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The impact of an exogenous adverse supply shock on the open economy

This paper analyzes the impact of an exogenous adverse supply shock on the open economy considering the fixed and floating exchange rate regimes. Carlin & Soskice (2006) develop a comprehensive model of an open-economy which allows us to explore the effects of a shock and policy response to this. The key components of this model are the aggregate demand (AD) curve, the balance trade (BT) and the equilibrium rate of employment (ERU) curve. Also, we have to consider one more variable, exchange rate (θ). In fact, the key differences between closed and open economy are trade in goods and trade in assets; output can differ from domestic demand because of the net exports which depend on the real exchange rate which, according with C&S can be considered as an index of national competitiveness. Thus, all the diagrams will be plotted in θ−y space and we will see the results of the analysis in terms of the real exchange rate and output and discuss what happens to prices/inflation. The AD curve shows the combinations of the real exchange rate and the level of output when the goods market is in equilibrium and the real interest rate is equal to the world interest rate and represent the demand–side of the model; AD curve is positively sloped taking into account that a more competitive exchange rate (high θ) raises aggregate demand and output. The BT curve, which shows the combinations of the real exchange rate and output at which trade is balanced, is positively sloped to the right as well; in fact an high θ raises exports and higher levels of output are required to get up the demand for imports to deliver trade balance. At the end the ERU curve, the supply-side of the model in which the key elements are Wage-setting (WS) and Price-setting (PS). As depicted in diagram 1 the WS curve is positively sloped because wage-setter asks a higher real consumption wage (in fact the utility of W-setters is the money wage deflated by the consumer price index) at higher employment (output). The PS curve, under the assumption of constant labour productivity and mark-up, is horizontal; P-setters consider their profits, defined in terms of the product price. There is no unique price. On the ERU curve (point A), which shows the combinations of θ and output at which the WS real wage is equal to PS real wage, θ is constant and inflation as well. The ERU depends on the real exchange rate (Ee = Ee(θ).

We would begin our analysis starting from the long run equilibrium i.e. at the intersection of all three curves (point A, diagram 3). We would also assume that world inflation is constant under fixed exchange rate; home sets the inflation rate in the medium-run equilibrium at a rate equal to world inflation (C&S, 2006). According to Mankiw (2002), an external supply shock would push employment and output away from their natural rates. According to C&S (2006), “an external supply shock is defined as an unanticipated change in the world terms of trade between manufacturers and raw materials”. A classic example of such a shock would be a change in world prices of oil. We considers three effects of an exogenous supply shock, namely, the impact on the AD curve, trade balance and the impact on the ERU curve: in fact an adverse external supply shock is a combination of an external trade shock and a supply-side impact on the price-setting wage curve. Therefore, as depicted in Diagram 3, it results in shifting all three curves in the same direction (red lines).

In the short-run (prices and wages are fixed) we analyze the impact of such a shock on AD and BT curve, in fact (in SR) AD curve fixes the level of output. The increase of oil’s price represents a negative aggregate demand shock: the higher import bill depresses the aggregate demand and decreases the net exports; AD and BT curves shift to the left (AD’ and BT’).

Since medium run equilibrium can be define as constant inflation equilibrium; the economy must be on ERU curve (WS=WP). Since assumption of fixed prices and wages is relaxed, they can respond to variations in output. If we consider only the effects on the demand-side (trade shock) the new medium run equilibrium will be at B (in which AD’ intercepts ERU) but, as said before, an oil’s price increase is also a supply-side shock and therefore the ERU curve shifts to the left (ERU’).

Diagram 3 shows the reasons; since firms’ (P-setters) objective is to protect real profit margins and their costs (after the shock) increased, a downward shift in the PS real wage curve (from PS(θ0;t0) to P(θ0;t1)) is verified. There is a fall in output (from y0 to y1) which indicates that the only way in which constant inflation is obtained is to reduce the real W claims of wage-setters. Thus, a higher level of unemployment. Given that PS curve shifts and θ remains constant, a negative oil price shock shifts to the left the ERU curve to ERU’. We notice that this result is consistent with the oil shock because this kind of shock affects the difference between CPI and PPI.

Now we turn on diagram 2 and since medium run equilibrium will be in B’, a movement along AD’ curve is required. The starting point depends on the exchange rate regime.

In a fixed exchange rate regime θ is not allowed to change and therefore the economy, after the shock, is at point C with lower output. Also, C is above the new ERU curve and so there is an upward pressure to inflation. Since at C WPS<WWS , at this level of employment workers ask for higher wage increases and so inflation goes up. At C therefore we have that output decreases and inflation increases; this is called stagflation. Central bank policy response would be to increase the interest rate until B` is reached.

Under flexible rate, the short run equilibrium after the shock will be A’. The θ rises until θ’ and the economy loses competitiveness while output is unchanged. As before to achieve the medium run equilibrium the economy moves along the AD’ curve but according to Mankiw (2002) and as we can see from the diagram 2, the adjustment costs required under exchange rate depreciation are higher than under a fixed exchange rate. This is due to the fact that at A` inflation is higher than at C.

To sum up the MR equilibrium (B’) is the same under both exchange rate regimes and at this point we have a lower output and higher unemployment. Also we have a trade deficit because B’ is below the new BT curve (BT’).

The long run equilibrium will be achieved at point Z that is the point in which trade is balanced ERU’ /BT. In the long run the AD curve is passive and in this case the persistent trade deficit, since B’ is below BT curve, can lead to a change in the credit condition and therefore a shift of AD’ curve to achieve the long run equilibrium with lower output and more competitiveness.

Now we have to present an analysis that explain why supply-side policies are considered more desirable than aggregate demand policies when the economy is struck by such a shock. As before, we undertake the analysis for both fixed and floating exchange rates.

We start with the aggregate demand policies which shift the AD curve. In the diagram 4 is depicted a fiscal policy; a fiscal expansion.

Diagram 4

After an adverse supply side shock, as described earlier, AD/ERU/BT curves shift to the left (AD’/ERU’/BT’). If policy response is a fiscal expansion we have a shift of AD curve from AD’ to AD’’.

In a fixed exchange rate, the θ behavior can be associated to the prices’ behavior; unchanged in the short-run and able to change in the medium run. After the policy response, to achieve the MR equilibrium, we have to move from C’’ to B’’ and, as discuss earlier, since C’’ is above ERU’ curve inflation is rising and also the real wage, adjustments conduct the economy to B’’. In this way output rises because of higher demand implied from fiscal expansion from C to C’’ and then, at B’’ falls because θ appreciates (θ2).

In a floating rate and to achieve medium run equilibrium the economy has to move from A to B’’ and after the fiscal expansion this process is conducted trough A’’. This point is above the ERU curve and the economy moves to B’’. We can state that in a flexible rate regime a shift of the AD curve after a supply shock caused by a fiscal expansion can increase lower the inflation.

In both exchange rate regime we can see that the MR equilibrium is the same (B’’). After a fiscal expansion we can see that output and employment is higher than before.

However the long run equilibrium, the point at which BT’ and ERU’ intercepts, is unchanged and the trade deficit is higher. To sum up we can say that a aggregate demand oriented policy such as a fiscal expansion is effective only in the medium run.

Now, in diagram 5 we analyze supply side policy which are able to shift the ERU curve. Obviously, since these policies have to be use to response to an adverse supply shock, we consider the case in which a rightward shift of the ERU curve is verified. This may happen via shift WS curve down and PS curve up. WS curve shifts down with, for example, fall in replacement ratio and less union power. PS curve shifts up if there is a tax cut, a fall in mark-up or if there is a rise in efficiency and therefore in productivity.

Diagram 5

As we can see the ERU curve shifts to ERU’’ and the medium term equilibrium became B’’ instead of B’. In the short run and in a flexible exchange rate regime, the economy moves to A’ as discuss earlier. A’ is above ERU’’ and so the higher wage increase-higher inflation adjustment process guides the economy along AD’ curve to B’’.

If we consider a fixed exchange rate regime, the economy moves to C as θ is not allowed to change. However, because of the new ERU curve C is below ERU’’. This imply that there is a decrease of the inflation and so real wages are higher than those required by the WS curve and therefore we can observe an increase in the demands lower than those reliable with the world level of inflation. At the new medium run equilibrium the economy is less competitive than in point B’ because the higher θ. Then output increases and the economy move from C to B’’.

To sum up, when a supply side policy is applied we have, in the medium run, that output is higher , the trade deficit is lower and the economy is more competitive since θ is higher.

About the long run we can see that the supply-side policies are able to modify the long run equilibrium (from Z to Z’). This is a very important fact because we can see that the economy is more competitive (θ2> θ1) and also the output is higher (Y2>Y1).

Finally, we can state that supply-side policies place greater emphasis on economic incentives than aggregate demand policies do. This is the point, in fact when an economy is being struck by an exogenous supply shock the result is that the economy become less productive because of the fall in output. According to Bosworth (1984), the supply side of an economy is the determinant of the productive capacity and therefore the supply side policies’ aim is to increase the productive level and growth.

There are many policy options ascribed to supply-side economics. According to Kennedy (2000), those options include import tariffs on intermediate goods, deregulation, preventing wage increases in the public sector from acting as a standard for the private sector, encouraging investment through tax credits, increasing depreciation allowances, lowering interest rates. Moreover, supply-side economists place a great hope on workers’ productivity; therefore, policy implications under an exogenous supply shock would be to increase government spending on public transportation, communications and infrastructure, research activity, simultaneously eliminating unnecessary health and environmental regulation (Kennedy 2000).

As it can be seen, supply-side policies are aimed at increasing productivity and lowering price levels. This takes care of an output decline brought about by the shift in the ERU curve as shown in the diagram 5. This type of policies provides a decrease in the price level. The major downside of Keynesian macroeconomics was that there was no possibility to avoid inflation and unemployment, and the only way out was to balance them by monetary and fiscal policy means. However, supply side policies are aimed at combating stagflation – the major negative result of an external adverse supply shock. Stagflation results in high unemployment and high inflation, and both of them cannot be dealt with by available means of demand-targeted policies.

A classic example of supply-side policies at work was the Reagan administration policy. President Reagan and his team believed that a reduction in tax rates in order to obtain lower marginal tax rates would lead to an increase in tax receipts. This decision was based upon the theory behind the Laffer curve. The Reagan administration aimed its policies at increasing incentives to work, participating in the underground economy less, saving and investing more. However, due to the fact that there were several mistakes made by the President’s administration, the effect of the supply-side policies was far from desirable. According to Bosworth (1984), “the administration and the Congress did not reduce expenditures in step with the cut in taxes, so that there was a large increase in the current and anticipated budget deficits”. Supply-side tax reductions led to increasing government debt. Taxes were also reduced for the rich. Finally, aggregate supply policies adversely affected aggregate demand. They also contributed to increasing interest rates and declining value of American currency.

However, it should be noted that impacting the supply-side of the economy brings positive results and should be done in coherence with demand-oriented policies. The supply side should not be ignored in macroeconomic analysis, so that the possibilities to provide incentives to economic agents would not be forgotten. Currently, the President’s administration is cutting on supply-side inspired policy actions, such as education tax credits. However, with low inflation gradually turning into deflation and high unemployment, supply-side policies should be considered to promote economic growth.

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