When supply takes a hit
When supply is restricted, on a grand scale, the result will be falling output and rising prices. This could be due to loss of oil supplies (failure to replenish them, actually), or due to a sudden upsurge of terrorism, or due to terrible weather caused by climate change, or even (dare I say it) to a sudden loss of competitiveness of exports. It fits simple textbook models of a restriction in Aggregate Supply. But oddly enough, the textbook models are inept at making policy prescriptions.
They usually make two mistakes. The first is to focus only on inflation, reasoning that other aspects of the economy are not subject to government modification in the long run. This logic takes too seriously the monetarist lesson of the 70s, namely that government action to increase demand only drives up inflation, with output returning to its long run equilibrium one way or another. Wisdom about dealing with excessive demand was hard won, and economists wanted to make the point firmly that incurring inflation to stimulate the economy “too much” (i.e. beyond the equilibrium long run supply path) would be fruitless, only building up inflation as the economy returned to its equilibrium naturally. They neglected to consider whether the analytical categories they were developing would actually fit other macroeconomic circumstances.
The second error was created by the theoretical strait-jacket imposed by economists to keep unruly politicians in line. It used the Long-Run Equilibrium model to analyze the adjustment path of the economy in other kinds of situations. If you can predict the economy’s path by comparing output to its long run equilibrium level, and prices to their anticipated level, then you don’t need to know how you got into that situation. All we need to know, in effect, is that supply has tightened, so aggregate demand is temporarily too high, relative to long run equilibrium aggregate supply.
So, standard analysis says that when supply is restricted, the central bank should tighten money. This advice firmly grasps the first error by opposing the problem that is supposedly the only one it can affect: inflation. Notice this implies that when output is falling and unemployment is rising, the central bank further dampens demand (although a more nuanced interpretation is available, as I will discuss in a moment). If you like that prescription, you will love the IMF. But that is tomorrow’s subject.
So what happens as a result of the falling output and rising unemployment? That is where we come to the second error: the economy’s reaction is supposed to follow a path derived by analogy to the situation of demand increasing too fast. So this would mean that resource owners, recognizing inflation higher than they anticipated, will withdraw supplies of other resources, driving up their costs and further adding to inflation. Output continues to adjust downward, because the “excessive” demand has it above the equilibrium level, and tighter interest rates can be justified as heading off the additional inflation by undermining the excess demand. If you think about it, it is a hoot.
First of all, it neglects the whipsawing "accelerator" response of investment, which will dominate all the short-term dynamics by quickly leading to demand lower than long run equilibrium. Second, it neglects the possibility of a downward spiral in demand taking things beyond the capability of the economy to right itself. And third, it ignores the resistance of labor markets to any reduction in wages, especially nominal wages, and of all prices to any reduction. In other words, the Keynesian issues. But then, we are back into Keynesian territory, and they are practical concerns again.
The truth is that the demand shock caused by the sudden disappearance of the need for new capacity means the demand shock will be bigger than the supply shock that caused it. As a result the economy will quickly be in a situation of demand below equilibrium. In that case, you might think, inflation will not be a problem and prices will fall, not rise. The central bank needn’t raise interest rates even if inflation is its only concern. Would that it were true.
The truth is that outside commodity markets, prices are resistant to falling. There is a small amount of give, such as the discounts offered by automakers and airlines in tough times, but it is slow and painful to get wages and other core prices to fall. So the net result of a supply restriction is still likely to be higher prices – but once they have ratcheted up they are unlikely to just backtrack with recession. Therefore, the textbook long run adjustment mechanism fails, even once we begin looking in the right place, where demand is below long-run equilibrium.
The textbooks say falling wages are supposed to induce employers to hire and falling prices to induce consumers to buy. Just stating the two of them together should remind us of Keynes’ fallacy of composition, and helps us visualize the futility of offering “wait and see” as advice. Looking a downward spiral in the eye, most central bankers would come quickly to their senses.
So the correct response to inflation from a supply shock is to lower interest rates, and risk more inflation? Precisely. Refer to the Japanese response to the 1973 oil shock. As long as the economy’s situation was not dominated by demand inflation beforehand, a supply restriction should lead to a pre-emptive reduction in interest rates (real ones, at least).
And if it is a big shock, that won’t be enough. Low interest rates may be just “pushing on a string,” sometimes thought of as a liquidity trap. Which means fiscal policy is needed too – government spending increasing or taxes decreasing to support the fall in interest rates.
Aha, the clever monetarist responds. This is a true Keynesian, arguing for lower interest rates not just when demand falls, to prevent deflation, but also when supplies are getting tighter and they think they can replace the lost resources with phony credit and make-work projects from the government. No doubt this guy also wants lower interest rates when aggregate supplies increase. Yes, in fact I would. The only situation calling for an increase in interest rates is when demand is growing too fast and outstripping capacity. Period. If that isn’t symmetric enough for you, get out of your tower and get to work. Before you put the rest of us on bread lines.
They usually make two mistakes. The first is to focus only on inflation, reasoning that other aspects of the economy are not subject to government modification in the long run. This logic takes too seriously the monetarist lesson of the 70s, namely that government action to increase demand only drives up inflation, with output returning to its long run equilibrium one way or another. Wisdom about dealing with excessive demand was hard won, and economists wanted to make the point firmly that incurring inflation to stimulate the economy “too much” (i.e. beyond the equilibrium long run supply path) would be fruitless, only building up inflation as the economy returned to its equilibrium naturally. They neglected to consider whether the analytical categories they were developing would actually fit other macroeconomic circumstances.
The second error was created by the theoretical strait-jacket imposed by economists to keep unruly politicians in line. It used the Long-Run Equilibrium model to analyze the adjustment path of the economy in other kinds of situations. If you can predict the economy’s path by comparing output to its long run equilibrium level, and prices to their anticipated level, then you don’t need to know how you got into that situation. All we need to know, in effect, is that supply has tightened, so aggregate demand is temporarily too high, relative to long run equilibrium aggregate supply.
So, standard analysis says that when supply is restricted, the central bank should tighten money. This advice firmly grasps the first error by opposing the problem that is supposedly the only one it can affect: inflation. Notice this implies that when output is falling and unemployment is rising, the central bank further dampens demand (although a more nuanced interpretation is available, as I will discuss in a moment). If you like that prescription, you will love the IMF. But that is tomorrow’s subject.
So what happens as a result of the falling output and rising unemployment? That is where we come to the second error: the economy’s reaction is supposed to follow a path derived by analogy to the situation of demand increasing too fast. So this would mean that resource owners, recognizing inflation higher than they anticipated, will withdraw supplies of other resources, driving up their costs and further adding to inflation. Output continues to adjust downward, because the “excessive” demand has it above the equilibrium level, and tighter interest rates can be justified as heading off the additional inflation by undermining the excess demand. If you think about it, it is a hoot.
First of all, it neglects the whipsawing "accelerator" response of investment, which will dominate all the short-term dynamics by quickly leading to demand lower than long run equilibrium. Second, it neglects the possibility of a downward spiral in demand taking things beyond the capability of the economy to right itself. And third, it ignores the resistance of labor markets to any reduction in wages, especially nominal wages, and of all prices to any reduction. In other words, the Keynesian issues. But then, we are back into Keynesian territory, and they are practical concerns again.
The truth is that the demand shock caused by the sudden disappearance of the need for new capacity means the demand shock will be bigger than the supply shock that caused it. As a result the economy will quickly be in a situation of demand below equilibrium. In that case, you might think, inflation will not be a problem and prices will fall, not rise. The central bank needn’t raise interest rates even if inflation is its only concern. Would that it were true.
The truth is that outside commodity markets, prices are resistant to falling. There is a small amount of give, such as the discounts offered by automakers and airlines in tough times, but it is slow and painful to get wages and other core prices to fall. So the net result of a supply restriction is still likely to be higher prices – but once they have ratcheted up they are unlikely to just backtrack with recession. Therefore, the textbook long run adjustment mechanism fails, even once we begin looking in the right place, where demand is below long-run equilibrium.
The textbooks say falling wages are supposed to induce employers to hire and falling prices to induce consumers to buy. Just stating the two of them together should remind us of Keynes’ fallacy of composition, and helps us visualize the futility of offering “wait and see” as advice. Looking a downward spiral in the eye, most central bankers would come quickly to their senses.
So the correct response to inflation from a supply shock is to lower interest rates, and risk more inflation? Precisely. Refer to the Japanese response to the 1973 oil shock. As long as the economy’s situation was not dominated by demand inflation beforehand, a supply restriction should lead to a pre-emptive reduction in interest rates (real ones, at least).
And if it is a big shock, that won’t be enough. Low interest rates may be just “pushing on a string,” sometimes thought of as a liquidity trap. Which means fiscal policy is needed too – government spending increasing or taxes decreasing to support the fall in interest rates.
Aha, the clever monetarist responds. This is a true Keynesian, arguing for lower interest rates not just when demand falls, to prevent deflation, but also when supplies are getting tighter and they think they can replace the lost resources with phony credit and make-work projects from the government. No doubt this guy also wants lower interest rates when aggregate supplies increase. Yes, in fact I would. The only situation calling for an increase in interest rates is when demand is growing too fast and outstripping capacity. Period. If that isn’t symmetric enough for you, get out of your tower and get to work. Before you put the rest of us on bread lines.