Tools and Tricks of the Trade, Part III:
The Dynamics of Temporary Shocks
In Chapter 4 we analyzed the behavior of the system
following an unanticipated, permanent shock that shifted the stationary equilbrium from (x1, o, x2, o) to (x1*, x2*). The phase diagram for this system is reproduced in Figure 7.1. x2 is a jump variable and x1 is predetermined. Immediately after the shock, x2 jumps by AB so as to bring the equilibrium onto the saddlepath S′S′.As x1 increases, the path moves along S′S′ until it arrives at the stationary equilibrium C.
The transitional dynamics are more complicated when the shock is temporary rather than permanent. Suppose the public knows that the shock that hits the economy at t = 0 will last only up to time t1. While the shock persists, the transition path is governed by the dynamic system associated with (x1*, x2*). Because the shock is temporary, however, point A remains the long-run stationary equilibrium. Convergence to the steady state at A requires that the equilibrium lie somewhere along the saddlepath at time t1. The path that fulfills this requirement usually involves one jump in x2 at t = 0, and possibly a second jump at t1. Furthermore, the equilibrium path is almost always a nonconvergent path of the system associated with point C. It is rarely optimal to simply traverse S′S′ prior to time t1 and then jump to SS when the shock is reversed. Nor is there any general presumption that the equilibrium path will “shadow” the saddlepath S′S′ up to time t1. In many cases, the transitional dynamics for temporary and permanent shocks are qualitatively different; the path for the temporary shock may well look like ADEF.
Our main motivation for studying permanent vs. temporary shocks is that the same distinction applies to credible vs. noncredible policy reforms. The economic landscape in the Third World is littered with failed attempts at reform. Knowing the history of failure, the public is likely to be sceptical of government pronouncements of a change in the policy regime — more likely than not, the newest attempt at reform will be