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To return for a moment to the discussion of structural versus cyclical factors in business cycles, let me draw attention to a few interesting posts on the topic, from Steve Waldman, Charles Davi, Tyler Cowen, and James Hamilton. I think these guys present some plausible scenarios about the way a downturn might unfold, and I think the focus on information changes as a driver of behavior is very smart. But a key question for me is the extent to which structural factors drive unemployment in a recession, and relatedly, the extent to which “hydraulic macro” policies can reduce the pain of recession by alleviating the cyclical pain in a downturn.

Along those lines, I think James Hamilton has a key insight here:

To their discussion I’d like to add a paper I published in 1988. There I presented a model in which unemployment arises from a drop in the demand for the output of a particular sector. The unemployed workers could consider trying to retrain or relocate, or might instead decide to wait it out in hopes that the demand for their specialized skills will come back.

If instead of a drop in the demand for sector A there was a boom in the demand for sector B, it is true that some workers in sector A might choose to retrain or relocate, and be temporarily unemployed as a result. But the key kind of unemployment that I think this sort of model describes– waiting for an opening in the particular area in which you’ve specialized– is caused by drops in demand, not increases.

Insofar as the frictions in that model are of a physical, technological nature, increasing the money supply would simply cause inflation and not do anything to get people back to work. I should emphasize that I built that monetary neutrality into the model not because I think it is the best description of reality, but in order to illustrate more clearly that there is a type of cyclical unemployment that stimulating nominal aggregate nominal demand is useless for preventing.

My personal view is that real-world unemployment arises from the interaction of sectoral imbalances with frictions in the wage and price structure of the sort documented by Truman Bewley and Alan Blinder. The key empirical test, in my opinion, is at what point inflationary pressures begin to pick up. If Krugman is correct, we could have much bigger monetary and fiscal stimulus without seeing any increase in inflation. If the sectoral imbalances story is correct, it would be possible for inflation to accelerate even while unemployment remains quite high.

I think you can make a compelling case (and Tyler Cowen seems to agree) that monetary policy could have been significantly more aggressive in this recession. Scott Sumner would disagree with me, but I think fiscal policy could also have been much more aggressive; certainly Christina Romer thinks more should have been done. And the extent to which inflation has remained conspicuously dormant tells us something, I think, about just how much of the unemployment in this recession is cyclical in nature.

Source: More Stimulus? Think 'Hydraulic Macro'