Economics 101 And Recovery From Recession

John Cochrane is a supply side economist.  He and other supply side economists blame our slow recovery from the Great Recession on shocks that cause business investment to decline.  Typically, the shocks to business investment are attributed to government policies that create uncertainty about the future. They also believe that government efforts to stimulate demand will be ineffective or harmful.  Demand side economists have a different perspective on the business cycle.  They believe that recessions are caused by cuts in spending.  Central banks are the first line of defense in a recession. They can cut interest rates which encourage business investment and consumer spending.  However, when interest rates have been cut to zero,  and we still have unemployed resources, demand side economists believe that fiscal policies should be used to stimulate economic activity.  That can be accomplished by increasing government spending and/or by cutting taxes.

Noah Smith understands that there is no simple way to end the debate between supply side and demand side economists that has long history.  In this article, he uses simple supply and demand graphs to illustrate what should happen to prices during a recession.  They show that prices should rise when the supply curve moves to the left.  That is, we should have price inflation.  In fact, supply siders have been forecasting price inflation for last several years and it has not happened.  Instead we have seen a decline in prices.  That is exactly what happens when the demand curve moves to the left following a shock to demand.  Smith argues that this simple illustration shows that demand side explanations are more intuitive than those used by supply siders.  That does not settle the debate, but it does explain why demand siders continue to advocate the use of fiscal policies to stimulate demand.  I suggest a test that anyone can use to test their intuitions about this debate.  Pretend that you are a business person, and consider each of the factors that supply siders use to explain why you are not spending money to increase capacity.  Then ask yourself what you would do if you saw an increase in demand for your products or services. 

When you have finished this task please enjoy the holiday in the US and the world cup matches over the weekend.