The current level of unemployment may be a factor affecting the NRU. A high unemployment rate means a fall in overall worker experience and job skills, and may also change people's attitudes toward working, increasing both structural and frictional unemployment. Economists use the word hysteresis to refer to the phenomenon whereby the historical unemployment path taken by the economy affects its NRU and creates a vicious or a virtuous circle depending on whether current unemployment is high or low. Hysteresis is a possible explanation for a rising NRU during recessions, and it may be one ingredient in the remarkable performance of the U.S. economy in the late 1990s.
Reaction to a Negative Supply Shock
There are two ways in which a negative supply shock can lead to an inappropriate central bank policy:
1. A negative supply shock makes the economy less productive, causing the level of national output/income to fall, even if the level of unemployment does not change. If the government does not recognize this fact and thinks instead that the decrease in income reflects a cyclical downturn, it may use monetary policy to stimulate the economy. The policy of targeting on the income level would then create a situation very similar to that described earlier for targeting on the unemployment rate. Stimulation will be successful in the short run but not in the longer run because the situation will require further stimulation and an acceleration of inflation will take place. By targeting on the pre-supply-shock level of output, the central bank could lose control of the money supply.
2. A negative supply shock decreases the productivity of labor. Firms cannot afford to hire as many workers at the prevailing real wage, so unemployment develops unless the real wage falls to reflect the lower productivity of labor. If the real wage is prevented from falling by strong labor unions, for example, or a national labor contract expressed in real terms the economy will become stuck at a level of unemployment above the natural rate. The central bank could misread this unemployment level as a cyclical phenomenon and adopt a stimulating dose of monetary policy. The result is similar to that given earlier for targeting on an underestimate of the NRU. As long as the real wage is artificially held too high, this policy will accelerate the inflation. By targeting on the pre-supply-shock unemployment rate the central bank could lose control of the money supply.
Fixing the Nominal Interest Rate
It has been common for central banks to adopt a policy of targeting on or fixing the nominal interest rate. Under this policy a shock to the monetary sector that causes a rise in the interest
