Introduction:

Thinking Like an Economist

CHAPTER
11
The Structural Stagnation Policy Dilemma

Illusions commend themselves to us because they

save us pain and allow us to enjoy pleasure instead.
We must therefore accept it without complaint why
they sometimes collide with a bit of reality against
which they are dashed to pieces.
— Sigmund Freud

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Chapter Goals

 Differentiate a structural stagnation from a

standard recession
 Demonstrate in the AS/AD model how globalization
can mask inflationary pressures caused by
expansionary policies
 Explain the role of globalization and the financial
bubble in creating a structural stagnation problem
 Outline the policy choices that policy makers have
to deal with structural stagnation

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The Structural Stagnation Hypothesis

 In December 2007 the U.S. economy fell into a

prolonged period of slow growth and stagnation that
was not a normal recession
 The structural stagnation hypothesis sees the
recent problem of the U.S. economy directly related to
the structural problems caused by globalization

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The Structural Stagnation Hypothesis

 Structural stagnation has both long-run and short-run

causes
• The long-run cause is intricately tied to
globalization, exchange rates, and the trade
deficit
• The short-run cause is intricately tied to the
aftermath of the financial crisis

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Changes in Employment from Peak

IIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIII
1 3 5 7 9 11 13 15 1719 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51
Percent

Months from peak before recession

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Why the Assumed Underlying Growth Trend
Is Important for Policy
 The biggest change that the structural stagnation
hypothesis makes to standard macro theory involves the
economy’s assumed growth rate in a recovery
• The standard macro policy assumption is that an
economy will quickly get back to its long-run trend
growth rate
• Structural stagnation assumes that the adjustment
will take much longer, perhaps decades
 Structural stagnation explains the decreased effectiveness
of expansionary monetary and fiscal policies

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Structural stagnation argues the economy is in need of

difficult supply side structural changes to accompany
any demand side stimulus.

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Expansions to maintain trend growth

Suppose real output is $10 trillion (point A)
Real output and the economy falls by 3 percent in one
(in trillions of dollars) year, to $9.7 trillion (point B).
For the economy to recover within two
years (point C),
10.9 it would have to increase at an

.
C
annual rate of somewhere around
3% trend 6 percent per year.

The economy needs to grow by more

.
than the 3 percent decline during
A the recession to make up for the
6% recovery
10.0 decline in output during the
recession and the rise in potential:
9.7
.

B $0.3 trillion + $0.6 trillion = $0.9 trillion

=
Time

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Structural Stagnation’s Implications for
Macro Policy
 The assumed trend growth rate is a central difference
between the standard theory and the structural stagnation
hypothesis
 The small difference makes an enormous difference in
one’s view of whether demand-side policy was too
expansionary
 If the structural stagnation hypothesis is true, the U.S. will
likely experience a decade of slow growth and high
unemployment

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Policy Implications of Structural Stagnation

Real GDP (in trillions of dollars)

Actual
2.25% trend

Years

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The AS/AD Model with Globalization

 The globalized AS/AD model adds a world supply curve to

the standard AS/AD model to capture the effect that
globalization issues can have on an economy

 Net exports are not part of the standard AS/AD model

 The world supply curve is the amount of tradable goods

other countries will supply to the country at a given price level
and exchange rate

• If domestic producers don’t match world prices, they

won’t be able to sell their goods

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The Globalized AS/AD Model

Price level
 By adding the world supply
LAS curve (WAS) we transform the
standard AS/AD model into the
globalized AS/AD model
SAS
 In this instance, the world
price level equals the U.S.
P0 WAS price level at equilibrium
and globalization by itself
does not change the results
AD of the standard model
Real output
Y0

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The Globalized AS/AD Model

Price level  During the 1990s, the world
price fell below the U.S.
LAS
equilibrium price due largely to
the integration of China and
India into the world economy
SAS coupled with their lower
production costs for numerous
tradable goods
P0 WAS
 This is illustrated by a
P1 WAS’ downward shift of the WAS
curve
AD
Real output
Y0 Y1

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The Globalized AS/AD Model

Price level The reduction in the world
LAS’ LAS price resulted in:
1. A decline in potential output

SAS 2. A trade deficit

P1 WAS’
Trade deficit AD
Real output
Y0 Y1

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The Globalized AS/AD Model

Price level
LAS’ LAS  The trade deficit arose
because domestic
consumption exceeded
SAS domestic production

Domestic Trade deficit

production

P1 WAS’
Domestic consumption
AD
Real output
Y0 Y1

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Globalization Can Limit Potential Output

 If the world price for goods is below the U.S. price of goods,
international competitive forces put a limit on domestic
potential output

 According to the structural stagnation hypothesis, potential

output depends on wages, technology, and global competitive
conditions as well as physical productive capacity

 A trade deficit translates into higher unemployment and lower

potential output until displaced workers find new jobs in
different fields that are competitive in the global economy

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International Adjustment Forces

 In the globalized AS/AD model international and domestic

adjustments will eliminate the trade deficit

 These forces include changes in:

• Exchange rates

• Relative wages and costs of production

• Aggregate demand

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Why the Adjustments Did Not Occur

 Government held up aggregate demand to hold unemployment

down which fueled a financial bubble and allowed private
demand to remain high despite structural problems

 By expanding aggregate demand, the U.S. avoided making the

adjustments to a long-run sustainable equilibrium

 With a sufficiently large increase in aggregate demand, the

unemployed in the tradable sector can shift to jobs in the non-
tradable sector keeping overall unemployment low

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Aggregate Demand Increases No Longer
Cause Accelerating Inflation
 In a globalized economy in which a country can run large
trade deficits, expansionary macro policy does not cause
inflation but can cause serious short-run structural problems

• Increased demand is channeled into increased imports

and demand for assets, creating a financial bubble

• The rise in asset prices makes asset holders feel richer

which further increases aggregate demand and
amplifies the effect of expansionary fiscal policy

 This structural change in the inflation process masked the

need in the 1990s and 2000s for real structural adjustment
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Shorter-Run Structural Problems Resulting
from the Financial Crisis
These structural problems included:

1. Housing inventory overhang

2. A reduction of perceived wealth

3. Unwinding the expansionary monetary and fiscal

policies that served to reverse gains from an
improvement in private sector wealth

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Structural Problems of Globalization

Globalization and Employment

 To remain employed in the tradable sector the unemployed

will have to

• Find new jobs they can do more cheaply than anyone

else in the world

• Be willing to accept lower wages

• Have access to better technology and capital than do

workers in other countries making them more
productive

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Structural Change in the Nontradable Sector

 The inability to continue large U.S. budget deficits will put

strong pressure on government to cut government employee
wages, benefits, and employment

 Globalization along with expansionary fiscal policy reduces

the spending power of those working in the tradable sector in
two ways: lower wages and higher costs of living

 According to the structural stagnation hypothesis the reality is

that significant structural change is needed to make the U.S.
internationally competitive

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Globalization and Income Distribution

 Structural problems of globalization involve income
distribution and affect different groups of the economy
differently

• The international traders, and workers associated with

them, have done phenomenally well

• The unskilled and not highly skilled in the tradable

sector are most hurt because they have lost jobs or had
wages significantly reduced

• Those on the nontradable sector who are indirectly

affected
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Remembering the Benefits of Globalization

 The costs of structural change do not mean globalization is
bad; it is simply competition on the global level, and it is
inevitable and beneficial

• Tradable goods become cheaper

• Production becomes more specialized resulting in

lowers costs and stimulated technological development

• Trade is expanded and the world growth rate is

increased

• U.S. consumption increases even as U.S. potential

output declines
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The Future of Globalization

 Countries such as China and India will move up the value-

added chain, the movement of trade from natural resources
to increasingly complicated goods and services

 Countries at the top of this chain are international traders that

experience enormous gains from trade

 As countries move up the value-added chain, the pressures

of globalization will feed back on traders, and international
traders will find themselves globalized as well; that is a long
way in the future

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Policies to Deal with Short-Run Structural
Problems
 Government can introduce policies that make it easier for
banks to restructure loans

 Government can temporarily rent houses to “underwater”

homeowners who otherwise would face foreclosure

 Government can do little about the effects of the decline in

wealth caused by the bursting of a bubble without causing
new problems down the road

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Policies to Deal with Long-Run Structural
Problems
Policies that will shift the world supply curve up

1. Decreasing the exchange rate

2. Differential wage growth

3. Tariffs and Trade Restrictions

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Policies to Deal with Long-Run Structural
Problems

Policies that will shift the SAS curve down

1. Lower wages

2. Reduce unemployment insurance

3. Increasing U.S. productivity by improving

training or increasing resource production

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Policies to Shift the SAS Curve Down
or the World Supply Curve Up
Price level
 Policies that address structural
stagnation will either shift the
SAS0 SAS curve down from SAS0 to
SAS1 or the world supply curve
B SAS1
up from WAS0 to WAS1
P1 WAS1
A
P0 WAS0  Either will shift globally
constrained potential output to
the right

AD
Real output

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Chapter Summary

 To remain on its growth trend, an economy must grow

more in an expansion than it fell during the recession
 During a structural stagnation, the economy grows more
slowly than is needed to return to its trend
 The U.S. economy today may be experiencing structural
stagnation, not a normal downturn
 The globalized AS/AD model adds a flat world supply
curve, which allows the possibility of a trade deficit that
limits a country’s potential output

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Chapter Summary
 Globalization with large trade deficits will limit domestic
inflation, allowing government to run more expansionary
policies than it otherwise would
 Globalization leads to structural stagnation by creating
competition in the tradable goods market which leads to
difficult structural adjustment
 The U.S. globalization experience has impacted various
groups differently
 Structural stagnation can be resolved if domestic exchange
rates fall, domestic wages and other costs fall, or
productivity rises
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