Supply shocks, demand shocks, and corridors

In a recent post by Arnold Kling I see him hinting at the similarities between his recalculation view of the current recession and the corridor theory of Axel Leijonhufvud.  Now I agree with both these theories, and feel they add an important flavour to current debate – but I think the theories actually tell us about very separate elements of any large scale recession.

In order to get my head around my feelings I’ll have a brief talk about shocks, and the kind of shocks I think are being represented by the different theories.  Feel free to tell me where I am blatantly wrong.

Now, for the non-economist readers I guess this post is a little wonkish in nature – although there will be no maths sitting around this time.

There are a bunch of “shocks” in economics that throw us around.

To start off with there are demand shocks.  These are the least scary – as monetary policy can respond to them and prevent anything really happening.  With a demand shock, people’s demand for everything changes at the current price level – if it is a negative demand shock people will want less of everything all of a sudden and the central bank can lower interest rates (or in a sense print more money) to increase demand again at current prices.

Then there are supply shocks.  Supply shocks actually impact on the economies general capacity to produce.  A negative supply shock will reduce the countries capacity (either temporarily or permanently).  How to react to a supply shock is a much more difficult issue.

Those are the aggregate concepts.  However, shocks are hardly ever aggregate in nature.  Kling’s recalculation theory is akin to a shock that changes the appropriate relative prices in the economy (and in the long-run, the make-up of capital in the economy).  Just like the above supply and demand shocks this shock presupposes a single long-run equilibrium, but in the short-run there is a change in the equilibrium which implies that there is a costly transition path between the two long-run states.

In MANY ways, this is similar to a mix of a temporary and permanent supply shock (depending on the value given to the separate long run eqm) – and the policy recommendations for both would be similar.  In fact many economists would just call this type of relative price shock a supply shock, and such shocks are at least partially incorporated in current DSGE models.

The key point in the recalculation theory is that at a point in time there is still ONE long-run equilibrium.  However, the costly adjustment of capital following a change in the relative value of goods and services in the economy implies that the short-run equilibrium of the economy can optimally adjust through time and remain separate of the long-run steady state for a while.

This implies that, even though it is clear the economy is below its “potential” it isn’t clear whether policy would help “readjust” the economy (and any policy that does is likely to be more nuanced and focused on helping speed up the adjustment process of the economy).

The corridor hypothesis is a bit different (a good discussion on just where it comes from is found here).  The corridor hypothesis says that there are multiple pareto-ranked equilibrium – both at a given point in time and in the long-term.  Many of the equilibrium will be locally stable, so that we seem to stick close to them in the face of small shocks.  However, when the economy faces a big shock (either a supply OR demand side shock) we can be flung into a different, possibly pareto-inferior, but still stable, equilibrium.

This type of “history dependence” of the equilibrium of the economy suggests that government action to “shock” the economy back to a pareto-superior equilibrium would be favourable in the face of a large shock.

Such a view relies on the idea that some actions inside the economy are strategic complements (or that some beliefs/expectations are self fulfilling), and as a result there are multiple different equilibrium where our economy could settle – depending on where it started.

Well, at least that is my impression of the different “shocks” that are being listed down.  I think real life shocks involve a little bit of all these things – and keeping in mind what they are and how they differ is important.

  • Pingback: Tweets that mention TVHE » Supply shocks, demand shocks, and corridors --

  • Pingback: Twitted by selfpublishingx()

  • Vince

    Isn’t talking in terms of shocks a very DSGEist view? In Leijonhufvud ( as in Minsky) isn’t the instability endogenously generated? Do DSGE models even allow for endogenous instability? Phase transitions are probably a better way of looking at sudden changes in the context of Leijonhufvud’s hypothesis.

  • @Vince

    Sort of and sort of not.

    The primary difference between the DSGE type view and the conclusion being discussed from Leijonhufvud is linearity vs non-linearity – and thereby single eqm vs multiple eqm.

    Now Leijonhufvud does also discuss the fact that we may not have stable steady states, and that would lead to the endogenous instability you are discussing for sure.

    But even when there are locally stable steady states that allow the economy to “rest” in the long run, there is no certainty that this steady state is unique and as a result even in the face of a “temporary” shock we may find ourselves moving towards a different steady state. Typical DSGE modeling would not lead to this – a temporary shock would not change the long-run eqm.

    Personally I think that the difference between the “endogenously generated instability” and exogenous shocks is one of semantics. It is an important difference to be sure, but in one case shocks are being generated endogenously and in the other shocks are being generated exogenously. Treating the shocks as exogenous (instead of a potentially more realistic endogenous case) allows us to get an idea of how the shock functions and what path it moves through – which gives us a clearer way of understanding change.