Tuesday, August 16, 2011

Supply & Demand-side Shocks in Business Cycles

Tyler Cowen and Alex Tabarrok have been going back and forth on a wage stickiness debate with Brad DeLong, Karl Smith and others. I'm not going to wade into that debate, but rather point out that in Tabarrok's most recent hypothetical example, he offers a real business cycle thought experiment that crystallizes the issues most economists have with RBC.

Tabarrok says:

Imagine a farmer whose farm produces 100 bushels of wheat. He hires 10 workers to bring in the wheat, paying each of them 9 bushels. Thus, each worker carries 10 bushels, the wage is 9, the wage bill is 90, and the farmer earns 10.
Now suppose that due to climate change or a swarm of locusts the farm only produces 90 bushels of wheat. If wages were fully flexible then an equilibrium exists in which each worker is paid a wage of 8 leaving the farmer with 10 bushels as before. The farmer doesn’t want to reduce everyone’s wages, however, because that will reduce morale so he fires one worker leaving nine. Each worker now brings in 10 bushels, as before, and is paid a wage of 9, for a total wage bill of 81 leaving the farmer with 9 bushels. The unemployment rate is 10%.

This is RBC in a nutshell. It assumes supply shocks, not demand shocks. And in Tabarrok's thought experiment we have to assume a natural disaster or some other catastrophe has struck and that this is the reason for lower production. Basically, RBC and Tabarrok's thought experiment require that we lower the firm's production possibilities frontier with no possible way to raise it in the short- or medium-term. But that's not a realistic example of what's happening in this economy. Recessions are usually demand-side problems (as is the current one). And it's not a natural disaster that's causing the 'farms' from Tabarrok's thought experiment to cut production. What's caused the drop in production at the country's 'farms' is a burdensome debt load held by the 'farm's' customers. The farm's customers are trying to repair their balance sheets, which means they've cut back on buying as much corn as the farmer usually makes.

And if you view recessions as demand-side shock, rather than supply-side RBC shocks, then you see where Keynesian solutions can really help... for instance, perhaps another employer (the government perhaps?) can step in, hire the unemployed worker (with the practically free money it's currently getting) and, I dunno, build a bridge or a road or something else that might benefit the farmer and/or the farmer's customers. The laid-off worker now has a job, is doing something productive and might even turn around and become a customer of the farmer who buys up the farmer's excess production. In this model, the households repair their balance sheets, the unemployed worker is able to work and create something productive and everyone benefits. 

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