Benefit-Cost Analysis
Tim Geithner and the Swedish Model

Bad Banks Are Not an Adverse Supply Shock

Nick Rowe asks a question:

Worthwhile Canadian Initiative: Banks, Aggregate Demand, and Aggregate Supply: can understand how bad banks could affect the AS curve. Long-run growth comes from the Long Run Aggregate Supply curve moving slowly rightward over time as savings create investment that adds to the stock of capital and increases productivity. A good banking and financial system will encourage savings and investment, make sure the investments are the most productive ones, and make the LRAS curve move rightwards more quickly over time.

Even in the short run a good banking and financial system will be important in re-allocating capital between growing and declining sectors, if there are shifts in relative demand. If people want fewer cars and more restaurant meals, but banks cannot shift loans from car manufacturers to restaurants, the Short Run Aggregate Supply curve may shift left, because the restaurants won't be able to expand to meet demand, and car manufacturers' prices or wages may be sticky downwards. If you see the financial crisis as causing the recession by shifting the SRAS curve left, then monetary and fiscal policies, which shift the AD curve right, are not the appropriate cure...

But if bad banks have shifted the AS curve inward, then right now we should have stagflation: depression and inflation, as output falls and prices rise. We don't. The argument that fiscal and monetary policies won't reduce unemployment to normal levels because we have a supply side problem is completely incoherent in an AS-AD framework.