Triple Option

By Michael Maynard

**This article served as the final project for Intermediate Macroeconomics at Franciscan University of Steubenville**

One of the hottest topics in global markets right now is the disruption of supply chains.  Explaining the mechanics of the situation is rather simple, but economists and international analysts are trying to make sense of the implications of from these disruptions, which is a significant enough economic event to drive a recessionary period.  The implications are significant, as the consensus view of analysts seems to be that the attempted rapid recovery from the pandemic left suppliers behind, as a return to pre-COVID level of productivity was implausible, and it became inevitable that supply chains would break down.

THEORY: NEGATIVE SUPPLY SHOCK

Using the aggregate supply and demand model, the supply chain disruptions are rather simple to examine from a macroeconomic perspective.  If the supply process becomes more costly and less efficient, this affects the AS curve, as a negative supply shock occurs.  The behavior of the aggregate supply curve is debated in macroeconomic theory, as Dornbusch, et. al (2018) outline three potential ways of representing AS.  In the short-run, AS is horizontally sloped, while it is vertically sloped in the long run, and the authors present a medium run that features a positively sloped (p. 5, 8-9).  Regardless of the slope, any negative supply shock shifts the AS curve to the left and will lower output.  The debate arises when considering how the price level reacts, which indicates how policymakers should treat a rise in the price level. The SRAS holds that the price level is constant, while the medium and long-run models say otherwise.

Both positive and negative supply shocks are common as a part of economic fluctuation, so at face value the current supply chain disruptions should be self-correctable, as companies respond by seeking to improve supply chain methods, which would revert the economy back to its initial equilibrium output and price level (why LRAS is vertical).  The fear becomes that the disruptions impact the LRAS and cause a permanent output decrease with inflation.

Figure 5-3 from Dornbusch, et. al (2018, p.102) demonstrates the leftward AS shift in a medium-run market.  The scenario is the 1973 oil embargo, which can apply to the present situation as the oil shock lowered the resource accessibility by way of reducing imports, which is the same thing happening now on a much broader scale.  As observed in 1973, oil tends to be a significant indicator of economic trends as the primary global energy source.   Considering the current spike in oil prices, a subsequent decline in supply procedures is a logical expectation.

HEADLINES

The supply chain issues are most significant in manufacturing.  Yap, et. al (2021) report how Chinese export costs are nearly five times higher than normal this year, most observable in reductions of automobile exports.  Magnesium prices have risen 60% in China, which affects the production of automobiles.  Yap, et. al (2018) conclude that with lockdowns, cars were not in as high of demand, but as economies open, demand returns to the pre-COVID levels.  However, as consumers flock to re-enter the car market, the product simply is not abundant. 

Lanng (2021) asserts that the institutional factor that has failed, as a combination of worker strikes and active COVID cases (Yap, et. al, 2021) cut into the productivity of port workers, therefore claiming that the current procedures in supply chains must be amended.  Laang (2021) claims the accelerated economy caught businesses off guard, as they were unable to return to optimal production before lockdowns and fell behind.  It is easy with this issue to pin the problems on the politicians who reacted impulsively to the pandemic, and increased spending to try and mitigate recessionary effects, which becomes relevant in the concerns of prolonging the shock and spiraling inflation.  However, the global nature of supply chains means that one government or one sector cannot be entirely responsible, as the issue remains that supply chains cannot keep up with aggregate demand, and the economy will have to adjust somehow.

DISCUSSION

Because COVID is culpable for the majority of the economic issues in the last two years, the supply chain disruptions are certainly related, and the lag for these problems to arise relates to the aggressive recovery efforts where aggregate demand outpaced aggregate supply, which contributed to this negative supply shocks. The likeliness these supply chain issues will need to be resolved over a longer period of time means that the SRAS model for aggregate supply can be disregarded, as it is illogical to see these disruptions as only affecting output.  Therefore, as inflationary fears rise, economic advisors and policymakers must reconcile that the COVID economic destruction is an long-run issue, and at this point a perfect solution where inflation and output reductions are both eliminated is unlikely according to macroeconomic models. 

Policy wise, a few solutions can be considered. As government spending is a variable of the AD model, throwing more money at the problems would be disastrous when dealing with supply chain disruptions.  Monetary or fiscal expansion to shift AD rightward would return the economy to the original output, but at the cost of an inflation even more pronounced than the natural price increases expected with a supply shock.  For the hands-on macroeconomic planners, this reality is unfortunate because the issue with supply chains is tough to solve outside of direct investment into the logistics industries where the problems occur, which is not a guaranteed path for success. 

At this point, the distinction between the medium-run, positive AS and LRAS becomes important to understand the implications of supply chain disruptions.  If this issue can be solved in the intermediate, there is hope that AS can recover to its original levels and logistics firm seek innovation to increase productivity.  Such an expected recovery would mean subsidies for logistics companies could accelerate a right-ward shift, but in reality, the supply chain disruptions are likely a long-run issue because of the necessary institutional reform.  The macroeconomic representation therefore is leftward shift a vertical AS curve, where the economy adjusts to a lower output at a higher price level.

REFERENCES

Dornbusch, R., Fischer, S., & Startz, R. (2018) Macroeconomics; 13^th edition.

Lanng (2021, Nov. 11).  “How to stop supply chain issues disrupting the economic recovery.” 

World Economic Forum. https://www.weforum.org/agenda/2021/11/how-to-stop-supply-

chain-issues-disrupting-the-economic-recovery/

Yap, C.W., Boston, W., MacDonald, A. (2021, Oct. 8) Global Supply-Chain Problems Escalate, Threatening Economic Recovery. Wall Street Journal. https://www.wsj.com/amp/articles/supply-chain-issues-car-chip-shortage-covid-manufacturing-global-economy-11633713877