ASYMMETRY IN THE EFFECTS OF MONETARY AND GOVERNMENT SPENDING SHOCKS: CONTRASTING EVIDENCE AND IMPLICATIONS

Magda Kandil (*) 1. INTRODUCTION Recent research on business cycles has produced evidence that demonstrates the asymmetric effects of monetary shocks on economic variables. (1) Specifically, the effect of expansionary monetary shocks on economic variables may be different from that of contractionary shocks. The empirical evidence has stimulated efforts to provide an adequate theoretical explanation to the observed asymmetry. Sources of asymmetry have varied sharply in the theoretical literature. Primary explanations may be classified into supply-side and demand-side sources of asymmetry. A strand of the theoretical literature has viewed asymmetry of economic fluctuations to be a supply-side phenomenon. Demand shifts along a kinked supply curve are likely to produce varying effects on the economy. As to the explanation of the kinked shape of the supply curve, competing models offer explanations. In one direction, some have explained the asymmetric shape of the supply curve by conditions in the labor market. This possibility arises in the context of models that advocate the contractual nominal wage rigidity explanation of business cycles. The stipulation of wage contracts may allow for asymmetric wage indexation. For example, if wages are more responsive to expansionary demand shocks compared to contractionary shocks, asymmetric wage indexation is consistent with a kinked supply curve in labor and output markets. Consequently, expansionary demand shocks are likely to move the economy along a steeper supply curve. (2) Alternatively, supply-side asymmetry may be attributed to conditions in the p roduct market that differentiate price adjustment in the upward and downward directions. Faced with menu costs, firms may be inclined for more frequent and larger adjustments of prices in the upward compared to the downward direction. This possibility also is consistent with a steeper supply curve in the face of positive demand shocks compared to negative shocks. (3) Another line of the theoretical explanations of asymmetric economic fluctuations has emphasized possible asymmetry on the demand side of the economy. Conditions in the money and/or goods markets may differentiate the response of aggregate demand to positive and negative shocks. (4) This possibility differentiates the size of aggregate demand shifts in the face of expansionary and contractionary shocks. In the absence of supply-side asymmetry, demand-side asymmetry differentiates the severity of economic fluctuations in the face of positive and negative shocks. The primary difference between demand-side and supply-side explanations concerns the output and inflationary effects in response to asymmetry. Supply-side asymmetry produces a trade-off between the asymmetric effects of demand shocks on output and their inflationary effects on wages and/or prices. The response of output growth is larger in the face of demand contraction compared to expansion. Concurrently, the inflationary effect of demand shifts exceeds the deflationary effect on nominal wage and/or price. In contrast, demand-side asymmetry produces a positive correlation between the asymmetric effects of demand shocks on real output growth and nominal wage and price inflation. That is, larger output contraction relative to expansion correlates with smaller inflation relative to deflation of the nominal wage and price in the face of demand shocks. The purpose of this investigation is to contrast asymmetry on the demand and supply sides in the face of two specific demand shocks: monetary and government spending shocks. Demand and/or supply conditions may differentiate the expansionary and contractionary effects of monetary and fiscal policies. The article's analysis will highlight the specifics of this asymmetry. The empirical evidence sheds some light on potential explanations of this asymmetry as follows. Conditions in the credit market and the behavior of Ricardian consumers may differentiate the effects of expansionary and contractionary government spending shocks on aggregate demand. …