Canada's Recession

Sumner has recently argued that Canada must have had both an adverse aggregate supply shock and a decrease in aggregate demand at the same time.   That is how Canada had a recession without there being any disinflation.   Sumner illustrates with an aggregate supply and demand diagram.

What was the adverse aggregate supply shock?   According to Sumner, it was a reduction in the demand for Canadian intermediate goods by U.S. firms.   He uses Canadian transmissions as an example.

 Many would see the drop in global trade as a demand shock hitting Canada, as there would have been less demand for Canadian exports. In fact, it would be an adverse supply shock. Even if the BOC had been targeting NGDP, output would have probably fallen. Factories in Ontario making transmissions for cars assembled in Ohio would have seen a drop in orders for transmissions. That’s a real shock. No (plausible) amount of price flexibility would move those transmissions during a recession. If the assembly plant in Ohio stopped building cars, then they don’t want Canadian transmissions. If the US stops building houses, then we don’t want Canadian lumber. That’s a real shock to Canada, i.e. an AS shock.

I suppose if it were really true that no cars were being produced or homes built, there would be no demand for Canadian car parts or lumber.   However, homes were being build and cars were being produced during in the U.S. during the period of Canadian recession. 

 If the Canadian car parts or lumber were the sole source for the U.S. firms, then lower prices of those products (even to zero) would likely not result in sufficiently lower costs for producing cars or houses so that the production of those goods remained unchanged (or growing) leaving the demand for Canadian car parts or lumber unchanged (or growing at trend.) 

If, on the other hand, the U.S. firms also use car parts from the U.S. and perhaps other countries, and also use U.S. lumber, then the Canadian exporters can increase their market share relative to foreign competitors.   The total output of U.S. cars or houses might be falling, but the amount of Canadian car parts or lumber in that smaller amount of reduced final product might be unchanged or growing on trend.

The "problem" is not low price elasticity of demand for exports exactly.   From the point of view of the Canadian export sector, the problem is that this drop in demand for exports makes it profitable to instead use Canadian resources to produce import competing goods.   From the point of view of Canadian exporters producing goods with exceptionally low price elasticity, there is the additional problem that it will be profitable to expand the production of export goods with relatively high demand elasticity.

So, Sumner is correct that a recession in the U.S. is going to make a reallocation of resources in Canada sensible, and that such adjustments have costs.     With a sticky wage trajectory, the most likely scenario is a more rapid contraction in sectors that need to shrink and a more measured expansion in sectors that should grow.  

Anyway, I think that the problem with Sumner's analysis is that it ignores the key problem--targeting consumer prices.   Consumer prices include import prices.    Maintaining aggregate demand would require a decrease in the exchange rate, and that will increase in prices of imported goods, including imported consumer goods.   

By targeting a consumer price index, the Bank of Canada interferes with the market process that would lead to the reallocation of resources described above.   Most directly, it restrains consumer price inflation by limiting the increase in the price of the U.S. dollar, and so limits the process that involves more demand for import competing goods and export goods with relatively high elasticities of demand offset by decreased demand for export goods with relatively low elasticities of demand.

Is there a supply shock?    Not really.    It was an increase in the prices of imported goods.   That looks like a supply shock.    Higher prices are what happens when the supply of some domestically produced good falls.    But imported goods are not domestic products.

Suppose that all Canada did was produce wheat for export and imported all consumer goods.   Further suppose that international wheat markets are competitive and Canadian wheat production is small relative to world wheat production.  

Further suppose the rest of the world goes into recession and the demand for wheat falls.  If the Bank of Canada targets nominal GDP, then the price of wheat in Canada dollars would stay the same, but the prices of imported consumer goods would rise.   (If some inputs for wheat production are imported, then the price of wheat in Canadian dollars would rise so that the Canadian value added to wheat evaluated in Canadian dollars would be unchanged.)

If, on the other hand, the Bank of Canada wants to target the CPI, including the prices of imported consumer goods, then Canada will have a deep recession.    The Canadian dollar would only be allowed to fall to the degree that there was disinflation in the rest of the world.   Canadian inflation would remain on target, but the rest of the world would have disinflation.

If the problem were bad enough, then cutting back on wheat production and instead producing some of the high priced consumer goods and services domestically would be sensible.   But really, the key problem here is the role of imported consumer goods prices in the price index being targeted.    If the GDP deflator were calculated properly, then targeting that price index would have had much the same effect as targeting nominal GDP.

I don't deny that significant shifts in the composition of demand for output will result in slower growth in aggregate output or even temporary decreases in aggregate output.   But I don't even count that as a recession.   It would be a "recession" in some sectors of the economy, but we could point to other areas of the economy that were booming, being held back by some kind of bottlenecks.   Real output might be lower.   Prices might be higher on average--higher in the profitable booming sectors and not very depressed in contracting sectors. 

To me, recession needs to be a situation where there are contracting sectors and whatever booming sectors that exist are rare.     I will grant that a shift in terms of trade is a "real" shock of sorts, but an adverse supply shock is when at least some sectors contract and there is no offsetting expansion.   A poor harvest would be the key example.   Less production and higher price in the contracting sector, and no offsetting booming sector.

No, Canada's problem was that it was targeting consumer prices, including the prices of imported consumer goods.