Aggregate demand shocks

It has been a widely acknowledged wisdom that adverse aggregate demand shocks are one of the culprits for the rise in German unemployment.

Aggregate demand is surely an important determinant of the level of employment, and hence unemployment. Among other influencing factors, fiscal and monetary policy has a significant impact on aggregate demand.

Nowadays, the primary aim of monetary policy is to stabilize inflation at relatively low levels. If aggregate demand is low, unemployment is high and the economy is in a recession, monetary policy will be loosened to stimulate aggregate demand with a fall in unemployment as the aim. On the other hand, in anticipation of inflation moving above target, monetary policy is tightened to mitigate inflationary pressure.

Since monetary policy plays an important role in aggregate demand determination, a consideration of different monetary policies over the last three decades should be necessary to understand unemployment evolution in Germany. In fact, restrictive monetary policy by German Bundesbank has often been criticized to be responsible for high unemployment rate in Germany.¹² Although a complete characterization of monetary policies stance is beyond the range of this work, there are some episodes worth noting. The stance of monetary policy in Germany from 1960 onwards, as captured by the development of the short-term interest rate, is given in Figure 3.9.¹³

According to Figure 3.9, German Bundesbank switched to a tighter

monetary policy in the latter part of the 1970s to reduce inflation arising from the first oil price shock. The rise in the short-term interest rate led to higher unemployment. In the early 1980s, the Bundesbank went on disinflating German economy to overcome the stagflationary 1970s. The central bank raised the short-term interest rate, with the jump of unemployment in that period as the consequence. Moreover, adverse demand shocks from tight macroeconomic policy in the post unification era certainly have played a dominant role in explaining high unemployment in the 1990s.

12 See, for example, Solow (2000), Linzert (2001) and Fritsche and Logeay (2002). See also Dolado and Jemino (1997) for Spain and Fabiani et al. (2000) for Italy.

Short-term Interest Rate

0,00 2,00 4,00 6,00 8,00 10,00 12,00 14,00

Figure 3.9 Short-term Interest Rate in Germany (1960-2003)

Note: Short-term interest rate refers to three-month money market rate.

Source: Sachverständigenrat.

Figure 3.10 shows the evolution of the real interest rate in Germany from 1960 till 2003. German unemployment development from 1970 onwards is also given here to illustrate the close correlation of these two series. It can be seen clearly that the high real interest rate in the mid-1970s, early 1980s and early 1990s correspond to the jump of unemployment in according periods.¹⁴

13 Monetary policy can be assessed by the evolution of the short-run real interest rate and modern central banks use the short-run nominal rate as an economic policy instrument.

14 Blanchard (1999) argues that the effects of the interest rate on unemployment are likely to be slow because they are primarily through capital accumulation, see also the text.

-2,00 -1,00 0,00 1,00 2,00 3,00 4,00 5,00 6,00 7,00 8,00 9,00

1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000

r (%)

0 2 4 6 8 10 12

u (%)

Real Interest Rate Unemployment Rate

Figure 3.10 Unemployment and the Real Interest Rate in Germany

Note: The real interest rate is computed as the short-term interest rate (Dreimonatsgeld) minus GDP deflator.

Source: The unemployment rate 1970-2003: Sachverständigenrat. Short-term interest rate 2003: Sachverständigenrat. GDP deflator 1960-1990: Layard et al. (2005), Annex 1.6, Table A4; 1991-2003: OECD Economic Outlook 77.

Besides monetary policies, fiscal policies also play an important role in influencing aggregate demand. Government investment is not only an essential component of aggregate demand in the short run, it also provides public infrastructure which is key to economic growth in the long run.¹⁵ The Maastricht Treaty and the Stability and Growth Pact (SGP) have enforced budget consolidation and restrictive policies on Germany (and other EMU member countries) at least since the mid 1990s. The development of real government expenditure, in particular real government investment since the mid 1980s is depicted in Table 3.4 to capture the fiscal stance in Germany.

The restrictive stance of German fiscal policies is quite obvious considering the growth rate of real public expenditure. The growth rate of real total public

15 A positive relationship between the growth rate of public infrastructure investment and GDP growth is found for Germany. See Pfähler et al. (1996) and Kitterer (1998).

expenditures has declined from an annual average of 3.5% in 1985-1995 to only 0.7% in 1995-2004. More dramatic is the dectrease in the growth rate of real public investment expenditure with an annual rate of –3.7% in 1995-2004.

The decline in public investment has led to a very low share of real public investment in real GDP.

Table 3.4 Fiscal Policy Indicators for Germany (annual average values, 1985- 1994 and 1995-2004)

1985-1994 1995-2004 Real total government expenditure,

growth rate (%) 3.5 0.7

Real government investment,

growth rate (%) 1.2 -3.7

Ratio of real government investment

to real GDP (%) 2.7 2.0

Note: 1985-1991: West Germany.

Source: Hein, Truger (2005b), Table 4.

Although adverse demand shocks (come from, for example, tight monetary/fiscal policies) may have played an important role in the rise of German unemployment rate, their effects cannot account for the persistent unemployment without some mechanism to ensure that the effects are propagated over time. One possible mechanism works as follows: with the short-term interest rate being raised, a negative output gap and higher unemployment came into being. This resulted in lower inflation according to the Phillips curve. Since inflation began falling and unemployment rising, the central bank lowered the interest rate. However, the Bundesbank opted for a very gradual disinflate process as compared with the Fed in U.S. In fact, the Bundesbank maintained tight conditions over so long a period of time that the equilibrium unemployment rate followed the actual unemployment rate (hysteresis mechanism). Although the central bank finally lowered its interest rate, this did not have any significant effects on the unemployment rate, because the equilibrium rate has risen as well by then. That means, the

disinflationary process initiated by the Bundesbank lasted too long such that hysteresis effects could arise.

Besides influencing unemployment through aggregate demand, monetary policy also plays a role in determining the natural rate of unemployment in two channels. One channel is that a monetary contraction will increase real wages, and thus decrease unemployment given the capital stock. The second channel functions through the effect of restrictive monetary policy in increasing the real interest rate and decreasing employment.¹⁶ Note that both channels were clearly at work in the first half of the 1980s.

The role of interest rates in influencing employment/unemployment has been pointed out by different authors. Newell and Symons (1987) assume that firms will incur a fixed hiring and training cost only if the discounted value of future quasi-rents on new employment is high enough. For this reason, firms will reduce the rate of hiring in the face of an increase in real interest rates. If the separation rate is exogenous, labor demand for a given real wage will decline consequently.¹⁷ Phelps (1994) emphasizes the role of the interest rate in affecting the price mark-up.¹⁸ Blanchard (1999) focuses instead on the effect through capital accumulation. He insists that an increase in the real interest rate increases the user cost of capital, ceteris paribus. Investment decreases, resulting in lower capital accumulation, and a decrease in employment. This goes on until wages have adjusted and the increase in the profit rate matches the increase on the user cost.