by Edmund Phelps

Many people see every downturn of employment from a long-sustained plateau as a fall of aggregate demand - “effective demand” in Keynes’s terms. They would have the central bank cut interest rates to restore that demand.

If employment is down because of aggregate demand, the problem can be addressed at zero cost through rate cuts and the ensuing rise in the money supply. Many central banks like to do that: to “lean against the wind”.

This time, though, there are forebodings of “stagflation” - lower employment without the solace of lower inflation. Some economists instinctively feel that the present downturn is the effect of structural shifts in the economy, not a shift in aggregate demand. They doubt that a central bank should retard effects it cannot prevent.

If employment is down because of shifting structures, gearing the money supply to attempt to prop up employment would generate ever-rising inflation. Inflation expectations would break loose from their moorings and the attempt would fail. Some central banks are refraining from rate cuts.

We have a difference of opinion and of policy. But the structuralist case needs to be argued. What are the primary forces of a structural nature? And, crucially, what are the nonmonetary channels through which these forces have structural impacts on the economy - on the size of the labour force and the natural rate of unemployment?

 The remainder of this post can be read here. Debate from our panel of economists appears below.

July 21, 2008 11:19am in Central banks, Credit squeeze | Comment