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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 at 15:25
Thanks @FooBar; I meant supply shock. –  RobEconomix Feb 16 at 16:17

2 Answers 2

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

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