Sumner on Supply vs. Demand Side Shocks

     Sumner makes the argument that the Canadian recession was a supply side rather than demand side recession. According to him, the problem is that most people don't think about A/S and A/D correctly

      "I doubt that most people see the situation the way I do, even though the AS/AD model is quite clear, indeed given the fall in output and stable inflation, there’s not even any room for dispute.  Both the AS and AD curves shifted left."

       "I think people disagree because they are affected by two common fallacies.  In the comment section of the previous post John Papola pointed out that many people don’t understand that AS and AD shocks are basically real and nominal shocks:

The language of AS/AD may work well among economists who have a careful understanding of the distinction between monetary effects and real effects, but I believe strongly that it is difficult, even destructive, for non-economist readers precisely because nominal vs. real distinction becomes entangled. This is made worse by the fact that Keynesians explicitly discuss “demand” in terms of targeting real variables.

.  .  .

You said recently that macro students should only be taught two concepts: Say’s Law, and NGDPLT. I generally agree (even if I have concerns about NGDP being a sufficiently broad proxy for the flow of nominal spending). AS/AD doesn’t aid this understanding without it being HEAVILY caveated.

When the public hears about “demand”, they think about “consumers” buying stuff. They think about wrong-headed ideas like the often-repeated notion that consumers “drive” economic growth, rather than production and investment. They think about the Keynesian approach, which is all they hear. And the Keynesian approach rolls in with it the conflation between saving and hoarding that has plagued macro since Malthus.

     "I think John is on to something here.  Most people think of AD in terms of the real quantity demanded, not a given nominal quantity of spending.  As an aside, most economics students make the same mistake in basic supply and demand.  They think the big boom in PC sales during the 1990s occurred because there was more “demand” for PCs.  Consumers piled into the stores and bought more PCs.  Of course economists know that the supply increased, reducing price, and increasing quantity demanded.  The same is true at the aggregate level.  The real shock hitting Canada in 2008-09 looked like a drop in AD, because real output fell.  But we know that even if the BOC had targeted NGDP, output would have fallen.  Targeting NGDP doesn’t magically make Ohio automakers want more Canadian transmissions.  It doesn’t make American home-builders want more Canadian lumber.  Yes, the Canadian dollar fell somewhat, but not enough to prevent a fall in exports."

    "Canada had a “reallocation recession.”  Labor had to re-allocate out of declining sectors into other sectors—like Canadian home-building."

     "But the BOC then made it worse; they reduced AD to keep inflation from rising above 2%.  Here’s where the other source of confusion comes in.  Most people have trouble envisioning that the BOC ran a tight money policy.  After all, they cut interest rates!!  If you don’t know the fallacy of that assumption by now then GET THE HELL OUT OF MY BLOG."

  

     "The proof’s in the pudding.  NGDP growth fell significantly; hence the BOC ran a tight money policy, at least tight relative to the policy that would have provided macroeconomic equilibrium.  That is, they failed to provide a steady growth rate of NGDP; a policy that would have allowed labor re-allocation to occur in an accommodating environment."

     "Canada was hit by a double whammy; a reallocation recession, plus a demand shock recession.  The net effect was a deeper than necessary recession, and no change in inflation.  Still it could have been worse.  Money wasn’t as tight as in the US and Europe."

   http://www.themoneyillusion.com/?p=19835#comments

    So what about these definitions of the demand side shocks as "nominal" and the supply side shocks as "real?" The anti Keynesian argument that people like Sumner and Lars Christensen make is that Keynes somehow neglected the monetary side-ie, he basically assumed that when you look at Y=C+I+G+(X-M) these are all real quantities forgetting about prices.

    However, Lars has answered Sumner himself and disagrees with him regarding Canada-it was not a supply side shock-he says Sumner forgot his own Sumner Critique.

    "Scott Sumner has a follow-up post on Nick Rowe’s post about whether a supply shock or a demand shock caused the Canadian recession in 2008-9. Both Nick and Scott seem to think that the recession in some way was caused by a supply shock."

      "I must admit that I really don’t understand what Scott and Nick are saying. It is pretty clear to me that the shock in 2008-9 was negative aggregate demand shock."

  

     http://marketmonetarist.com/2013/03/08/2008-was-a-large-negative-demand-shock-also-in-canada/

    Looking at both headline CPI and the price deflator, Lars says:

    "Both measures of inflation were running higher than the Bank of Canada’s official 2% inflation target when the crisis hit in the autumn of 2008.

    "However, it is pretty clear that inflation slowed sharply and dropped well-below the 2% inflation target in 2009 as the Canadian economy went into recession (real GDP contracted). It is hard to say that this is anything other than a rather large negative AD shock"

    "Obviously inflation increased above 2% in 2011, but we all know that a major negative supply shock hit in 2011 as global oil prices spiked. In the case of Canada this in fact is both a negative supply shock and a positive demand shock (remember Canada is an oil exporter). That said, the rise in inflation was certainly not dramatic and since 2012 inflation has once again dropped well-below 2% indicating that monetary policy in Canada has become overly tight given the BoC’s 2% inflation target."

     "Given the very clear evidence of a negative demand shock I find this comment from Scott somewhat puzzling:

Let’s suppose that the BOC had been targeting NGDP in 2008, when global trade fell off a cliff.  How would the Canadian economy have been affected?  Many would see the drop in global trade as a demand shock hitting Canada, as there would have been less demand for Canadian exports.  In fact, it would be an adverse supply shock.  Even if the BOC had been targeting NGDP, output would have probably fallen.  Factories in Ontario making transmissions for cars assembled in Ohio would have seen a drop in orders for transmissions.  That’s a real shock.  No (plausible) amount of price flexibility would move those transmissions during a recession.  If the assembly plant in Ohio stopped building cars, then they don’t want Canadian transmissions.  If the US stops building houses, then we don’t want Canadian lumber.  That’s a real shock to Canada, i.e. an AS shock.

     "I simply don’t understand Scott’s argument. A negative shock to exports obviously is a negative demand shock. From the perspective of nominal spending a negative shock to exports is a negative shock to money-velocity in the exact same way as a tightening of fiscal policy. Therefore, if the BoC had been targeting NGDP (it actually also goes for inflation targeting) the Sumner Critique would apply - the BoC would offset any negative shock to exports by easing monetary policy (increasing M to offset the drop in V). As a consequence domestic demand would rise and offset the drop in exports. And this obviously applies even if prices are sticky. Yes, the production of transmissions in Ontario drops, but that is offset by an increase in construction of apartments in Vancouver."

     Yet this is an interesting question as I'm currently reading Alan Blinder's book about the 70s stagnation. This was a decade that many Keynesians like him tended to ascribe largely to supply shocks. 

     I'm not entirely sure what to make of all this. I'm not entirely sure what the Keynesian position on the supply side is. Of course we can follow Keen in questioning the supply curve's shape itself. Anyone have any ideas about this? Woj? Anyone else...