“Shock Signatures”

Nick Rowe, Scott Sumner and Lars Christensen have been debating whether Canada was subjected to an AD or an AS shock or, naturally, some of both. Like serial criminals, economic shocks leave ‘signatures’ to help you identify the perpetrator.

From AD/AS analysis, if aggregate demand is the major source of the (negative) shock, we would expect to observe a fall in RGDP growth and a fall in the rate of inflation. In other words, the leftward movement of the AD curve is more pronounced than any leftward movement in the AS curve.

If, on the other hand, the major source of the (negative) shock is aggregate supply, we would expect to observe a fall in RGDP growth and a rise in the inflation rate. The leftward movement in the AS curve is more pronounced than any leftward movement in the AD curve.

The charts below indicate that Canada experienced what was (mostly) an AD negative shock. Inflation (the headline CPI which is the inflation that the BoC targets) came down while RGDP growth also fell.

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Just to show a contrasting result, Iceland during the crisis experienced a (mostly) negative AS shock. Inflation jumped while RGDP growth tanked.

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The following two charts corroborate that view – AD shock in Canada and AS shock in Iceland. Observe that in Iceland NGDP growth only decelerates to bring it back to trend. In Canada, on the other hand, NGDP falls below the trend level (by not as much as in the US, not to mention the euro zone) and remains ‘tracking’ the trend on a lower ‘parallel’ course.

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Canadian quarterly data, however, indicates that over the past 18 months nominal spending growth has been trending down and is now getting dangerously low. So has inflation which at present is below the lower bound of the target band (1% – 3%). The charts illustrate.

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Only hope that Mike Carney changes strategy (as he hinted in December) after taking over at the BoE!

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