Friday, February 20, 2009

Calvo, January 28, 2008: The Crisis is Unlikely to Be Resolved by a Stimulus to Aggregate Demand

In a reply to a text by Summers in the Financial Times on January 28, 2008, more than one year ago, Columbia economist Calvo made an extremely important comment that continues to apply today and that nonetheless appears to have been forgotten by most. Here's what he said (italics are mine):

Thus, we are witnessing the effects of a “supply” shock, implying that the crisis is unlikely to be fully resolved by a stimulus to aggregate demand through lower interest rates. And even less by transitory fiscal expansion, for the additional reason that credit crises involve “stocks,” while transitory fiscal policy involves “flows.” Thus, if you agree with my view, a key to resolving the current crisis is to reinforce the financial sector which, incidentally, leads me to enthusiastically agree with Larry's thrust in his column. But, on the other hand, I have a much less favorable opinion about expansionary monetary and fiscal policy. These aggregate demand policies are easy to implement in the short run, while strengthening the financial sector is time consuming. Since the latter would be key for avoiding a slowdown, expansionary aggregate demand policies are likely to bring about a period of stagflation, seriously undermining the credibility of policymakers.

The distinction between supply shocks and demand shocks, and between a crisis of stocks versus a crisis of flows is essential. In other words, all that the government is doing right now could easily make things worse in the near future.

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