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Stephen, you had me right up to the point where Canada starts running a trade deficit in mid-2004. Something missing in the explanation?

It is amazing how closely the terms of trade and commodity prices track each other in your graph.

Commodity prices (the ones you plotted) are measured in C$, right? Are the different commodities weighted by their shares in Canadian production, or shares in Canadian exports, do you know?

It makes me wonder what is happening to the terms of trade of non-commodity exports and imports. Staying constant? Which would be strange.

Marc: isn't that because the export and import series are deflated by their own price indices, not by some common price index? So they represent the quantity of beer exported, and quantity of pizza imported, not the values. The trade deficit is the value of pizza imported minus the value of beer exported. (I always have difficulty keeping my head straight on this, so it really helps me thinking about beer and pizza.)

But here's the thing of it, and it really goes back to the debate we were all having about QE/inflating our way out. If I may briefly paraprhase the story, we have a situation where the real price of commodities (world market price) went up. Since Canada was selling commodities our real incomes went up. Now the qestion arrises, do we spend the income on imports or domestically produced goods and services? The answer was: imports. Now why was that? Well, we where at full employment, it was not physically possible for us to produce more at home. Higher demand for domestic production would just raise its price. More to the point, the improvement in our terms of trade made foreign tradeables look cheaper relative to domestic production (tradeable or not), thus there was a price signal causing us to substitute away from domestic production and towards imports.

So why does this matter? Because Stephen's story doesn't live up to the title of the post. It explains why Canadians have lost real income but NOT why we have unemployment. The qestion is, as the terms of trade deteriorate, why don't we substitute back to domestic consumption? Why does domestic aggregate demand slump? After all, this sort of price signal is somethng like the story in favour of floating exchange rates, is it not?

You could tell stories of real frictions, our stock of real and human capital was not set up to produce non-tradeables or something like that and so we may have an increase in the natural rate of unemployment for a time. However, a simpler explanation goes back to what we've been arguing about over the last week. Consumption was high, now it is and will for some time be lower, thus people's conumption euler equations say they should all save. The solution then is inflation, in our arguments over the last week Nick and I disagreed about the various transmission mechanisms from monetary policy to the real economy (we also argued over the basic causes of the trap, the last sentance was my version). But we always agreed on the prescription.

The post basically says that the drop in real commodity prices means Canadians have gotten poorer, this nobody can argue with. But that doesn't HAVE to mean a recession.

One more quick point. The unexpected drop in incomes could also cause people to become liquidity constrained, as in Nick's recent model. I was not arguing between mine and Nick's story. I only claim that you need one of our stories, or something else, to explain why we have a recession. It doesn't seem to me that the story in the post does it.

Marc: Those are the constant-dollar series (as labeled on the vertical axis). If export prices grow faster than import prices, then the nominal trade balance can stay in surplus even if real imports rise while real exports remain constant.

Adam: Import-substitution on the part of consumers is perhaps not as smooth a transition as all that.

Stephen you say it so lightly!

So your story is of real frictions, that is, our stock of real and human capital was not set up to produce non-tradeables or something like that. But this is a radically different interpretation than Nick's and it begs for the opposite policy response. Your story is fundamentally an RBC interpretation in the time-to-build tradition. If that's the case then expansionary monetary policy is the absolute last thing we should be doing.

The difference matters!

For what it's worth though, seems to me the liquidity trap/demand slump story is a better description of reality, it's not clear why your story would produce disinflation/deflationary pressures.

Kudos to you Stephen for such a delightful and engaging post (I'm notifying AA on your behalf just so's you know how engaged I am) and esp for the last Fig which looks normal until you click on it to see the post 2008 part (the gods are with you or you are beyond smart with these graphic thingies).

But the real story has little to do with declines in housing prices or consumer debt loads. It's all about the terms of trade.

You figure the real story is about housing price declines & consumer debt loads...in the US...soon to arrive in Canada, not just another country in the gobal economy, but almost another state in the US?

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