Aggregate Demand and Long-Run Unemployment

WHAT DETERMINES the unemployment rate?In answering this question, mainstream economics draws a sharp distinction between the short run and the long run.According to the conventional view, short-run movements in unemployment are strongly influenced by monetary policy and other determinants of aggregate demand.In the long run, however, unemployment returns to a natural rate or NAIRU (the nonaccelerating-inflation rate of unemployment), which is determined by labor market frictions.The NAIRU can change over time for microeconomic reasons, such as changes in labor market institutions.But the conventional wisdom holds that the NAIRU is unaffected by aggregate demand, and thus that demand does not influence long-run unemployment trends.This paper argues that this conventional view is wrong.Monetary policy and other determinants of aggregate demand have strong effects on longrun as well as short-run movements in unemployment.And this is not just a theoretical point.Over the last twenty years the behavior of demand accounts for much of the differences across countries in the evolution of unemployment.Aggregate demand has long-run effects on unemployment because of what Olivier Blanchard and Lawrence Summers have called hysteresis. 1 At a given point in time, there exists a NAIRU: pushing unemployment below 189