May 22, 2023

Are financial crises a negative shock to aggregate demand or a negative shock to aggregate supply? This is a fundamental question for both macroeconomics researchers and those involved in real-time policymaking, and in both cases the question has become much more urgent in the aftermath of the recent financial crisis.

Arguments for monetary and fiscal stimulus usually interpret such events as demand-side shortfalls. Conversely, arguments for tax cuts and structural reform often proceed from supply-side frictions. Resolving the question requires models capable of admitting both mechanisms, and empirical tests that can tell them apart.

In a forthcoming paper at The American Economic Review: Insights, Felipe Benguria with Alan Taylor at the University of California at Davis, develop a simple small open economy model, where a country is subject to deleveraging shocks that impose binding credit constraints on households and/or firms. These financial crisis events leave distinct statistical signatures in the time series record, and they divide sharply between each type of shock. Household deleveraging shocks are mainly demand shocks, contract imports, leave exports largely unchanged, and depreciate the real exchange rate. Firm deleveraging shocks are mainly supply shocks, contract exports, leave imports largely unchanged, and appreciate the real exchange rate.

To test these predictions, the authors compile the largest possible crossed dataset of more than 200 years of trade flows and almost 200 financial crises in a wide sample of countries. Empirical analysis reveals a clear picture: after a financial crisis event they find the dominant pattern to be that imports contract, exports hold steady or even rise, and the real exchange rate depreciates. On the basis of this macro-level evidence, financial crises are a negative shock to demand.