In the realm of monetary policy, demand shocks and supply shocks are the “two wolves” that determine economic outcomes, and recognizing which one to address is crucial for effective policy decisions, according to a Westpac economist.
Demand shocks are familiar territory for policymakers. When demand is robust, policies tighten to control inflation; when weak, they ease to boost demand.
“The demand shocks are well known and well understood. Policymakers know how to respond to these,” said Luci Ellis (pictured above), chief economist at Westpac Group.
On the other hand, supply shocks present a dilemma, balancing inflation control with stabilising output or employment.
“Adverse supply shocks are less comfortable, with higher prices and lower output,” Ellis said.
The impact of these shocks is evident in the Reserve Bank’s analysis and broader economic discussions.
Ellis urged not to assume but to test the impact of strong demand, especially considering the massive stimulus during the pandemic.
“Recognising and understanding the supply shocks – much like making the virtuous choices involved in feeding the good wolf – can be hard,” she said.
Policymakers often find it easier to address demand issues, even when supply constraints are at play.
Economic relationships are not always straightforward. The Phillips Curve, for example, is obviously not a straight line.
“Some economic relationships are nonlinear and others can shift,” Ellis said, highlighting the need to understand these nuances in policy formulation.
The labour market exhibits nonlinear behavior and shifts. US Federal Reserve governor Christopher Waller and others argued that high job vacancies can decline without a significant rise in unemployment, supporting the nonlinear relationship theory.
“Subsequent events, including in other countries, have supported Waller’s thesis,” Ellis said.
Ellis emphasised the importance of understanding supply constraints and their persistence. She questioned the assumptions behind RBA’s policies, urging for more focus on supply issues.
“It would be good to know what the RBA is assuming about supply constraints, their causes, and their likely persistence,” the Westpac economist said, hoping for more resources to be directed towards this analysis.
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