Arnold Kling  

Do AS and AD Intersect in a Recession?

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As you may know, I have been recording chalk-talks for my high school economics class. I did macro first, and now I am working on micro (I am now quite a few lectures ahead of where we are currently in the course). After I did the basic factor demand story (wage equals marginal revenue product), I thought it might be ok to introduce PSST. The result is here. Think of it as an introduction to PSST for students who have gone through the rituals of introductory macro and just barely learned basic supply and demand in micro.

In my own mind, PSST is more for a student who understands the 2x2x2 model of international trade. I hope you do not need that level of math, but if I were trying to explain PSST at a graduate seminar, I would want the students to have the intuition of the 2x2x2 model clearly in their heads.

Anyway, what occurred to me while trying to do my talk was that there may be some intellectual swindling going on with AS and AD analysis. More below.

I started with the textbook model. There, the only problem in the economy is that the wage rate is too high. Thus, you get an excess supply of labor. Given the too-high wage, there is no excess supply in the goods market (firms are producing where marginal revenue equals marginal cost). But I have two issues with the textbook model.

1. It is nearly an abuse of language to call the problem a shortfall of aggregate demand. That makes it sound as if the problem is a lack of demand for goods, when in fact the problem is an above-market-clearing wage.

2. My verdict is that the textbook model does not hold up empirically. There are too many recessions on record where you do not see the real wage rising as the model predicts. This has nothing to do with whether you like PSST or not. As an empirical matter, if you are trying to explain every change in unemployment on the basis of a reverse movement in real wages, you cannot do it.

In my talk, I addressed these issues by drawing a goods market with excess supply using the standard picture. That is, the price is above the equilibrium price. This avoids the problems (1) and (2). In particular, it implies inelastic demand for labor in recessions, so that workers cannot get their jobs back simply by offering to work at somewhat lower wages.

But now we have two very different pictures of the goods market. The one I just drew to illustrate excess supply shows the economy not at the intersection of supply and demand. Instead, it is a standard analysis of what happens when the price is too high to clear the market.

But this exact same situation in macroeconomics is depicted as an intersection of the aggregate supply and demand curves. So, what we show students is an intersection, and what we have in the back of our minds is a non-intersection. That is what I mean by a swindle.

I think the best way to handle it would be to illustrate excess supply in AS-AD the same we would in micro: as a gap between the demand curve and the supply curve, caused by a too-high price. So, my answer to the question in the title of this post is "No." I would prefer not to teach under-employment as an intersection of AS and AD.

In the textbook model, workers can get their jobs back by offering to work for less. In the modified AS-AD story above, they can get their jobs back if firms cut their prices to get rid of the excess supply. The PSST story is that the workers cannot get their jobs back at all, because the former production patterns are not sustainable. Only when new patterns of specialization and trade are discovered will we see full employment return.


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CATEGORIES: Macroeconomics



COMMENTS (10 to date)
JoeFromSidney writes:

I'm dubious about the whole idea of "aggregate" demand and, for that matter, "aggregate" supply. Nobody buys or sells an "aggregate." I need to learn more about PSST, and will look at your slides.

david writes:

Obviously there has to have been a shock that has invalidated the previous prevailing price vector and the economy must shift to a new one; is PSST a contention that the price mechanism, even flexible prices, cannot permit this shift?

And of course the New Keynesians don't need procyclical real wages...

Nick Rowe writes:

Yep. What i tell my students is that the SRAS curve is not in fact a "supply" curve. because a supply curve is supposed to show the quantity that sellers *want* to sell. So if there's excess supply of output in a recession, we must be off the true supply curve. The SRAS curve is really a sort of Phillips Curve thing.

But this is one case where New Keynesian macro gets it right. Even the LRAS curve isn't really a supply curve, if firms are monopolistically competitive. It's just the curve that shows equilibrium price that firms set as a function of Y. It's vertical because at Y /= Y*, there is no long run equilibrium price level.

Karl Smith writes:

So that's not quite right.

I am not sure what textbook you are using but the change in aggregate output from an AD shock is not because the Aggregate Demand does not meet Aggregate Supply.

That is, we are not imagining a surplus on the AD-AS graph.

This is because AD is not decomposible into some Slutsky matrix based on income and substitution effects. There is not some alternative good to substitute into nor a budget constraint to impose an income effect.

Instead its represents the set of equilibrium points for money demand and money supply. Given this Output level people will be satisfied with their money holdings at this price level.

Aggregate Supply is in truth a creation of empirical convenience. It just really looks like money is non-neutral in the short run.

However, you can motivate by suggesting that their is monopolistic competition and that prices are sticky. Thus, at any time T sellers want to sell more output at the prevailing price AND price does not immediately adjust.

Alex Godofsky writes:

It would be nice if Arnold ever actually told us what PSST means besides "the economy is really complicated". I'm not yet convinced he knows.

Nick Rowe writes:

Karl: "Instead [the AD curve] represents the set of equilibrium points for money demand and money supply. Given this Output level people will be satisfied with their money holdings at this price level."

Yep. The AD curve only tells us what demand is if we are on the AD curve. If there were shortages of goods, so people held excess money they couldn't get rid of, we would be off the AD curve.

"Aggregate Supply is in truth a creation of empirical convenience. It just really looks like money is non-neutral in the short run."

Yep. We should really call the SRAS curve "the other curve, the one we seem to move along whenever AD shifts". But that's a bit of a mouthful.

david writes:

Incidentally, the magic word "recalculation" appeared in Krugman's blog but there was no reference to Kling.

Nathan Smith writes:

Hi Arnold,

We're thinking along the same lines here. Under the stimulus of the general macro debate, and with a good deal of inspiration from this blog, I have been drafting a model which rethinks AD and AS. My working title is "Start from Here: Aggregate Demand is a Function of Permanent Value of Present Income" (or AD is a function of PVPI). That is, I draw AD and AS in current income/permanent income space. The next step is to assert that the economy is usually-to-always in a state where AD

The intuition here is that AS shows how much suppliers are willing to sell, and AD shows how much consumers are willing to buy, and it is characteristic of capitalist economies that sellers are ALWAYS willing to sell more than consumers are willing to buy. The proof of this is simple: there are goods on store shelves. Markets do not clear; instead, there are always surpluses sitting around, waiting to be sold. We call them inventories. Inventories are part of AS since suppliers are willing to sell them. AD and AS do intersect, but their intersection is not where the economy is located. The economy is located below the intersection, in the surplus region of the chart, in current income/PVPI space, where AD slopes up and AS slopes down. (I suppose in income/price level space, the economy would always be above the intersection of AD and AS, but I don't think it actually makes sense to draw AD and AS in income/price level space; that miss understands how the price level functions in the macroeconomy.)

In a boom, the surplus of AS over AD becomes too small, and inventories are run down below what suppliers want. In a recession, the surplus of AS over AD becomes too large, leading to excess inventories / unemployment (and unemployment simply IS an excess inventory of labor; willing workers unhired are conceptually the same thing as goods sitting on store shelves unsold). That's the explanation of the Phillips curve, that rough and slippery but still partly accurate generalization: when AD minus AS is too small, short inventories give an opening for price hikes, whereas when AD minus AS is too large unemployment rises. However, I'll send a link when I'm done with it. It's a loose "undergraduate textbook" style model... kind of an experiment... we'll see how it works.

By the way, concerning PSST, at some point you should check out the second paper of my dissertation if you haven't already. http://digilib.gmu.edu:8080/dspace/handle/1920/6608 What makes PSST difficult, I think, is that traditional formal economics relies on the assumption of equilibrium so heavily that stories that can't be reconciled to the economy being in a permanent state of equilibrium, in some Walrasian or quasi-Walrasian sense, seem vague and arcane and get neglected. I start from a different place, namely, agent-based simulations, which meet the standard of methodological individualism but drop the assumption of equilibrium (though some form of equilibrium often emerges). From there, I arrive at a place where I can describe an economy progressively exploring landscapes of heterogeneous technological possibilities. It's a growth model, not a business cycle model, but I think it's a method of formalizing PSST that can help you make your case.

Scott Sumner writes:

I don't think that the AS/AD model predicts that real wages rise during recessions.

I don't see the problem with using AS/AD as a way of explaining why inflation sometimes rises during recessions, and sometimes falls during recessions. The equilibrium of SRAS and AD is not the same thing as equilibrium in the labor market.

My suggestion would be to replace AS/AD with a graph that had hours worked on the horizontal axis and NGDP on the vertical axis.

Daublin writes:

"My verdict is that the textbook model does not hold up empirically. There are too many recessions on record where you do not see the real wage rising as the model predicts. This has nothing to do with whether you like PSST or not. As an empirical matter, if you are trying to explain every change in unemployment on the basis of a reverse movement in real wages, you cannot do it."


I am stuck on this observation myself. It sure looks like we simply don't have a robust theory of macroeconomics right now.

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