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Relative supply shocks, Unobtainium, Walras’ Law, and the Coronavirus

Summary:
Here's the basic idea: A temporary 100% output cut in 50% of the sectors (what the Coronavirus does) is very different from a 50% output cut in 100% of the sectors (what our intuitions might expect from supply shocks in aggregate macro models). The former can easily lead to excess supply in the unaffected sectors; the latter leads to excess demand in all sectors. Here's the intuition: (As they say: "Shit just got real". And one of my daft old thought-experiments just got very real.) As you know, unobtainium is a very desirable good. Everyone wants to buy it. But nobody produces it. It doesn't exist. You could say there's an excess demand for unobtainium, because people want to buy some of it, at any price. Maybe they want to spend half their income on unobtainium. But supply is zero.

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Here's the basic idea:

A temporary 100% output cut in 50% of the sectors (what the Coronavirus does) is very different from a 50% output cut in 100% of the sectors (what our intuitions might expect from supply shocks in aggregate macro models).

The former can easily lead to excess supply in the unaffected sectors; the latter leads to excess demand in all sectors.

Here's the intuition:

(As they say: "Shit just got real". And one of my daft old thought-experiments just got very real.)

As you know, unobtainium is a very desirable good. Everyone wants to buy it. But nobody produces it. It doesn't exist.

You could say there's an excess demand for unobtainium, because people want to buy some of it, at any price. Maybe they want to spend half their income on unobtainium. But supply is zero. And if you do say there's an excess demand for unobtainium, and if you also believe in Walras' Law, you get into one helluva mess theoretically, because the excess demand for unobtainium must (by Walras' Law) be matched by an excess supply of other things. So even thinking about unobtainium creates a general glut -- a recession. Which is silly. Because Walras' Law is wrong. Because, as Clower said long ago, it's constrained not notional demands that matter. As I explained in my old post.

But now imagine that someone actually invents a way to produce unobtainium. They can't produce it just yet, but everyone knows they will produce it, and sell it at an affordable price, a few months from now.

What happens when they hear the news? Everybody (or everybody except borrowing-constrained Hand To Mouth agents) suddenly wants to save up to half their income, so they can spend it on unobtainium in a couple of months time. Their money will be worth more in a couple of months than it is now, because they will be able to buy unobtainium with it, and not just all the stuff they can already buy now. We get a general glut (deficient demand) now.

And that is pretty much what's happening with the Coronavirus, in the real world. Half the goods we used to buy are temporarily unobtainium. But we expect to buy them in a couple of months.

It would be very different if unobtainium were a perfect substitute for existing goods, so its invention is exactly like increasing the supply of existing goods in a couple of months. Then we would want to dissave now, like in standard aggregate macro models, because the Marginal Utility of Consumption is high when consumption is low, so we want to prepone consumption from the future to the present. But unobtainium isn't a perfect substitute for existing goods. High intertemporal substitution can beat low cross-section substitution.

(Sure, unlike in my thought-experiment, we used to be able to buy unobtainium in the past. But that's irrelevant; bygones are bygones. It's only the present and the expected future that matter.)

That's why we need temporarily looser monetary and fiscal policy. (Plus, we also need fiscal policy to redistribute between people differentially affected by the Coronavirus, but that's another story.)

Think that's (basically) right.

OK, I've oversimplified (of course). Much of the stuff that's still obtainable is the more essential stuff, like food. But not all. And, at the margin, we still face intertemporal vs cross section substitutibility.

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