Thursday, June 13, 2019

The Monetary Implications of A Supply Side Shock

The Federal Reserve was and is instrumental to stabilising the economy counteracting periods of unexpected deflation. However, Trump's trade war, if extended, could cause one of the worst economic downturns in the United States. Not because it will rival magnitude of the Great Recession and Great Depression, but because the federal reserve can't counteract a negative supply shock. The Fed can only really effect demand side inflation so a supply side shock would be rendered ineffective. Instead of raising rates in response to a trade war, the Fed should aim to keep rates steady at the Wicksellian equilibrium rate. Since this natural rate is likely to fall during a trade war, the Fed should cut rates. However, this wouldn't actually have an impact on the nominal wages of the economy. Fiscal policy would be needed to counter to adverse effects of a trade war. It's unclear if Congress is in the political state to effectively do this.