Demand shocks

Demand shocks

The global financial crisis of 2008 caused a negative demand shock in the American economy.

What is the appropriate way to deal with demand shocks? Let us look at some historical policy implications. After all, history is a great teacher. The more I have reflected on the past, the better I have been able to see what actions are appropriate for the future and most importantly what not to do.

In the '60s, the prevalent view was that demand shocks were the main determinant of business cycles. Keynes in particular argued that private business men were driven by “animal spirits" and that these spirits lead to repeated coordination failures like the one described above. This view lead to the idea that the government had to stabilize the economy by adjusting government purchases or money supply to compensate for the variation in private demand.

The smooth run of many economies in the '60s lead many to believe that this type of stabilization was very effective and that business cycles were dead. More recently, a majority of economists believe that demand fluctuations, although important, cause  fluctuations in productions that are short lived, while supply shocks cause more sustained fluctuations and so that an effective stabilization policy should focus more on the production side, removing inefficiencies and distortions and facilitating production.

This change in view has been caused mainly by the episodes of the 1970s, or by the recent Japanese experience in which demand management policies have not lead to very effective stabilization. I guess an economy is just like anything else in life and there will continue to be ebbs and flows. It is not necessary for people to panic.