Shocks and Transmission Mechanisms Outline Uncertainty and Irreversible Investments Labor Adjustment Costs Time Bunching Collateral Damage Introduction Transmission mechanisms economic forces that can amplify the impact of shocks on the economy We focus on five transmission mechanisms Intertemporal substitution Uncertainty and irreversible investments Labor adjustment costs Time bunching Shocks to collateral and net worth Intertemporal Substitution Intertemporal substitution the allocation of consumption work and leisure across time to maximize well being Examples Lack of rainfall affects crops directly but it also affects the farmer s willingness to work hard which may reduce output further When unemployment is high some productive people fearing they may lose their job leave the work force and go back to college reducing output even further Intertemporal Substitution Intertemporal substitution magnifies economic shocks When things go a bit bad the rate of return to work and investing falls and people work and invest less On the upside Intertemporal substitution can feed an economic boom and make it more intense Amplifying Shocks Intertemporal Substitution Irreversible Investments Irreversible investments have high value only under specific conditions they cannot be easily moved adjusted or reversed if conditions change Negative shocks increase uncertainty especially for irreversible investments Uncertainty slows investment and keeps resources in less productive uses Labor Adjustment Costs Labor adjustment costs the costs of shifting workers from declining sectors of the economy to growing sectors Adjustments to shocks are not always rational A union worker in the auto industry making 100 000 a year without a high school degree will probably turn down a lot of available jobs before he finally accepts reality and takes a job at a lower wage Result even higher unemployment and lower real GDP growth Time Bunching Time Bunching the tendency of economic activities to be coordinated at common points in time Bunching causes shocks to spread through the economy and through time Suppose a negative economic shock slows the economy down Many people will be less keen to work because of Intertemporal substitution This will induce others to cut back on their work as well Time Bunching The seasonal business cycle is one form of economic clustering in time The fourth quarter October December brings more economic activity than any other time After Christmas the party is over and economic activity is the lowest Once some economic activity is moving in given direction other parts of economic activity tend to follow that momentum Collateral Damage Collateral a valuable asset that is pledged to a lender to secure a loan If the borrower defaults ownership of the collateral transfers to the lender Collateral shock a reduction in the value of collateral Collateral shocks make borrowing and lending more difficult Collateral Damage A negative shock slows the economy down and asset prices fall causing the value of collateral to fall Loans are more difficult to obtain if the value of collateral is low Investment slows down and growth slows even further During an economic boom asset prices rise and it becomes easier to get loans and makes the boom even bigger Collateral Damage Collateral damage also affects consumers Falling asset prices like homes make it difficult for people to move to better jobs General lesson If the nominal owner of a property has no equity in it they don t do a good job of taking care of it Banks Houses Conclusions Transmission mechanisms magnify shocks We identified five of these mechanisms A medium sized negative economic shock is capable of causing a disproportionately large downturn in production and employment
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