support not extending unemployment benefits?
I’d have to see better employment reports than I did today for starters. And I agree that the extensions can’t go on indefinitely, but the sheer number of unemployed now, coupled with the low rate of participation would surely suggest that now is NOT the time to do this.
The time to start is when you see three solid months of employment gains and improvement in the participation rate. So extend for another 12 weeks or so and then check it. But by the numbers, this talk is vastly premature.
-ium
I don’t think you make good points. You may think UI benefits are not enough to live on, yet many do. And where do you think the money to pay for the benefits come from, the government? How about the spending/saving that does not occur because workers are being taxed to pay for UI benefits?
To paraphrase Bastiat, the benefits are seen but the side effects (less money for those being taxed) are not. At least not by you.
enconominium I’d have to see better employment reports than I did today for starters. And I agree that the extensions can’t go on indefinitely.
Fair enough, but then what part of your previous argument (i.e.if you cut off unemployed people’s benefits they lost their ability to spend right? How man people will fall from the rolls overs the time indicated on the graph?…) no longer applies that allows you to say extensions cannot go on indefinitely?
If the benefits are a net plus to the economy, then why end them?
Rich Berger A little friendly advice. If you want to be taken seriously, don’t quote Bastiat unless you’re hanging out at some crackpot Austrian site like von_Mises.
And this statement makes no sense whatsover:
“How about the spending/saving that does not occur because workers are being taxed to pay for UI benefits?”
Why the slash between spending and saving? Those are either/or outcomes. Income is either spent or it is saved. The problem today is that there is too much private sector saving, which leads to weak aggregate demand. In the absence of strong private sector demand for goods and services, it’s up to the government to act as the spender of last resort and absorb all that excess private savings. Sorry, but your whole string of posts is just a series of muddled ramblings.
tj Yes, the kind of countercyclical UI policy is more or less the kind of policy that we have been pursuing, but in spite of the GOP. Crackpot GOP congress critters would have cut off unemployment payments long ago. And we have probably turned the corner and (barely) avoided a depression, but we are a long ways from being out of the woods. The economy is only creating enough jobs each month to barely keep up with population growth. It will be a long time before people who are currently out of work for an extended period of time will have any chance at all of finding new employment. Some of them are probably permanently unemployable by now and eventually society will to come to terms with that. That’s why it would have been better if those folks had been employed doing “make work” projects as planned under the original Obama stimulus plan.
Ryan Stambaugh: If the benefits are a net plus to the economy, then why end them?
Ugh. Let’s try this one more time, only v-e-r-y s-l-o-w-l-y. The reason unemployment benefits are good for economic growth is because the central economic problem we face today is weak aggregate demand. Unemployment insurance increases aggregate demand, which raises total economic output. But eventually the economy will recover and weak aggregate demand will be a thing of the past. At that point the central economic problem becomes finding ways to push out the aggregate supply curve. In other words, eventually we’ll get back to normal, run-of-the-mill economic issues. At that point it no longer makes sense to extend unemployment benefits beyond what is needed to manage ordinary short term structural employment problems. Got it? There is no single economic policy that should be pursued at all times. You adopt the policy tool that is best suited to fix the current problem. Right now the problem is weak aggregate demand, so we need policies that address that problem. When the central problem changes, then so too should the policy.
Tis a devastating graph and I can see the anxiety it causes here among the Jobbed, (payin taxes for those slackers!) or part-timed or seasonal workers (just back from the fishin grounds) or the no longer jobbed,(could be a few here…not many) or the semi-retired/retarded (you know who you are!)
No, the real anxiety of those whose ideology got stuck at 1990.
That’s the ting about ideology, yes? It gets stuck *somewhere* otherwise we can discourse reasonably –instead of feeling compelled to shout down (and over) and over again, the totally obnoxious crankpots.
Ok, Menzie thanks for the post, that mathematical notation characterizing UI,UE et al, those broad guidelines re careful reading/linking …and the care you take that Mulligan doesn’t.
2slugbaits I can tell when I’m winning a debate or the other person is losing it by the fact they get personal.
Your flaw is in that you really are not understanding what exactly it means to say there is weak aggregate demand, i.e. what the cause of it is and therefore what the remedy is.
Could it be a solution to provide extended benefits subject to a clawback, eg, the recipient would have to repay any support at 2x the normal UI rate after returning to work until the amount of support was repaid?
This would solve the disincentive to work issue, while permitting a continuation of benefits in a still very poor job market, as well as taking some of the pressure off the deficit, at least over time.
The austerians are already on the offensive. The CEO of PIMCO was on Bloomberg this morning with “estimates” that not extending the UI past current lengths would only reduce GDP growth by 0.1%.
2sb-
A little unfriendly advice – Bastiat had his finger on a basic flaw in simplistic analysis like yours. I know you feel like you can dispose of logic with a slur, but it just highlights your ignorance.
Second, try to understand what I mean before you jump to conclusions. What I clearly meant is that money taxed away could be spent or saved. If my taxes go up next year I will reduce my spending and my saving. I do not yet know the proportions and I am optimistic that the Republicans will shame the Democrats into deferring the tax increase at least until the change in administration.
I think the emphasis on spending as much as possible is fundamentally wrong. Production and increases in productivity comes out of savings. If all is consumed, there is no surplus to build capital. Furthermore, employing a person in a make work job just means that he or she has to find a new job once the make work ends.
TJ wrote:
“The economy is starting to turn the corner.”
Huh? Do you mean through the guardrail and off a cliff?
We’ve had below average RGDP growth for two consecutive quarters, there were 55,000 fewer payroll jobs in November than in May, and the unemployment rate just hit 9.8%, the highest level since April. Not only that but the employment to population ratio just fell to 58.2%, tied with December 2009 for the lowest level in 27 years.
And the prospects for an increased level of aggregate demand? Less than zero. QE2 likely will end up as inert bank reserves thanks to interest on excess reserves (instituted for the first time in Federal Reserve history on October 6th 2008). And thanks to the GOP takeover of the House there’s absolutely no prospect for additional discretionary fiscal stimulus. All this with core deflation imminent.
Now’s just the dandiest time to cut off 2 million households from UI.
Fasten your seatbelts and get ready for real fun to begin.
Rich Berger: From your comment on 10/22/2007:
That was your prediction back then; how does it compare? You also ruled out a 50% reduction in home values; we are now 33% down by the Case-Shiller, surely by more in real (PCE deflated) terms. In fact, it’s down by 45%…(log terms).
I assure you, I will laugh about that for years on end. And you persist in keeping me in stitches. You are indeed the gift that keeps on giving. Thank you.
Well Menzie, I have always been happy if I can bring a little sunshine into someone’s life. Nevertheless, I cannot find the comment you are citing – what post was it in response to?
Rich Berger: Apologies, the link is now there in the comment. You were commenting a “distressing picture of the day”.
Menzie-
Found it – https://econbrowser.com/archives/2007/10/distressing_pic_1.html#more.
I made a number of posts including one pooh-poohing a claim that the value of housing would fall to $10 T. According to http://www.freddiemac.com/investors/pdffiles/investor-presentation.pdf, it’s currently around $17T.
I think you misread my specific post which indicated that the long term return on housing was a little above inflation. My bigger point was that doomsayers are usually wrong in the long run.
Rich Berger: I agree the value of housing has “only” fallen about $5 trillion, so “only” about 22% fall.
Regarding long run returns, well, we’ll see. In the long run, many things are true. Heck, we may even see Dow 36,000 someday.
ryan stambaugh No one knows the cause of weak aggregate demand. There are plenty of candidates; but we don’t need to know the causes of weak aggregate demand to understand how to fix it. People still debate what caused the Great Depression, but what policies we pursued to get us out of the Depression have been long settled. For whatever reason people are sitting on money. It could be because they are repairing balance sheets. It could be because they are anticipating deflation. It could be that whatever spending people are doing is leaking out through imports. Could be a lot of things. Doesn’t matter why aggregage demand is weak; it just is.
Rich Berger Bastiat is interesting if you’re a sophomore taking your first history of econ thought class. Most econ students grow out of him before they graduate.
“money taxed away could be spent or saved.”
What do you think happens with income that’s taxed? Do you think that the govt just buries the tax receipts in some abandoned mine in Utah? It gets spent. Ever hear of something called a balanced budget multiplier? Given an output gap, one dollar taxed and spent will generate more aggregate demand than a dollar left as disposable income. The proof is easy. Go look it up.
“I think the emphasis on spending as much as possible is fundamentally wrong. Production and increases in productivity comes out of savings. If all is consumed, there is no surplus to build capital.”
We’re in a midst of a deep recession. Output is running far below potential output. Today’s economy suffers from many maladies, but weak productivity and strained capital stocks are definitely not among those problems. Consumption and saving are out of balance right now. No one recommended “spending as much as possible,” so that’s a fake argument. The problem is that there’s a global glut of savings, and if someone wants to save money, then someone else has to borrow it. Borrowing and saving are two sides of the same coin. You cannot increase savings without increasing borrowing. The problem is that no one wants to borrow either. Result: we get an implied NAIRU clearing interest rate that’s negative, but the Fed is constrained by a zero lower bound. So it’s the government’s job to be the borrower of last resort, and if it’s the borrower of last resort it also has to be the spender of last resort.
-2slugbaits
Mmm no it is pretty easy to figure out why aggregate demand is weak. Unemployed people have less money. Foreclosed homes generate no equity lines of credit. Debt constrained consumers can’t rack up any more credit purchases. Aggregate demand sucks because the consumer got wrecked. If you want to bring aggregate demand back, target each of those problems.
UI insurance = unemployed people are spending again.
Mortgage Cramdowns = homeowners opening up home equity lines of credit again.
Bankruptcy courts = debt constrained consumers are going back into debt again.
2slugbaits: I think you must have the highest rate of non-sequiturs per post as anyone I’ve seen. “Consumption and saving are out of balance right now….we get an implied NAIRU clearing interest rate that’s negative, but the Fed is constrained by a zero lower bound. So it’s the government’s job to be the borrower of last resort” I may regret this, but what on earth are you talking about?
This is a post on UI. However I couldn’t help but notice the exchange between Menzie and Rich Berger on real estate.
The best cure for the delusion that in the long run real estate appreciates is data. Fortunately Shiller maintains an Excel file on historical US real home prices here:
http://www.irrationalexuberance.com/
You’ll note that his real home price index stands at 110.2 in 1898. Nearly one hundred years later (on the eve of the bubble) it stands at 109.6.
Not convinced? Try this paper by Piet Eichholtz on for size:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=598
In 1632 his index of real housing prices on the Herengracht Canal in Amsterdam is 213.2. Three hundred and forty years later in 1972 it stands at 218.7.
Real estate does not and cannot appreciate over the long run for common sense reasons. Some people just have to learn that the hard way.
P.S. Between 1732 and 1814 (82 years) the Herengracht Index fell from 358.7 to 68.1 for a decline of over 80%. In Japan the real land price index has fallen by nearly 60% over the period from 1990 to the present. It is possible for real estate bubbles to decline by over 50% and for very long periods of time.
Anonymous “I may regret this, but what on earth are you talking about?”
Not that complicated. Currently there’s so much excess savings floating around and so little demand for that savings that the market clearing interest rate needed to maintain full employment is negative…probably around -4% or so. But the Fed cannot set a negative nominal interest rate. That’s one reason Krugman and others think a little positive inflation above the Fed’s target wouldn’t be a bad thing; i.e., a zero nominal rate coupled with inflation would effectively give us a negative real rate, which is what the economy needs to return to full employment. Like I said, not that difficult.
Jason Wolfe Yes, all of those things contribute to weak aggregate demand right now, but I don’t think that’s what Ryan had in mind when he asked about what “caused” weak aggregate demand. I think he was asking what caused the unemployment that caused people to have less money; what caused the foreclosed homes that caused people to have shorter equity lines; what caused the consumer to get wrecked. The govt has limited policy tools to deal with weak aggregate demand…it’s basically monetary policy or fiscal policy. Okay, I’m ignoring exchange rates, but that’s because I don’t think the govt has all that much direct control over exchange rates, and what control the govt does have is reducible to monetary or fiscal policy choices. We need to spend on unemployment insurance, back up state and local govts, gin up some infrastructure projects, and then cut back like hell and raise taxes once the economy gets its legs back.
2slugbaits wrote:
“That’s one reason Krugman and others think a little positive inflation above the Fed’s target wouldn’t be a bad thing; i.e., a zero nominal rate coupled with inflation would effectively give us a negative real rate, which is what the economy needs to return to full employment. Like I said, not that difficult.”
Or we could fix things with a monetary policy that wasn’t focused on interest rates and more focused on results (NGDP targeting a la Menzie Chinn).
2slugbaits wrote:
“We need to spend on unemployment insurance, back up state and local govts, gin up some infrastructure projects, and then cut back like hell and raise taxes once the economy gets its legs back.”
There’ll be less need to “cut back like hell” than you realize. AS is flat as a pancake right now. Inflation is long on the way.
I generally agree with you but there’s no need to give an inch. After all they (the buttheads) will take a mile.
It’s not hard to understand why demand is deficient if you start from “desired savings”. Households’ desire to save has taken a big jump. They want to spend less than their income, to improve their balance sheets. You can see this in the personal savings rate, which has jumped to over 5% despite the fact that huge numbers of people are unemployed, unable to exchange their labor for income, and in general being forced into dis-saving.
Why has the desired savings rate increased? Three factors: (1) For 30 years, but accelerating after 2000, households took on more and more debt. Look at a series like household debt vs. median income. Households felt OK about that, because it was balanced by rising asset prices, specifically houses. They became more leveraged, but maintained their net worth. Now house prices have fallen, stocks fell, a lot of people looked at their balance sheet and asked, “How the heck am I going to retire? I’d better start saving more.” (2) Income insecurity. Do you think your job might disappear? If it did, could you find another that pays just as well? A lot of people are worried, and saving to build a cushion, just in case. (3) Credit restrictions. Not so much “desired savings”, but many of those who might desire to dis-save are now unable to; in the aggregate, this contributes the same.
Everyone’s income is someone else’s spending. We can’t all save (have income higher than spending) at the same time. Ordinarily, the Fed would lower the interest rate to make borrowing more desirable, saving less so. Right now, they can’t.
So someone has to dis-save, to accommodate households’ desire to save. The business sector has healthy balance sheets, but sees little reason to borrow-and-invest during demand-deficient conditions. They’re not using all their capacity now. If the problem were localized to the US, the dollar would fall and our trade balance would improve — which is to say we would have more income and less consumption, thus more saving, in aggregate. But the problem is global, and anyway some of our largest trading partners are fixing their currency. The government could and should run a larger deficit. That means pushing money out to households, so that they can satisfy their desire to save without cutting back their spending, that is someone else’s income. But the GOP successfully made the deficit rather than unemployment the focus of national conversation, and Obama bought into their framing. Now we’re producing the dis-saving required to balance desired savings by the only mechanism left — destroying people’s income through widespread involuntary unemployment.
Mark A. Sadowski Yep, I agree. We’re very much on the flat part of the AS curve and a long way from having to worry about inflation. Still, some folks on the whacko right are forever trapped in the economics of the disco era…forever living in the late 70s. My concern is that we’ll be stuck on the flat part of the AS curve until deep into President Palin’s second term.
lilnev Nicely said.
Menzie,
How can we get you in the White House with about 15–20 such graphs like the one presented below, together with a “modern day” Ted Sorenson???? You give President Obama the graphs/charts, the “modern day” Ted Sorenson writes the speech to go with it—-what do you think of this suggestion from “the peanut gallery” here—namely me????
http://www.nytimes.com/2010/11/01/us/01sorensen.html
You could become famous for saving an American President and helping him “get his groove back”—I’m being serious here, no sarcasm
I meant to say the UE graph above. Oh well, just another one of my political fantasies apparently.
read with great interest the build up of Piet Eichholtz real estate index in Amsterdam.
One has to assume the same study as of 2007 would not deliver the same conclusion.
IMF House price developments in Europe: A comparison
http://www.imf.org/external/pubs/ft/wp/2008/wp08211.pdf
For example P13 the real estate price index has jumped from an average 173 to 328 index for Netherland
Thanks to the glut of savings? to a glut of credit? a glut of money supply?
ppcm,
Actually Eichholtz updated his index in 2008 and discovered that real home prices on the Herengracht had more than doubled in the preceding decade. They had risen so high they were actually tied with their previous peak, that had occured some 270 years prior.
http://www.imf.org/external/pubs/ft/fandd/2010/03/pdf/loungani.pdf
Since then which direction have they gone? I’ll give you one guess.
ppcm wrote:
“Thanks to the glut of savings? to a glut of credit? a glut of money supply?”
No, more likely a glut of stupidity. What goes up must come down.
Menzie,
It may seem immature or whatever, I would appreciate a response to my comments above, especially sense they were intended in a complementary way. PLEASE
The idea of letting unemployment benifits lapse when the job market is so poor that alien imigrants are leaving the country volentarily, is criminally absurd. As has been extensively proven many times, the multiplier effect of these support payments is large. And it is morally repugnant to let common people starve while funding lavish Bankster bonuses.
Beyond just relieving the individual suffering of the people without jobs, and the short term benefits to the economy gained by helping them; There must be a consideration of the long term social aspects. In the middle of winter, just before Christmas, a lot more of these hungry and now freezing people will commit crimes. They will do this both from need and moral outrage. Is it really necessary to use these tactics to fill the “Private Prison System”??
Anyone who thinks that letting the benefits expire is a reasonable course is either freakin stupid or a sociopath, and stupid! Remember;” the cause of all revolutions is an empty belly and crying babies”.
Ted K: Sorry, there is a tradeoff between responding to comments and thinking of new posts (and of course everything else in life, including the day job).
In any case — thank you for the compliment. However, rest assured the people at the CEA are well aware of all these graphs (heck, they generated Figure 5). The constraint is probably on the “Sorensen” end rather than the economist end.
Mark A. Sadowski, 2slugbaits: As an aside, the slope of the AS curve strikes me as an interesting research topic. Typically we assume linearity (perhaps in logs), but I remember in the mid-1990’s some work on nonlinearity. I wonder what the estimates would look like if one included recent data.
Question for 2slugbaits and lilnev:
Apologies if this is a stupid question, but I don’t entirely understand why we CAN’T all save at once, at least to a certain limited but nontrivial extent.
If we are all willing to save in actual cash, and forego any interest income, isn’t it possible for savings-minus-borrowing to equal the total value of printed currency (plus coins) in circulation?
We are, of course, far from that situation here in the USA, but I get the impression that lots of foreigners have probably been doing just that for decades – hoarding U.S. dollars under the mattress – especially in dysfunctional countries where the government and banking system aren’t trusted.
Karen: Here “saving” means spending less than your income. It should be clear that, in a private-sector-to-private-sector transaction, someone is spending and someone is collecting income, in exactly the same amount (note, combining the foreign sector and even state/local govts with the domestic private sector here; the distinction is really between the federal govt, which can create new dollars, and “everyone else who uses dollars”, who can’t). So if the govt ran a balanced budget, then aggregate spending and aggregate income in the private sector would have to balance, aggregate saving would be zero, and for every individual who saved you’d be able to find someone who had dis-saved (spent more than he’d earned).
“Everyone in the private/foreign sector” could save at the same time if the govt ran a sufficiently large deficit. Deficit spending creates new money, added to private sector income. (The reason not to do this all the time is that adding to aggregate demand would be inflationary if the economy were running at full capacity). For several years, the foreign sector was saving (mostly central banks accumulating US govt bonds), the federal govt was dis-saving (running a deficit and creating those bonds), business savings were variable, but not large overall contributors, and household savings were very low, flirting with zero. Now households want to save again, and govt dis-saving has increased some due to automatic stabilizers, but not enough.
Thanks for your reply, lilnev.
You say, “It should be clear that, in a private-sector-to-private-sector transaction, someone is spending and someone is collecting income, in exactly the same amount…”
I think you can’t use single transactions to show anything about the savings rate.
Saving does not occur as part of such transactions. It occurs later, after I receive my paycheck from my employer for my outstanding work efforts during the previous month. Instead of spending all of it, I engage in private-sector-to-whatever-sector buying transactions that total, say, 75% of my income and stuff the rest under my mattress each month (I actually put it in a bank, but I certainly could stuff it under the mattress, and if I did nobody would be able to borrow that money).
I agree that an overall net positive savings rate is possible in the long run only if someone – the central bank – adds more money to the economy each year. But it does seem to me that an excess of saving over borrowing CAN persist for some period of time even without that, and in fact tends to occur during recessions. The result is a shrinking economy, of course (if everyone somehow saved ALL their money then the economy would be at a full stop).
Menzie wrote:
“As an aside, the slope of the AS curve strikes me as an interesting research topic. Typically we assume linearity (perhaps in logs), but I remember in the mid-1990’s some work on nonlinearity. I wonder what the estimates would look like if one included recent data.”
Thanks Menzie, but that thought has already occurred to me. Unfortunately, first (sigh) I must finish my dissertation (which is on the effects of tax structure on growth). Obviously monetary issues are much more interesting right now.
Karen “…it does seem to me that an excess of saving over borrowing CAN persist for some period of time even without that, and in fact tends to occur during recessions. The result is a shrinking economy”
Seems to me that you’ve done a pretty good job of answering your own question. In saying for each saver there has to be a borrower I simply mean that as a necessary condition for maintaining output. Obviously people can insist on saving even if there is no one wanting to borrow even at a zero interest rate; people can always stuff their paycheck under the mattress. But what we’re really talking about is saving from a flow variable (income). Putting your paycheck under a mattress is a leakage from the system, and if not offset by fiscal or monetary policy leads to a drop in aggregate demand.
Menzie There was a time when many textbooks sketched an AS curve as having an intercept, then a long flat part, then an upward sloping curve that turned sharply vertical. The flat part was never really explained in any detail, but the intuition was that the trade-off between the price level and the output gap was not linear. In other words, potential GDP might be more or less linear with respect to prices, but due to short run price rigidities output would fall faster than prices beyond some threshold point in the same way that prices would rise at a faster rate than output beyond another threshold point. So too much demand shows up as inflation, too little demand shows up as a drop in output.
That said, I’m not an economist so I can’t say that I ever gave those textbook pictures of the AS curve all that much thought. On the other hand, Krugman not only doesn’t insist on a linear AD curve, he even argues against a monotonic AD curve (i.e., it can be locally upward sloping). So if we don’t insist on a linear and monotonic AD curve, why insist on a linear AS curve?
Oops. “Anonymous” in two posts above was yours truly.