Arnold Kling  

Macro Without Aggregate Demand

Disastrous Voting... Perspective on Freddie and Fan...

I have two essays out today. The first one is called The Depressive Realism Economy.

It now appears that we were living in a dream world a few years ago, with oil prices unsustainably low and house price inflation unsustainably high. Reality is less pleasant.

In theory, a student who suffers a blow to his or her self-esteem can continue to work hard and learn. In practice, educators worry that this will not happen.

Similarly, the asset revaluations that represent blows to our economic self-esteem could be shrugged off by workers and businesses. We still have all of the capital equipment and know-how for the U.S. economy to continue growing.

I go on to suggest, however, that the overall economy will not just shrug off these events and plow ahead.

The essay is in fact a subtle attempt to do macroeconomics without the concept of aggregate demand. I think of aggregate demand as a rather misleading metaphor that is actually contrary to ordinary economics. It might take longer to explain what I'm doing than to write the essay, but here goes:

My intuition is that we are going to see a drop in employment and production as a result of the oil shock, the collapse of the housing bubble, and the drop in stock prices. Of course, the oil shock will lower productivity, but that's not what I'm talking about. I'm talking about the reduction in employment and output that macroeconomists typically attribute to aggregate demand.

Instead of calling these events demand shocks, I want to call them adjustment shocks, or relative-price shocks. The market is sending signals that some industries need to expand and other industries need to contract. However, it takes a long time for these signals to work their way through the economy and get processed to the extent that people get new jobs and so forth. Meanwhile, we get employment and production that are below capacity levels.

A key difference between thinking in terms of aggregate demand and thinking in terms of adjustment is the role of policy. In the aggregate-demand formulation, we don't need any complex adjustments to take place to restore full employment. We just need more aggregate demand, and fiscal and monetary policy can do that.

In the adjustment-shock story, government does not know better than anyone else how firms and workers need to adapt and where production needs to expand or contract. So, even though I am expecting the new realism in the housing market, the oil market, and the stock market to lead to a drop in employment and output, I conclude:

Adapting to the reality of higher energy costs and an excess housing stock requires myriad complex adjustments, some of which may be obvious but many of which are subtle. Chances are, it will take several years to complete the transition. Meanwhile, there is little, if anything, that policymakers can do to hasten that process.

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CATEGORIES: Macroeconomics

COMMENTS (9 to date)
liberty writes:

Interesting. Its funny, but I think my father would agree with your analysis, but think government has a major role to play in aiding adjustment. He sees shocks and readjustment between industries, along with adaptation to new technologies, as a major cause of business cycles but he believes in active fiscal and monetary policy to help smooth things over.

He would argue for government re-training programs, unemployment and income support, and maybe government employment programs on the fiscal side (along with tax policy shifts probably to aid the new up and coming areas); and not sure what he'd say on the monetary side but I'm sure he'd have something.

eccdogg writes:

Arnold, this is exactly the way that I think about Macro and I think the Agg Demand stuff misses (or obscures) the point.

Chuck writes:

It is crazy, is it not, how much of our capital is tied up in homes?

Has anyone figured what our GDP growth would be if that capital was invested in productivity enhancement instead?

BGC writes:

AK: "Meanwhile, there is little, if anything, that policymakers can do to hasten that process."...

...but *a great deal* that policymakers can do to retard that process.

MattY writes:

The legislature will be overwhelmed into inefficiency and mostly making the problem worse.

Our "putting things off to the long term" and "managing short term crisis" have merged. Long term is in six years, short term is in two years; its all one adjustment period.


I've got a mechanism that fits with your alternative theory:

If the managers and investors are looking at historical time-averaged costs for manufacturing, factoring in the new astronomical oil and commodity prices, and then estimating how big their next batch of production should be, then that might explain why their cutting labor now. They're predicting that price increases will lead to decreased demand. The cost accounting methodology is the root cause of this problem.

If IN ADDITION the managers and investors were looking at the historical turnover rates in their inventory and raw materials, then there wouldn't be a disemployment effect as quickly, because cuts to labor could be made as demand fell off in real time. The firms that are able to pass on products at higher price (because of better quality) should be able to weather the downturn without too many labor cuts.

But you can't make adjustments the second way when all you're looking at are the time-averaged costs of production. You have to look under the hood and see the cycles of production.

When are we going to stop measuring our productivity and growth entirely in terms of time-averaged costs? What the hell is "equity cost of capital" anyway?

Thanks for the interesting post.

The Sheep Nazi writes:

Just the right amount of 'our' capital is tied up in 'our' house, which 'we' own for cash, thank God. 'We', in this case, means me, and She Who Must Be Obeyed. Apart from us two there ain't no our, so far as that house is concerned. Folk marxism, indeed.

Nick Schulz writes:

Arnold, I wonder if this view (adjustment vs. aggregate demand) is a model that works well to explain past periods in economic history. For example, how does the Depression fit in to this idea of aggregate demand vs. adjustment? Or, say, the stagflation of the 1970s?

Arnold Kling writes:

What is interesting about both the 1930's and the 1970's is that there were impediments to adjustment. In the 30's, there was Roosevelt's NRA, which attempted to fix wages and prices, rather than let them adjust. In the 70's, we had wage-price controls.

It could be that the adjustment required today is just as large, but the adjustment process isn't being impeded so much. But I would not make that claim.

However, I would suggest that one does not necessarily need ordinary macro to tell the story of the 30's or the 70's.

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