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From what I understand about Keynesian theory, when we're facing deflation, lowering interest rates or increasing government spending/lending (when consumers are cutting back) helps stimulate economic growth through consumption (GDP = C + I + G + NE). While a few loud voices (Schiff, the ZH guy, Martin Armstrong, etc) have been screaming about hyperinflation, Krugman has been right that we haven't seen it, even with the Federal Reserve's QEs. It does seem like QE has helped move the economy along, even though I know this depends on a person's point of view; ie: Austrian economists won't agree.

What happens in the case of a major drought causing food prices to rise, as in double, triple or quadruple (See this post by Bill McBride. and now this post)? Is the Keynesian solution here to raise interest rates => wouldn't that be a double whammy on the poor in that it would be more difficult to get a job and food prices would be rising? What is the Keynesian solution to supply shock problems, like a major drought, impacting basic necessities, such as food prices?

To be more specific because of the comment, I am looking for the Keynesian solution to a supply shock, or major crises that involve a supply shock - such as a drought that causes food prices to rise?

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I think "major crises" is too broad. First, you presume deflation. Your second paragraph then asks about a supply shock. Could you focus on one issue? – FooBar Feb 11 '15 at 15:25
Thanks @FooBar; I meant supply shock. – RobEconomix Feb 16 '15 at 16:17
up vote 3 down vote accepted

In what follows, I'm going to be very hand wavy - take with a grain of salt.

If you think about it, a demand shock is like a scenario of multiple equilibria (given the fixed levels of wages and prices):

  • If everyone is employed, everyone has a lot of income, can spend that on goods, and the demand for goods implies a large demand for labor, making everyone employed
  • If few people are employed, total spending is smaller, so is demand for goods and labor, corresponding to only fewer people employed

The Keynesian solution can be thought of as forcing the first case to happen rather than the second.

If you really have a supply shock, that is, lack of a factor important to production, there is no indeterminacy here. There just isn't that much (oil) available, increasing its price. The RBC spokesperson of your favor would say

The high price stems from scarcity; both the high price, the low production and high unemployment are efficient.

In the standard problem, rigidity of wages and prices create inefficiency, they can be dealt with. Here, there is no such inefficiency, and no inherent solution to a supply side shock.

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I came across this post by Krugman and I think for those interested in learning about these different theories that the below quote helps when thinking about supply shocks and Keynesian economics:

OK, stop right there. That’s an adverse supply shock, and no Keynesian claims that demand-side policies can cure the economy from the effects of such shocks. If you have a harvest failure, deficit spending can’t put the crops back in the fields. But that’s not what happened to the world economy in 2008, or in 1930; productive capacity was unimpaired, as was the willingness to work, so what we were looking at was something quite different — a demand shock, according to most economists, and everything we’ve seen is consistent with this view.

This isn't to say I agree or disagree; I find it helpful to understand that focusing on the demand side cannot help if we have a supply shock. To my knowledge, the best preparation for a supply shock, like the California Drought leading to food prices quadrupling (ONLY in theory), would be to have a supply surplus saved or ready in case of such events.

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Last analogue in US was Nixon years: Price Controls first, interest rate changes second.

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