Arnold Kling  

Explaining Aggregate Demand and Aggregate Supply

Washington Snowstorm and Commu... Roosevelt and the Puritans...

I am constantly amazed by bloggers and commenters who sneer that I do not understand macroeconomics in general or aggregate demand in particular. Often, the most sneering comments come from people who have no clue about the way economists use supply and demand.* Here is a simple tutorial.

1. Non-economists think of demand and supply as separate and fixed. There is no mechanism to regulate them. Instead, if there is a shortage (of oil, or nurses, or what have you), there is no notion that the price system will change this. Non-economists have no problem talking about a "shortage" of jobs ("we're not creating enough jobs!"), as if jobs are something that are "demanded" by households and "supplied" by businesses or government.

2. To economists, supply and demand are regulated by price. When market conditions change to increase the demand for oil, the price of oil goes up, until demand is curbed and supply is induced sufficiently to eliminate any incipient shortage.

3. For example, in the late 1990's, I heard a talk by a non-economist, speaking to a group of management recruiters, in which he argued that they faced a labor shortage that would last for decades. I explained what was wrong with this thinking in this essay, reprinted in my book Learning Economics.

4. When it comes to aggregate supply and demand, the regulating mechanism is what is called the real wage rate, which means the wage rate adjusted for the general level of prices (or the cost of living). When prices go up, the real wage rate falls, and vice-versa. When the real wage rate falls, firms hire more workers, raising output and employment. That is the aggregate supply that goes along with aggregate demand.

5. This aggregate supply mechanism assumes that wages stay fixed while prices move. This sticky wage hypothesis is at the center of the whole mechanism. But it raises all sorts of questions. Why are wages sticky? For how long do they remain sticky? How is it that the same workers who refuse to take lower nominal wages at a fixed level of prices are happy to see the same nominal wages at higher prices? Thousands of journal articles have dealt with these questions.

6. My point is that aggregate demand is not some deus ex machina that controls output regardless of anything else. The theory of aggregate demand and supply depends on the supply mechanism, which is quite tenuous.

An alternative tradition in macroeconomics, which includes Clower, Leijonhufvud and which Tyler Cowen and I have been pushing, looks at macro as a more general adjustment problem. I call it PSST, for patterns of sustainable specialization and trade. The advantage of this is that it ties to some of the most well-developed, reliable economic theory, including the theory of international trade. It also ties in with theories of entrepreneurship and Schumpeterian dynamics.

I focus on patterns of trade to try to avoid being shoehorned into defending a notion that the economy faces a skills mismatch. Yes, you are more likely to find a job these days if you are a nurse than if you are a construction worker, but that is not the whole story. The whole story is the need for the economy to grope its way toward new configurations that exploit comparative advantage.

*I want to particularly exempt Scott Sumner from this. He understands aggregate demand and supply exactly as I understand it. Paul Krugman is perfectly capable of understanding it, also, as in his article on the euro, where he wrote,

Milton Friedman offered an analogy: daylight saving time. ..By requiring that everyone shift clocks back in the fall and forward in the spring, daylight saving time obviates this coordination problem. Similarly, Friedman argued, adjusting your currency's value solves the coordination problem when wages and prices are out of line, sidestepping the unwillingness of workers to be the first to take pay cuts.

Note that it is the unwillingness of workers to take pay cuts that is the key to aggregate supply.

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CATEGORIES: Macroeconomics

COMMENTS (14 to date)
david writes:

Note that the New Keynesians focus more on (both real and nominal) price stickiness than wage stickiness.

Nominal wage stickiness was the hobbyhorse of the (old) Keynesians, but the New Keynesians pointed out that if one interprets wages as part of implicit lifetime contracts, there is nothing necessarily sticky about nominally fixed wages. Instead we generate price stickiness via monopolistic competition and assorted real/nominal adjustment costs + rational agents.

Unemployment is then caused by excessively high prices driving down aggregate demand, etc.

Compared to this, assorted "coordination problem" views must necessarily either argue that people are systematically irrational in the economic sense ($500 bills on the sidewalk - because coordinating the search for said bills is difficult, perhaps?) or that the market does not "tâtonne" well on a gen. eq. basis. All this must work well with empirical boom vs. bust asymmetries, empirical comovements, etc., of course.

It is weird when the Austrians are more skeptical of the market's equilibriating powers when the mainstream is, but such as it is.

Curious writes:

david, do you know of any affordable books that explain New Keynesian economics?


david writes:

I take this article ("What Is New-Keynesian Economics?", RJ Gordon 1990) to be authoritative, at least of NK's foundations, but I do not know of any ungated sources.

Of books, there are plenty, but they tend not to be affordable.

N. Greg Mankiw has written a good synthesis right here on EconLib, though. He describes a "coordination problem" about halfway through. Don't get confused here; this is not the same type of coordination problem as what Kling & the Austrians are focusing on - Nick Rowe at WCI wrote a post explaining the differences.

Arnold Kling writes:

A distinctive feature of Austrian economics is that it does not posit "equilibrating mechanisms." Entrepreneurs have to actively take steps to address imbalances and make the best use of resources.

The very concept of equilibrium is very neoclassical and not very Austrian. Austrians see the economy as constantly evolving and changing.

david writes:

A bad choice of words, I concede. Consider this as a substitute: the Austrians are more skeptical of the market's coordinating powers than the mainstream is, which is why they emphasize its absence as a (cyclical) problem. The mainstream doesn't - the mainstream presumes that the market coordinates so well that we can regard Austrian-type coordination failures as macroeconomically irrelevant.

One of Mankiw's ten principles is that people follow incentives - the neoclassical corollary is that all incentives that exist, are followed.

A long time ago, the mainstream argued that the market never coordinate; now the mainstream argues that it always does - in either case, the Austrians and anybody who argues for cyclical failures is going to left out in the cold.

Maniel writes:

Do contemporary economists view external (e.g., government) influences such as subsidies (which tend to raise supply) and taxes (which tend to lower supply) separately or do they consider such influences as variations of price? Thanks.

david writes:

More broadly - I think there is a philosophical conflict between the (Hayekian?) Austrian vision of capital time-structures irreversibly responding to very fine manipulations in the price signal and the (neo-)Austrian emphasis on the difficulty of coordination and thus the implied non-responsiveness to fine changes in the price signal. Investors must be very myopic indeed to participate in irreversible anything in such an environment.

There isn't any escape route here; if one argues that the slowly-adapting price signal is the (slow) means of coordination, I can only congratulate you on re-discovering nominal stickiness and suggest a re-reading of the history of mainstream macro, starting with the General Theory.

If I were attempting to link microeconomic coordination problems to macroeconomic fluctuations today, I would not go via the route of ABCT; the New Keynesians set a much higher bar for themselves (defending a type of macroeconomic coordination failure even with perfectly rational agents) and have managed to vault it. The Austrians specify less about their agents and, unsurprisingly, find more possible coordination failures. It may be too easy.

The danger here is in proposing an explanation under-constrained by empirical evidence, and thus being able to explain anything and predict nothing. Coordination failures are so expansive that the time-structures can be dispensed with; one can generate macroeconomic fluctuations merely through asserting a failure to Recalculate, with a theory for the cyclicity assembled post-hoc, linking one's favorite targets through a sufficiently imaginative series of price distortions. Mr Kling, it is not a good thing to emphasize how difficult it is to be shoehorned into defending your pet theory.

Catron writes:

Non-economists think of demand and supply as separate and fixed.

I think the disease has metastasized far beyond that relatively benign (and curable) state. A large percentage of the population (about the same number who support PPACA) believe that "supply" and "demand" are social and linguistic constructs of business civilization.

Not all of them would articulate it that way, but many people clearly believe that there will be no change in price if the quantity demanded (of health care or whatever) goes way up while the available supply remains relatively static.

In fact, many such people hold seats in Congress.

Doc Merlin writes:

I think wage stickyness is far less important than you guys think it is, and accounts for far less stickiness than you assume.

A simpler, stickier, and more international transmission mechanism is nominal debt. It also has the interesting property that short term deflation (while NGDP drops) causes more pain than short term inflation (while NGDP rises).

david writes:

@Doc Merlin

Isn't "nominal debt" reflected in existing theories of liquidity preference? Every nominal debt is someone else's nominal asset, so for this not to cancel out, there must be an asymmetric response to liabilities vs. assets. Insert liquidity preference and we are done; we arrive at textbook models of real money demand and supply.

Ivan writes:

I think you should admit PK got you on that one and call it a day.

fundamentalist writes:
A distinctive feature of Austrian economics is that it does not posit "equilibrating mechanisms." Entrepreneurs have to actively take steps to address imbalances and make the best use of resources.

The very concept of equilibrium is very neoclassical and not very Austrian.

That's not quite accurate, although I may have not understood what you meant. Austrians emphasize prices as the coordinating mechanism, even for entrepreneurs. Yes, entrepreneurs must act, but they act on price signals.

Mises had a version of equilibrium he called the evenly rotating economy. Hayek used equilibrium analysis extensively, although he disagreed with the way Keynesians and Monetarists interpreted it. Both Hayek and Mises asserted that the economy has a tendency to move toward equilibrium but never reaches it. You might say equilibrium is like gravity and the economy is an airplane.

A book that contrasts Austrian, neo-Keynesian and Monetarist economics is Roger Garrison's "Time and Money." But it ain't cheap either.

david writes:


I am far from Austrian, but that is also my understanding of the Austrian position.

I wasn't about to defend something I don't agree with to Kling, though...

Julien Couvreur writes:

I agree overall. But I have one question.

I don't understand what is wrong with talking of "supplying" jobs. Demand and supply are symmetric, two goods get exchanged. It is simply that monetary wage is one of the two goods, and the other one is labor. The employer buys labor with money, and the employee buys money with labor.
That said, I understand that in exchanges that involve money, one side is usually called buyer and the other seller. But they are both supplying something and also demanding something...

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