Aggregate Demand–II

by Russ Roberts on October 28, 2011

in State of Macro

Karl Smith has responded to my post on aggregate demand. He has a lot to say, but I think the nub of it is right at the beginning:

First, like ordinary demand, Aggregate Demand is not a quantity but a relation. It matches the total amount of goods and services people want to buy with the price level. So, saying Aggregate Demand has increased, in-and-of-itself doesn’t say anything about the volume of transactions in the economy. That depends on the equilibrium between Aggregate Demand and Aggregate Supply.

I understand what Karl calls “ordinary demand.” You want to buy less of a good when it gets more expensive, more of it when it gets cheaper. Suppliers tend to have the opposite behavior. They want to sell more of it when it’s more expensive and less of it when it’s cheaper. When you aggregate across all buyers in a market, you get the market demand curve. Do the same across all sellers you get the market supply curve. Each of these is well-defined as the horizontal sum of the individual curves. I say, well defined, but in fact, they don’t really exist. They are concepts that help us organize our thinking about how prices get determined, how much of a good will be bought and sold, and market forces that move prices and quantities.

But what are aggregate demand and aggregate supply for an economy? Karl writes that aggregate demand “matches the total amount of goods and services people want to buy with the price level.” I’m not sure what he means by matches. I think he just means the relationship between goods and services and prices. But what does it mean to say that when the price level of all goods goes up, people want to buy less stuff? What’s the behavioral assumption? Is there a budget constraint? Is it meaningful to talk about aggregate demand at all, as if all the goods could be aggregated into a single good with a single price? Are people spending all their money?

And when you add in aggregate supply, that where it crosses with aggregate demand, does where they cross on the vertical axis determine the price level? That would be weird. Where’s monetary policy?

I was really good at IS-LM when I was an undergrad. Fortunately, as you can tell from the above, I have forgotten all of it. So I’m starting from scratch looking at what makes sense. What am I missing Karl?

At the end, Karl asks if I think money can be non-neutral in the short-run. Non-neutral means–can have real effects on the economy and the choices people make rather than just affecting the price level. Sure. I have no problem with that. Looking forward to Karl’s response.

 

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{ 51 comments }

Slappy McFee October 28, 2011 at 10:50 am

I’m sorry but I am more confused than I was before. I think I will just skip the aggregate posts from now on.

One of the first posts I read at CafeHayek was regarding a crab fisherman that accepted “working on the open ocean” as part of his compensation.

If neither aggregate demand nor aggregate supply account for this important part of trade, how can they be called aggregates in the first place.

Jon October 28, 2011 at 10:51 am

This would be a great EconTalk podcast, no?

Josh S October 28, 2011 at 10:59 am

Here is Smith’s post, which Russ didn’t link:
http://modeledbehavior.com/2011/10/27/russ-roberts-and-aggregate-demand/

Russ Roberts October 28, 2011 at 11:17 am

Fixed. Thanks.

Vagabundus October 28, 2011 at 3:42 pm

Please give posters a edit capability as well.

Fred October 28, 2011 at 11:05 am

If there is aggregate supply and aggregate demand, does that mean there is an aggregate price?

Jon October 28, 2011 at 11:06 am

It’s called the price level.

Obama October 28, 2011 at 5:19 pm

No, its called the interest rate. The economy-wide average price do not clear the goods market because both AD and AS are independent of the economy-wide price level.

Dan H October 28, 2011 at 5:21 pm

Really? So if prices decline, demand will stay the same?

Karl Smith October 28, 2011 at 8:06 pm

You can do AD/AS with the overnight inter-bank lending rate (Fed Funds in the US) or the price level. I usually think in terms of the overnight rate but I think its easier to explain with the price level.

Dan H October 28, 2011 at 11:13 am

The problem with aggregate demand is that it can only be measured in a monetary sense, whereas supply can be measured by other means. Demand can fall and wealth can increase. The same cannot be said about supply. Imagine “The Galt Motor”, a perpetual energy machine where the marginal cost of producing energy is practically zero. There is just the one time cost of producing each motor. After I pay for it, my demand for electricity – monetarily speaking – is zero. I will never again pay for energy. But the supply of energy that I’m receiving (in Killowatt hours) is greater than it has ever been. A single motor can could reduce the aggregate demand of energy to zero in monetary terms. But the supply of energy to all of us is greater than ever.

Rusty Seveniron October 28, 2011 at 11:13 am

Question – doesn’t aggregating demand, or supply, ignore the important hierarchy within each? Not all demand is equal, or equally beneficial, to an economy. Bottom tier supply would be “malinvestment” for example, and aggregating simply dilutes or masks (ignores?) the lower, least productive range of each. I think about all that glass fiber laid in the late 90s that was liquidated for cents on the dollar just a couple of years later. Are buying pet rocks and beannie babies as productive as buying CNC machines?

Karl Smith October 28, 2011 at 8:40 pm

Lots of people are making this essential point, but I hope its ok if I just respond.

AD/AS is not a theory of why some economies are rich and some economies are poor. It is a theory of why sometimes economies are at full employment and sometimes they are not.

So you could have an economy at full employment producing worthless things and you could have an economy at less than full employment producing lots of valuable things. Not only is that plausible but it almost certainly will be the case during most business cycles.

Even during this recession for example, China maintained close to full employment during the global downturn and recovered quickly. However, China is a much poorer society than the United States and Chinese production is less valuable than US production.

None of those facts are at odds with AD/AS paradigm.

Greg Webb October 28, 2011 at 11:31 am

Aggregate demand is a difficult topic and may be a good one for future EconTalk podcasts. I do not think anyone has more than an abstract understanding of this important concept.

ryan October 28, 2011 at 11:52 am

Roger Garrison has the best explanation and critique of the AD/AS framework—at least that I’ve read—here: http://www.auburn.edu/~garriro/hoasad.htm

Darrel October 28, 2011 at 11:56 am

I was having an email discussion with a friend about economics and monetary policy. I explained to him the Austrian Business Cycle theory and how it explains the boom and busts. In doing so – I oftent used the term “Malinvestment” to describe “mistakes” in allocation of resources that have alternate uses. My friend told me that he things that “malinvestment” is simply a made up word with no real meaning. Personally – I believe that could be said about “Aggregate demand” and market “equilibrium”. Not many people can explain what those things are, not to mention WHY and where they exist. Malinvestment on the other hand is pretty straightforward.

Josh S October 28, 2011 at 1:53 pm

If he thinks “malinvestment” has no meaning, he should talk to one of the many, many failed restaurant owners in America.

Jeremy October 28, 2011 at 2:13 pm

This can’t be what a malinvestment means in an economic terms. If this is true, then malinvestments are not things caused my monetary policy, but are a natural outcome of competitive capitalism.

Jon October 28, 2011 at 2:15 pm

Right, Jeremy. Malinvestmest refers to investments made with perverse incentives, like the housing bubble or tech bubble.

Fred October 28, 2011 at 2:30 pm

Better yet talk to someone who owes a bank more than their home is worth.

vikingvista October 29, 2011 at 1:19 pm

One can’t consistently believe that malinvestment doesn’t exist, AND that market signals can be wrong. I doubt your friend would deny the latter.

rbd October 28, 2011 at 11:58 am

Temporary price changes usually have a much larger impact on demand, than do permanent changes. Should we not, then, see a much more dramatic economic response to fiscal stimulus? But we don’t. And doesn’t this further demonstrate that this “aggregate” demand is much more complex than most think?

Jon October 28, 2011 at 12:03 pm

There is also the assumption that wages and prices are sticky in the short term and flexible over the long term

Michael E. Marotta October 28, 2011 at 1:10 pm

The nonsense begins at the most basic level. The statists (static-ists) are hypnotized by the “equilibrium” point where two curves intersect. The fact is that at every point on the Supply curve and at every point on the Demand curve, someone is happy, or the point would not exist. I pay more for less right now to meet a need. The seller moves more product at a lower price, accepting lower profits, to gain shelf space, cash, or reduce the cost of counting. In either case, the truth is not that one person “buys” and another “sells.” Every transaction is bilateral: both parties sell and buy. A so-called “Demand” curve must be also a “Supply” curve.

There is no absolute observable motion, no favored frame of reference. A street map will get you where you are going regardless of whether or not the Sun orbits the Earth.

We have these pictures to help us think about economics, but it is important to remember that they are arbitrary constructs, not physical entities.

Doc Merlin October 28, 2011 at 7:55 pm

‘Every transaction is bilateral: both parties sell and buy. A so-called “Demand” curve must be also a “Supply” curve.’

EXACTLY there is no aggregate demand curves there is only aggregate supply and then preferences for how that aggregate basket is made up. There is /no/ such thing as aggregate demand.

vikingvista October 29, 2011 at 1:32 pm

The S&D curves are deliberately money-centric. For any plot of ‘A/B vs B’ there exists a plot of ‘B/A vs A’ where the roles of supply and demand are reversed. Perhaps if people thought more often in terms of simply ‘A vs B’, the symmetry of trade and properties of money as a good would be more intuitive. It would be one step in the process of demystifying money.

morganovich October 28, 2011 at 1:27 pm

the thing that makes a concept like aggregate demand so slippery, is that demand functions change as well.

sometime higher price is a function of higher demand. you get more demand AND higher prices.

prices of meat during the atkins craze provide an excellent real world example.

price went up and so did quantity consumed. the reverse happened to pasta..

the problem with notions like aggregate demand is that they assume that you know what the curves are and that they are affected by price as opposed to price being affected by shifting demand.

Becky Hargrove October 28, 2011 at 2:27 pm

As I told Karl, glad you are having this conversation, it is most helpful.

Brutus October 28, 2011 at 3:06 pm

Hi Russ,

I am quite taken aback by this series of posts. Originally, they tried to address the response of business owners were asked why they were not spending. Had those business owners said, “economic uncertainty,” I would have agreed that there is something wrong with our approach to regulations/policy. Instead, they said it was due to “lack of demand.” If you have any faith in Occam’s Razor, sometimes the simplest answer is the right one. I don’t think I (or you) would hire more people if nobody was buying my product.

Above all, I am really left wondering: What type of empirical evidence do you have to see in order to change your view? If you can’t find an example, I think you can then classify yourself as an ideologue.

Brutus

Dan H October 28, 2011 at 3:20 pm

“What type of empirical evidence do you have to see in order to change your view?”

I can’t answer for Russ, but I know for me you would have to prove that – in the aggregate – an economy can consume more than it produces.

Brutus October 28, 2011 at 8:21 pm

That was never the argument on the other side. In fact, Keynes based his arguments using national income accounting. Understanding that fact is quite important…

Jon October 28, 2011 at 4:09 pm

Hi Brutus,

For a business to say their number one issue is lack of demand in a slow economy really doesn’t mean anything. Of course demand is slow when the economy is.

Brutus October 28, 2011 at 8:25 pm

If you accept that fact, then the explanation for the low unemployment is lack of demand (and not lack of supply – we can make as many iPhones today as we did yesterday). From there, the Keynesian argument is to then boost demand via government spending. Economists such as Russ do not want to accept this, so they have to find a way to sidetrack the argument.

John Papola October 30, 2011 at 9:37 pm

That’s not true. Coordination failure due to a cluster of production errors can lead to a fall in real demand because it is revealed the a large number of specific goods aren’t worth what was their producers expected. When we waste, we are poorer. And so, falling prices due to what amounts to a negative supply shock from malinvestment (like trillions in housing and related goods) can reveal that total real value of production and thus income has fallen. Since demand is constituted by the supply of goods (I must earn a paycheck being productive before I can demand anything else), a supply shock can and likely should lower real demand.

The flow of spending has an end: production of goods which people actually value. If government spending were effective at that task, socialism would work.

Now, that doesn’t mean that NOMINAL demand must fall. The negative supply shock of malinvestment could see stable nominal spending due to higher prices. This assumes a functioning free banking system or a central bank targeting stable NGDP.

If people demand to hold larger cash balances, the banking system should increase the supply of money to match the demand, lest we get secondary deflation that makes matters worse.

But maintaining nominal spending in this monetary sense is NOT the same thing as government spending. Government spending consumes real resources. And since government is much less productive due to public choice incentives and knowledge problems, that resource consumption is likely to put the economy on a slower growth path, which doesn’t help unemployment, it hurts it.

Just ask the Japanese how their “infrastructure” adventure in Keynesianism worked out. Not so well.

Charles R. Williams October 29, 2011 at 9:56 am

Yes, businesses would hire if demand increased for their products and services. The problem is that there is no policy lever to boost consumer spending that does not have damaging side effects. The reason for this is the need of consumers to save more and spend less on goods that are in oversupply. The way to prosperity is for consumers to employ their savings in ways that boost their income. Under the best govt policies, this process of developing new investment opportunities would take a long time. The current policy mix discourages sound investment through subsidized malinvestment, regulations, uncertainty and the prospect of huge future taxes on investment income. Changing this policy mix will help the economy heal but so much damage has been done that it will take years.

vikingvista October 29, 2011 at 1:42 pm

Brutus,

That isn’t the simplest answer, because it is a chicken-or-egg regress. An actual answer must either be causally decoupled from that regress, like a preceding event, or simultaneously account for all casual elements in that regress, like equilibrium theory.

As you can see, the simplest answer cannot be simple at all.

Brutus October 29, 2011 at 3:32 pm

The question is: what type of evidence would change your mind? Do you, Mr. Viking Vista, have an answer? If you don’t, then there is really very little reason to engage in a discussion. I am looking at economists like Russ and realizing that no matter what evidence is placed in front of them, they will simply dig their heels into their existing positions.

Russ was a certain routine – if something is not consistent with his ideology, he says “things are more complicated.”. I am not saying that that may not be a fair answer under certain circumstances, but if someone cannot say “if this happened, I will change my mind,” then they are an ideologue, and, as I see it, there really isn’t anything interesting about an ideologue.

vikingvista October 29, 2011 at 4:26 pm

If there *is* wholly empirical evidence of macroeconomic causal relationships that would change your mind, that only reveals that you are blind to the magnitude of confounders inherent in those data. That is, it reveals that you understand neither the data nor economics. Wishing the inevitability of such confounders did not exist, will not make it so. So, to understand anything about economics requires a higher level of deduction from principles than any hard science. It is because of the wide disagreement in those principles, and the capacity for deductive error, that you dismiss Russ as merely an ideologue.

Brutus October 29, 2011 at 5:38 pm

That is the actual definition of an ideologue. What you are saying is that economics should be left to be decided by ideologues. In other words, it is not a science nor should it be exposed to the scientific method.

If that is your view, I don’t have a problem with it, but you should embrace the term ideologue. To imply that you are applying the scientific method is misleading.

vikingvista October 29, 2011 at 8:01 pm

Odd. So, you think Kurt Godel was an ideologue for not deriving his incompleteness theorems empirically?

Your problem is an inability to see where empirical data are applicable and where they are not. When they are not applicable, that doesn’t mean there is no means of gaining an understanding.

Or look at it this way. Physicians are always reading studies and trying to determine if the results are relevant to their patients, and how persuaded they should be by the results. Medical epidemiology has made great strides in helping physicians answer those questions. For one, physicians are commonly taught about different levels of evidence, with a double blinded randomized placebo controlled prospective trial of sufficient power being the gold standard. It is not an uncommon experience to see such a gold standard reverse the results of lesser studies.

Now, the absolute best level of evidence a macroeconomic study can offer is a nonrandomized nonblinded retrospective observational study attempting post hoc to control for just a few of the countless confounders, with essentially no power at all. A physician would never be persuaded by this level of evidence, but you claim that anyone who isn’t is an ideologue.

Science and the scientific method are not what you think they are. Instead what you advocate, is scientism.

vikingvista October 29, 2011 at 4:32 pm

The reason to engage in discussion is, therefore, to identify principles and logical errors. If you do not want to do that, then economics is not something you can even hope to understand. Sorry economic data aren’t as straightforward to interpret as data from your pchem lab, but that is the reality.

Brutus October 30, 2011 at 11:15 am

In the area of math, we use the word theorist rather than ideologue. A definition is a definition. Why do you want to run from the label? I am not arguing that deductive reasoning is good or bad. What I am saying is that it is not the scientifIc method. This is not my opinion and is not something you can argue away.

Lastly, if you do not believe believe in using empirical data, then you must also believe that many of the posts here at cafe Hayek are misguided.

Brutus October 30, 2011 at 11:37 am

By, I didn’t know about Hayek’s embarrassing history with the word scientism. If he could do it over again, he certainly would not have boxed himself in. Note that later in life, he never talked about scientism when the data supported his view that socialism doesn’t work. For me, that is the nail in the coffin for Hayek. If I anyone ever brings up his name in a conversation, I will always have this story to show how self serving this guy was.

vikingvista October 30, 2011 at 1:52 pm

Brutus,

“Ideologue” implies dogmatic, not reasoning. That you believe “theorist” in the field of mathematics has the same meaning reaveals only that you have rather profound difficulties with the English language.

Scientism is *not* in my mind or Hayek’s mind a disapproval of data, and science is not a disapproval of everything else. Here again you understand neither.

A rational approach to understanding the world reaveals that data always have a context and require an interpretation, and data alone NEVER impart understanding. You remove rational interpretation from data and satisfy oneself with the superficial trappings of tabulation and mathematical manipulation, and you have scientism. Call it merely “bad science” if you wish, but it is very real, and the bread and butter of modern macroeconomics.

JoshINHB October 30, 2011 at 12:10 pm

@ Brutus -

Instead, they said it was due to “lack of demand.” If you have any faith in Occam’s Razor, sometimes the simplest answer is the right one. I don’t think I (or you) would hire more people if nobody was buying my product.

Above all, I am really left wondering: What type of empirical evidence do you have to see in order to change your view? If you can’t find an example, I think you can then classify yourself as an ideologue.

What evidence would you have to see in order for you to change your view?

How does the persistent trade deficit factor into you belief in a lack of demand as the source of high unemployment.

Eliminating the regulations and prohibitions that contribute to that deficit would most certainly lead to higher employment rather quickly.

Brutus October 30, 2011 at 2:56 pm

Had business owner’s said that policy uncertainty was causing them to not invest/hire, I would happily accept that policy is a problem.

I think you are saying that our deficit is causing a lack of demand. I haven’t seen any data to support this. In fact, the European episode is an interesting experiment and the data points the other way. As countries try to take the path to austerity, demand is worsening. Looking at historical data, I can’t find any supporting evidence that a deficit causes lack of demand.

I’m not clear as to how regulations lead to a larger deficit. The deficit is basically the government spending more than it takes in.

Ivan Georgiev October 28, 2011 at 6:39 pm

If you ask me the most fundamental thing that is wrong with the doctrine of Aggregate D/S has to do with the fact that these aggregates are outside the means-ends framework. As we know the individual himself know best about WHAT he wants and WHEN he wants it. That is why the so called stimulus does not stimulate anything but rather WASTE resources that would have other been put to their highest valued use. (the so called idle resource are idle for purpose – for example, and entrepreneur who has SOME (physical) capital but does not utilize it in a production in the present/nor does he sell it, but rather keeps it (conserves it) because he speculates that better profit opportunities are to be expected in the future).

Aggregates don’t care about value, means, ends and etc. They care about meaningless sums of money that are spend. That’s all they care about – someone to spend money. From this spending they somehow magically derive their “multiplicator” which is even a bigger joke.

Martin Brock October 29, 2011 at 9:20 am

Even ordinary demand is an aggregate. What does demand for chocolate mean? Hershey or Cadbury? Dark or milk? How dark? Do chocolate covered cherries count? The usual “supply and demand” story applies, at best, to a commodity like 24k gold, but even in this context, in practice, Kruggerands don’t always trade for exactly the same price as American Eagles at the same table in the same market.

vikingvista October 29, 2011 at 1:51 pm

Micro S&D demand analysis is about a population of market participants all bidding for a particular type of trade, which may or may not include substitutes. Macro aggregates presume a market where everyone is bidding for everything. The very meaning of the analysis is discarded, and it simply cannot be thought of in the same way.

Doc Merlin October 31, 2011 at 12:06 pm

Aggregate demand /is/ meaningless. Every demand is someone else’s supply. So really we just have supply. A global Edgeworth box methodology is more enlightening here.

Jack Hill November 24, 2011 at 6:33 pm

Demand is different for every person. Every day.Individuals make incremental, variable incremental and sequential decisions to make on time decisions regarding their individual demand.

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