When supply is demand
By Scott Sumner
In order to do good economic analysis, it is important to distinguish between supply and demand shocks. Commenter SG pointed me to this curious post by Paul Krugman:
For those new to or confused by the term, secular stagnation is the claim that underlying changes in the economy, such as slowing growth in the working-age population, have made episodes like the past five years in Europe and the US, and the last 20 years in Japan, likely to happen often. That is, we will often find ourselves facing persistent shortfalls of demand, which can’t be overcome even with near-zero interest rates.
Secular stagnation is not the same thing as the argument, associated in particular with Bob Gordon (who’s also in the book), that the growth of economic potential is slowing, although slowing potential might contribute to secular stagnation by reducing investment demand. It’s a demand-side, not a supply-side concept. And it has some seriously unconventional implications for policy.
SG wondered why slowing population growth is not an adverse supply shock. Of course it is an adverse supply shock, more specifically it causes the vertical LRAS curve to shift right more slowly, or even move to the left.
Krugman’s a smart economist, and certainly knows this. So why does he consider it a demand shock? Because under certain policy regimes an adverse supply shock can shift AD to the left. If you are foolishly targeting interest rates, as the Keynesians advocate, then a reduction in population growth will cause the Wicksellian equilibrium interest rate to fall relative to the target interest rate, and this will depress NGDP growth. If you are foolishly targeting a monetary aggregate, as older monetarists suggest, it will reduce NGDP by reducing velocity (due to lower nominal interest rates.) If you are foolishly targeting inflation, as the Germans advocate, then an adverse AS shock forces the central bank to tighten money and reduce AD.
On the other hand if you sensibly target NGDP, as market monetarists advocate, then a supply shock such as slower population growth will not impact AD at all. With sound monetary policies all of macroeconomics becomes much easier to understand. The book Krugman touts in his post is full of arguments that are almost incomprehensible, because you can’t tell whether the author is talking about a supply-side problem that cannot be addressed with monetary stimulus, or a demand-side problem that is nothing more than monetary policy failure.
In a world of NGDP targeting, level targeting, internet macroeconomics debates would be 100 times more transparent. People would stop talking past each other. The relevant concepts would be clear.
PS. I have a related post at MoneyIllusion.