I don’t understand aggregate demand

by Russ Roberts on October 27, 2011

in Stimulus

Does an increase in aggregate demand increase employment?

Yes, if by an increase in aggregate demand you mean people buying and selling more from each other where buying and selling includes consumers and manufacturers.

The above statement has virtually no informational content. It is equivalent to saying that when the economy is healthy, there is lots of exchange going on. When an economy is not healthy, there is less exchange. There is less buying and selling of goods and services and labor. To describe that unhealthiness as less aggregate demand is just to put the problem into different words.

It does not follow that an increase in government spending increases the amount of buying and selling or the health of the economy. It is an empirical question. It would surely depend on what the government buys when it increases spending. Proponents of increased government spending during bad times often argue that this is irrelevant. Keynes said so and so has Joseph Stiglitz. I’m sure they are not alone.

The essence of economics as I think George Stigler or Thomas Sowell or both would say, is to ask “and then what?” Why is it that the proponents of more spending by the government to stimulate “aggregate demand” do not ask and then what? How can you increase spending by government and assume that everything else is unchanged?

Right now, there is a drumbeat for more infrastructure spending. Repairing dangerous bridges is a good idea when the economy is healthy or when it is unhealthy. Building a bridge to nowhere that uses concrete and skilled architects and construction crews is not a good idea. It may put some unemployed workers to work. That depends on the type of skills necessary to build bridges and whether the unemployed have those skills. But it will also certainly increase the demand for some resources that are not unemployed, driving up their price and discouraging existing users of those resources from using them. So the net impact on buying and selling is an empirical question.

The attempts to measure the multiplier between .5 and 2. A multiplier of .5 means that for every dollar of government spending, there is a 50 cent reduction in spending by non-governmental sources (private consumption and investment). A multiplier of 2 means that a dollar of spending encourages an additional dollar of spending by non-governmental sources (private consumption and investment).

The imprecision of these estimates is alarming and should induce caution. Why do the people who advocate increasing government spending right now in large amounts act as if there is a free lunch–that aggregate demand will go up by the amount of the spending as if economic activity will go up by the amount of the spending or even more? Is it because they believe that the multiplier is 2 rather than .5? Is it because they believe it is better to do something than nothing? Is it because they do not believe there are any offsetting effects as I have mentioned above? Or do they believe that the answer to “and then what” is that eventually the spending cycles through the economy to reach all of the unemployed resources and that is why you get a multiplier of 2.

I have ignored the cost of taxes in this discussion and any risk of damage to the health of the economy when the government continues to leave beyond its means in increasing amounts. Do the proponents assume that these risks are minimal or to be ignored in the face of short-run problems?

I do not understand aggregate demand.

For those who think they do, I would be interested in reading something to help me understand it rather than being told that I am a moron or that I don’t understand it. I would be interested in some evidence that makes the case for why the estimates of 2 rather than .5 are better estimates.

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{ 116 comments }

Daniel Kuehn October 27, 2011 at 8:22 am

This is good for explaining the source of some of the variation: http://www.voxeu.org/index.php?q=node/4036

carlsoane October 27, 2011 at 9:57 am

There’s a problem with that link.

Daniel Kuehn October 27, 2011 at 10:03 am

It appears to be something with the VoxEU site. Even when I google the title of the piece and click on the link it won’t come up. Anyway – try googling “Determining the size of the fiscal multiplier” and click on the VoxEU link – hopefully it’ll work soon.

carlsoane October 27, 2011 at 10:50 am

Thanks. It seems the site has come back to life now.

Daniel Kuehn October 27, 2011 at 8:22 am

The other thing you have to remember is that the multiplier is not a parameter that is consistent over the business cycle (discussion of that here: http://www.voxeu.org/index.php?q=node/5462). I know I’ve mentioned this before when you discussed the low multiplier studies. Barro is the most famous case, and what is the one thing that people always note about the Barro paper?? It’s that he uses data from good and bad times, producing an averaged estimate which is obviously going to be much lower than the multiplier we’re presumably interested in. His instrument also of course heavily depends on spending during WWII and Vietnam, when we were certainly above the full employment level of unemployment. Of course you’re going to get an estimate that’s lower than the multiplier during recessions. Wouldn’t we be surprised if we didn’t.

I think it’s important to remember the nature of the parameter that we’re looking at. Keynesian theory says that government spending varies from being deleterious to being beneficial during depressed periods. It doesn’t make sense to me to point to a range that reflects that and suggest there’s something wrong. Most of the low estimates are low when we would expect them to be low. Most of the high estimates are high when we would expect them to be high.

tarran October 27, 2011 at 8:43 am

This is pretty non-responsive to the question Don is making.

What is the mechanism by which an increase in government spending, any spending, including Keynes infamous bury-jars-of-money-in-old-mines program that leads to a increase in peoples ability to satisfy their wants?

Daniel Kuehn October 27, 2011 at 8:49 am

Russ asked several questions and I am being very responsive (perhaps overly responsive) to one that I know has bothered him for a while.

Nikolai Luzhin, Eastern Promises October 27, 2011 at 9:39 am

Since you admit that Keynes thought that “government spending varies from being deleterious to being beneficial during depressed periods,” why do you blame Keynes when people have engaged in Gov’t spending when Keynes would have thought such to be a negative?

Daniel Kuehn October 27, 2011 at 9:52 am

I’m not sure I understand the question.

tarran October 27, 2011 at 11:10 am

Daniel,

In my experience Nikolai has a rich dialogue with people in his head.

I expect that because Nikolai sees your name as a frequent commenter here that the Daniel Kuhn in his head agrees with the Don in his head that government spending is always bad.

Josh S October 27, 2011 at 11:28 am

You can take any two quantities and define a new parameter as their ratio. There are lots of such parameters in engineering, some of them of dubious usefulness precisely because defining such a parameter doesn’t mean you can predict it and thus use it to make predictions.

An example in fluid dynamics is the “eddy viscosity,” which is defined in terms of a ratio of certain mean and rms fluctuating velocity components. The problem is that experimental evidence shows there isn’t much correlation between the two. Sounds like your Keynesian multiplier works a lot like that.

Daniel Kuehn October 28, 2011 at 6:12 am

It “sounds like” that on the basis of reading Russ’s posts regularly or on the basis of familiarizing yourself with the literature?

Josh S October 28, 2011 at 7:49 am

I will usually read at least the abstract of anything you or Russ link here. Since I’m working on my own PhD in a completely different field (fluid dynamics), obviously, time spent digging into papers on the Keynesian multiplier is time *not* spent digging into papers on gas turbulence. You’re a grad student, too, so you know what I’m talking about.

Also Krugman’s own macro textbook claims “The multiplier
is larger than 1.0 because a change in autonomous expenditure also changes induced expenditure” (Ch 13). He claims it can be calculated as 1/(1 – dAE/dGDP). So if the multiplier really is all over the place, ranging from 0 to 2, it at least raises serious questions about the accuracy of what’s taught in undergrad macro.

Daniel Kuehn October 28, 2011 at 2:54 pm

Right but remember that is the formula for stable, linear aggregate expenditure schedules and it’s just introducing the concept – not taking into account public choice issues, etc.

I’m not sure I would call that “inaccurate”. It’s an introduction to the multiplier.

Daniel Kuehn October 28, 2011 at 2:55 pm

If you start thinking about economics like you think about physics that’s bound to run into trouble!

PrometheeFeu October 27, 2011 at 12:21 pm

It seems that the multiplier would have to be different depending upon what the government spent on. For instance, if the government started a bunch of software development projects today, the multiplier would be very small if not negative because resources in that area are already tapped by the private sector. However, if the government was to build houses, the multiplier would be much higher because plenty of house-builders are currently out of work.

I think another big problem is that of measurement. What is GDP supposed to mean? If it is simply meant to mean the number of dollars that change hands, that’s not a very useful number. If on the other hand, it is supposed to represent some sort of an aggregation of produced utility, then we have a problem: what is the utility of government spending? If I go to the store and spent $10, then I am getting $10 worth of stuff otherwise I would not have spent that money. So private sector GDP makes sense. If the government spent $1 billion on a bridge to nowhere, the GDP numbers would look the exact same as if it spent $1 billion on a bridge to somewhere. Yet, the bridge to somewhere is clearly more valuable than the bridge to nowhere. How do we account for that? What might it do to the multiplier?

Mark Bahner October 27, 2011 at 12:44 pm

“Most of the low estimates are low when we would expect them to be low. Most of the high estimates are high when we would expect them to be high.”

Here is a paper that has a very low estimate of the multiplier for the latest “stimulus” (add the http junk):

http://www.volkerwieland.com/docs/CCTW%20Mar%202.pdf

Note that this was a period when one would certainly expect a high multiplier.

P.S. Note that the federal government was able to borrow the most recent “stimulus” money at low interest rates. It’s hard to imagine that continuing even a decade into the future.

Mark Bahner October 27, 2011 at 12:47 pm

Hi,

Sorry about this. I’m posting again, because the hyperlink puts the comments to “awaiting moderation.” (I don’t like moderation.)

Mark

“Most of the low estimates are low when we would expect them to be low. Most of the high estimates are high when we would expect them to be high.”

Here is a paper that has a very low estimate of the multiplier for the latest “stimulus” (add the http junk):

http://www.volkerwieland.com/docs/CCTW%20Mar%202.pdf

Note that this was a period when one would certainly expect a high multiplier.

P.S. Note that the federal government was able to borrow the most recent “stimulus” money at low interest rates. It’s hard to imagine that continuing even a decade into the future.

Mark Bahner October 27, 2011 at 12:48 pm

Hi,

Sorry about this. I’m posting again, because the hyperlink puts the comments to “awaiting moderation.” (I don’t like moderation.)

Mark

“Most of the low estimates are low when we would expect them to be low. Most of the high estimates are high when we would expect them to be high.”

Here is a paper that has a very low estimate of the multiplier for the latest “stimulus” (add the http www junk):

volkerwieland.com/docs/CCTW%20Mar%202.pdf

Note that this was a period when one would certainly expect a high multiplier.

P.S. Note that the federal government was able to borrow the most recent “stimulus” money at low interest rates. It’s hard to imagine that continuing even a decade into the future.

Daniel Kuehn October 27, 2011 at 8:33 am

For those that don’t know what I mean when I talk about Barro’s “instrument” – when you want to empirically measure endogenous processes you need to know that your independent variable isn’t being caused by your dependent variable. If we do stimulus when the economy is weak, simply regressing GDP on spending is going to get you an estimate that’s biased downward because GDP looks bad in the periods when spending is high. This isn’t a problem Keynesian macroeconomists have just made up – you see it in a lot of places.

So what you need is an exogenous source of variation in your independent variable that you know is not caused by your dependent variable. That exogenous source of variation is called an “instrument”. Barro uses war spending because he (probably rightly) figured we don’t increase war spending based on what the economy is doing – we do it based on external geopolitical causes (there are lots of diagnostic tests you can do to confirm the instrument is a good one). The problem with Barro’s instrument, as I noted above, is not that it’s a bad estimation strategy – it’s just that it gives you multipliers during periods when we don’t expect the multiplier to be that high. So while it’s a great study, we should be careful how we generalize it. And we certainly shouldn’t say that because he forms a low end and other studies form a high end the multiplier could be anywhere in between. The second link I provided is good at highlighting this point.

Daniel Kuehn October 27, 2011 at 8:35 am

The other place where you see this problem a lot – in fact the place where a lot of advances in instrumental variables have been made – is the “returns to education” literature. Education is endogenous. Does education make people successful, or are naturally successful people just the sort of people to pursue more education? It’s an endogenous process and you need some sort of exogeneity to answer the question. IV models are very common in this field. There are others, but that’s a very prominent example.

Miles Stevenson October 27, 2011 at 9:49 am

Daniel,

Is there a “micro-economic” model to explain why government spending during bad times is beneficial, but spending during good times is harmful? What would cause this strange behavior?

Also, is there are more specific/formal macro explanation of what is considered to be an economic “slump” in need of stimulus? Is the idea that stimulus becomes beneficial once a certain level unemployment is reached, or some other economic indicator? Or is it more done by “feel” (enough economists agree that unemployment is high enough that stimulus seems like it would be beneficial).

Thanks.

Daniel Kuehn October 27, 2011 at 9:54 am

My understanding is that microfounded New Keynesian models reproduce the insights of the macro models, but I have to confess these models are (currently) over my head.

kyle8 October 27, 2011 at 8:43 am

DK the multiplier is always negative. Unless the government is using saved up money. When it is using borrowed money the money comes directly from the pool of available investment capital so it is a wash.

It can never work because Businessmen unlike Keynesians are not stupid. They can see that a massive increase in the deficit today will lead to a massive increase in either taxes or inflation tomorrow, so they delay or decrease investment.

If the money is ONLY used for NEEDED infrastructure, then that infrastructure might have a stimulative effect over time. However in practicality, those projects usually take too long to help in a recession.

Keynesian-ism is not based upon reason, it is based upon ideology.

Daniel Kuehn October 27, 2011 at 8:51 am

re: “When it is using borrowed money the money comes directly from the pool of available investment capital so it is a wash.”

To be able to say this, you are leaving a very important assumption unstated, namely that loanable funds are necessarily channeled into new investments.

re: “It can never work because Businessmen unlike Keynesians are not stupid. They can see that a massive increase in the deficit today will lead to a massive increase in either taxes or inflation tomorrow, so they delay or decrease investment.”

Also dependent on a very famous assumption called Ricardian equivalence.

The question is – are these two unstated assumptions justified?

Seth October 27, 2011 at 9:40 am

“To be able to say this, you are leaving a very important assumption unstated, namely that loanable funds are necessarily channeled into new investments.”

When?

Darren October 27, 2011 at 3:33 pm

The question is – are these two unstated assumptions justified?

Are you saying the reverse of the above ‘unstated assumptions’ are justified?

Daniel Kuehn October 27, 2011 at 4:49 pm

“reverse” is probably too strong, but I would relax it certainly.

kyle8 October 27, 2011 at 4:19 pm

Extraordinary claims require extraordinary evidence. Since the Keynesian idea is to drown the Republic in crippling debt, then the payoff ought to be without doubt. But it is in a lot of doubt.

kyle8 October 27, 2011 at 4:36 pm

Also, I cannot prove my claims using theory, but I can point to the fact that MARKETS have always acted as though they are true!

Indeed, they seem to be acting that way right at this very moment.

Sam October 29, 2011 at 5:13 pm

Is your first part true? If I save money under the mattress, the important point is that I’m *not* consuming some resources. They are still available for entrepreneurs, and their prices will come down, again because I’m not demanding them anymore. So my savings will still be channeled into investment, and gov spending won’t be a free lunch.

Miles Stevenson October 27, 2011 at 10:02 am

kyle8,

To play devils advocate (I’m not a Keynesian), I believe their position position to be similar to the idea of a college loan. When you take a college loan, you are borrowing money from the future, which you will have to pay back later. The reason that this is often beneficial, is that the investment in education will lead to a higher paying job. Even though you have to pay back this large debt, the idea is that you are being even more productive at that later time, and paying off that debt isn’t a big deal because you are a lot wealthier. Basically, your increase in wealth is greater than the debt you would have to pay off.

I think Keynesians are essentially making a bet, the same way a potential college student makes a bet. We are of course quite uncomfortable with this, because unlike the college student, Keynesians are gambling with everyone else’s money. I think Keynesians are comfortable with that because they are convinced that they really do have it all figured out. Making sure that they “win the bet”, in their mind, is a simple matter of mathematics and wise government policy.

kyle8 October 27, 2011 at 4:18 pm

Well, it is a suckers bet. Japan made a bet that Keynesian stimulus would work and they spent many billions. The result was more than a decade of depression and a whole lot of crippling debt.

PrometheeFeu October 27, 2011 at 12:28 pm

“DK the multiplier is always negative.”

That’s not what Russ’ evidence seems to show.

“When it is using borrowed money the money comes directly from the pool of available investment capital so it is a wash.”

Unless that money is sitting on the sideline waiting to see what happens. Having been in finance, I can tell you that putting your money in Treasuries until you can see what happens in the market is a time-honored strategy.

“It can never work because Businessmen unlike Keynesians are not stupid. They can see that a massive increase in the deficit today will lead to a massive increase in either taxes or inflation tomorrow, so they delay or decrease investment.”

I have not seen much evidence of that and having interacted with businessmen for a long time, I don’t think that is true. Businessmen understand that there is very little that can be known about future government action within very large bands. Yes eventually you have to pay back the debt, but how will you do it? Reduce spending? Raise taxes? Simply through economic growth? Will it happen tomorrow, in 10 years, in 100 years? There is basically no way to know and so you don’t see businesses internalizing future tax rates as a result of deficit spending.

kyle8 October 27, 2011 at 4:23 pm

Money sitting in “treasuries” is still invested funds. The idea that you are going to force people to invest their own money is not only stupid, but not in keeping with the ideas of freedom, liberty, and democracy.

If you wish to entice those people into investing, then the government should do those things which we know favor investment, You know things like, sound money policies, low marginal rates (not temporary tax cuts, they do nothing). And not going on an orgy of wild spending and increased regulations.

PrometheeFeu October 27, 2011 at 4:56 pm

First, I did not say I favored such a policy. I simply showed that your statements were wrong. And no. Putting money in treasuries is not economic investment because it is not the production of capital.

Martin Brock October 27, 2011 at 1:13 pm

If investment requires saved up money, how did investment get started in the first place?

Investment has nothing to do with saving money. Rather, extending credit is the act of creating money.

I have something valuable to you. You can use what I have to be productive, so I give it to you. You give me a promissory note, promising to return things of comparable value, in terms of market prices, as you produce.

Your note does not specify particular things you will return, only unspecified things of comparable value. If others value your promissory note as I do, the note is negotiable, so it is money.

Sam Grove October 27, 2011 at 4:21 pm

If investment requires saved up money, how did investment get started in the first place?

Investment doesn’t require saved up money, it requires surplus resources. Extending credit allows the borrower to consume resources to be earned later (should the investment pan out).

kyle8 October 27, 2011 at 4:25 pm

I didn’t say that investment required saved money, What I said was that unless the government uses saved up resources it will not get a return on it’s stimulus because it’s own borrowing crowds out private investment.

If it were to use assets it already possesses then that would perhaps have some sort of stimulative effect.

Martin Brock October 28, 2011 at 4:15 am

You wrote, “saved up money,” but I accept the revision. State spending crowds out other spending (including private investment) regardless of how the state obtains the money it spends. A state can tax or borrow or create money by fiat. It’s hard to say which is worse, but the real problem is spending channeled by political forces rather than market forces.

Resources that become idle during a recession are not saved up. The resources are not unemployed because people wish to substitute future consumption for current consumption. This sort of “saving up” is a marginal effect at best.

Typically, resources become unemployed because, for various reasons, they are producing things that people don’t want to consume at all. Consumers don’t want more of these things in the future. They want less of these things in the future. People don’t want the idle resources producing more goods for future consumption. They want the resources producing different goods for current consumption.

For this reason, I’ve never fully accepted the Austrian theory of the business cycle as I usually see it presented. It’s not all about intertemporal coordination. I agree that fiat money and state spending generally creates malinvestment, but this malinvestment has nothing fundamentally to do with intertemporal coordination.

Fred October 27, 2011 at 8:55 am

I’ve never figured out this multiplier.

First, money is taken out of the economy through taxation, selling of bonds, or devaluing the currency by printing money. So step one is opportunity cost. A negative multiplier.

Second some of this money is spent paying government employees who produce nothing of value. I assume that if that money was left in the economy someone would have been paid to create something of value. Sure these government paychecks will be spent, but since nothing of value was created in exchange for the paychecks, the result is a negative.

Finally this reduced amount of money is divvied out based upon political considerations, instead of being invested in something that will produce value, which essentially destroys this wealth.

The net result can only be negative.

How people can see this as a positive is something I just don’t understand.

Methinks1776 October 27, 2011 at 9:02 am

Depends on the “people” you’re talking about. Congresscritters have carte blanche to pay off political cronies and buy votes. Very positive for them. Think of it as a bailout for politicians.

Fred October 27, 2011 at 10:33 am

I don’t consider Congresscritters to be “people”.

Methinks1776 October 27, 2011 at 11:26 am

Oh, my bad. “critters” is not usually the adjective I use. I cleaned it up for the blog.

Daniel Kuehn October 27, 2011 at 9:08 am

How sure are you about the logic of that first step?

Fred October 27, 2011 at 9:14 am

What is the alternative?
Where else does the money come from? Thin air? The money tree?

Unless that money was stuffed into a mattress, it would have been used for something. Invested in the production of something of value, deposited in a bank to become loanable funds, or spent on something of value.

If there is a flaw in the logic, please explain it to me.

PrometheeFeu October 27, 2011 at 12:44 pm

“Unless that money was stuffed into a mattress, it would have been used for something. Invested in the production of something of value, deposited in a bank to become loanable funds, or spent on something of value.”

There is no flaw in your logic. It just happens to be wrong here.

Let’s say what you are saying is true. So the government is competing for funds with other profitable investments right? In order to keep issuing treasuries, the government has to keep issuing treasuries at a higher and higher rate of interest as the investments they are competing with are more and more profitable. So if your theory is right, given the record levels of borrowing, we should see record interest rate levels. Agreed? Check out the yield curve: http://www.bloomberg.com/markets/rates-bonds/government-bonds/us/

Seth October 27, 2011 at 1:16 pm

“So if your theory is right, given the record levels of borrowing, we should see record interest rate levels. Agreed?”

Not necessarily.

You are considering one interaction: gov’t borrowing competing with private borrowing.

You are not considering another: gov’t actions reducing the demand for private borrowing.

If the second interaction is more than offsetting the first, then you would not necessarily see record interest rates.

And, even if the second interaction is not offsetting the first, aren’t you looking only at nominal rather than real interest rates?

Fred October 27, 2011 at 1:57 pm

You assume interest rates are free from artificial manipulation.

PrometheeFeu October 27, 2011 at 5:09 pm

@Seth:

“You are not considering another: gov’t actions reducing the demand for private borrowing.

If the second interaction is more than offsetting the first, then you would not necessarily see record interest rates.”

That is true. Do you have any evidence that it is the case?

“And, even if the second interaction is not offsetting the first, aren’t you looking only at nominal rather than real interest rates?”

We are currently doing about 2% inflation YoY. Those (real and nominal) interest rates are low by historical standards. At the very least, they are not very high which your theory would most likely demonstrate.

@Fred:
“You assume interest rates are free from artificial manipulation.”

No. I am just assuming that manipulation is not enormous. If monetary policy really was pushing rates down by a significant amount, we would see large levels of inflation right? “Inflation is always and everywhere a monetary phenomenon.” But inflation is very moderate today. So I think we can say that interest rates are not overly manipulated.

Seth October 28, 2011 at 2:45 pm

“That is true. Do you have any evidence that it is the case?”

Low investment spending despite what appears to be record low interest rates and gov’t borrowing seems like convincing evidence.

“We are currently doing about 2% inflation YoY.”
As I’m sure you know, interest rates are not based on what we are ‘currently doing’. They’re based on expectations. There could be deflationary expectations built into interest rates.

Not saying I’m right. Just saying these are possibilities and are possible enough that I don’t find your claim that Fred’s logic is flawed convincing.

Economiser October 27, 2011 at 2:01 pm

Correct. EVEN IF the money is stuffed in a mattress, the resources that money could otherwise command are still in use somewhere. When the government creates money out of thin air and injects it into the economy, it’s not taking resources that the miser stuck under his mattress. It’s taking resources away from other, currently productive uses in the economy. The miser’s money is devalued at the same rate as everyone else’s money.

Apropos of nothing, the misunderstanding of the miser’s role in the economy is how I picked my commenting handle.

Darren October 27, 2011 at 3:38 pm

I never understood why banks would take money (savings) and pay interest on it when they intended to do nothing with it. It doesn’t seem like a sound business plan.

Methinks1776 October 27, 2011 at 4:21 pm

Darren, I think banks are levering up to buy treasuries and earning the spread. At least they were. They’re also still making FHA backed loans. So, they’re not doing “nothing”, but they’re not lending to a productive borrower.

Sam Grove October 27, 2011 at 4:26 pm

Some of the difficulty in this discussion is the equating of money with resources. They are not the same. (As you obviously realize.)

kyle8 October 27, 2011 at 4:27 pm

How sure are you that he is not correct? Since it is the Keynesian who wishes to take an action which carries some risk then it is he who has the burden to prove that he is right, and that he will always be right in each case.

dictateursanguinaire October 27, 2011 at 2:01 pm

‘Second some of this money is spent paying government employees who produce nothing of value.’

this has to be a joke

Darren October 27, 2011 at 3:40 pm

A government employee does produce value. The real question is whether that value produced exceeds the cost of keeping the employee. Of course, some types of employees will produce more value than others.

Jon October 27, 2011 at 3:43 pm

Sure. The postman, the soldier, the policeman add significant value. But does the FCC add much value? Or the TSA? How about the Office of Indian Affairs?

andy October 27, 2011 at 8:59 am

I have come slowly to the conclusion that there is mostly no theoretical argument for aggregate demand analysis. Which does not mean it’s conclusion are false. Government spending might be positive in the crisis; but I would like to hear a very different argument than the ‘aggregate demand’. Because the aggregate demand argument is in it’s strength very similar to the argument Bastiat was trying to refute.

I am not saying that Bastiat refuted AD; rather that the construction of the AD argument is essentially same as the ‘Broken window’ argument; and as Bastiat has shown, this type of argument can lead to wrong conclusion. Therefore, the AD argument is basically no argument at all – the fact, that we didn’t find a refutation does not mean, that the argument is ‘strong’.

Miles Stevenson October 27, 2011 at 10:41 am

andy,

I’m right there with you. But at the same time, I think we need to be careful with Bastiat’s lesson. It can essentially give us plausible deniability to dismiss any argument we don’t like.

Planning on defending yourself in a war? Don’t do it! By spending money on tanks, you are taking money away from other things that would have happened, had you not bought the tanks.

Planning on having a police force? Don’t do it! If you spend money on police, you take money away from people that they could have otherwise used for more productive purposes.

The value of the broken window fallacy is to get us to realize that there is an opportunity cost for everything, not to automatically assume that the lost opportunity is always the better option.

I’m not accusing you of making this error, Andy. I’m just saying that we need to be careful not to let it cover our eyes in an ideological blindfold against anything we don’t like.

Miles Stevenson October 27, 2011 at 10:43 am

Self-correction. The point of the idea is actually to illustrate that we don’t really gain from economic destruction. But the broken window fallacy is often used to illustrate opportunity costs.

paul October 27, 2011 at 9:20 am

“Repairing dangerous bridges is a good idea when the economy is healthy or when it is unhealthy.”
- my guess is that it may be cheaper to higher people with this skill set (construction) because we have a larger number of people skilled at this and it may be less in demand at the moment. This may be a bad example but if i work at a job 8 months out of the year and am unemployed the other 4 months it may be worth doing some of the things that need to get done anyway, paint the house, learn a new skill, and so on when i am off of work. I could do it while i am working as the house can go for 6 more months without being painted but it would me much less costly to me to paint it while i am off as my free time is much more valuable to me when i am working. Same idea with economy.

“Building a bridge to nowhere that uses concrete and skilled architects and construction crews is not a good idea.”
- yea, probably not a good idea. :)

“It may put some unemployed workers to work. That depends on the type of skills necessary to build bridges and whether the unemployed have those skills.”
- I think that is the idea. Assuming the people with this skill set are not using the skills they have and these are skills that will eventually need to be used it is much more efficient to use them now.

“But it will also certainly increase the demand for some resources that are not unemployed, driving up their price and discouraging existing users of those resources from using them.”
- great point, I had not thought that. Depending on the amount of unemployment and current demand that will have a larger or smaller impact on those that are currently using that type of resource. If private business end up paying 1% more and we get bridges that needed to be built anyway and it costs 50% as much to do so as workers are not in demand that may be a good idea. In theory it is a much better use of resources assuming it is doing something that is useful that would have been done at a higher cost at some other point of time such as when most of the construction workers were fully employed. If the bridges need to be built and we wait until the economy is good it will have an even higher impact on the private sector.

“Why do the people who advocate increasing government spending right now in large amounts act as if there is a free lunch” – it may not be free but the idea is that we are using our resources more efficiently. Skilled workers doing something that had to be done and doing it when they are not in as much of demand and can ask for less compensation.

I am making a lot of assumptions such as that the government can make rational choices, is not to swayed by special interest and so on. If a person does not think that the government can ever make these decisions adequately than these ideas will not be very helpful. That said the Government does build the bridges and I would rather them make the most out of the current resources (unemployed skilled workers) when possible.

I also want to say thank Russ for you Great podcast. I have learned so much from it! One of my all time favorites!

Sam Grove October 27, 2011 at 4:30 pm

Government doesn’t build bridges.
Governments hire contractors to build bridges.

paul October 28, 2011 at 2:55 am

“Governments hire contractors to build bridges” and it is more cost efficient (for both the tax payers and potentially the contractors) to hire contractors when a large number of them are unemployed, underemployed or working a position that is not making use of the specific skill set they have. This approach will not work as well if the Government hires people for a job that does not need to be done “bridge to nowhere” or does not need to be done any time soon (like roofing a house after 10 years even if it still had 20 good years on it because you had access to much cheaper labor). But if you had access to that labor for a couple more years and you needed a project done now or soon that seems to be a perfect time to do it. That seems like smart use of resources and tax payers could pay now at a cheaper rate or in a few years at a higher rate.

I can imagine all of the incentives and signals for the government to make a perfect decision may not be in place at all times. It can also imagine it would change the signals to other companies about how to spend money as the supply of cheap workers would become smaller.

Either way i am all for the most efficient use of resource. lot of variables and externalities to look at in looking at what is best for a society on both the goals and the process of getting to the goal.

Corey October 27, 2011 at 9:46 am

Reading the title of this post was a bit like imagining Vin Scully announce to his colleagues that he dosent know what a balk is.

Corey October 27, 2011 at 9:53 am

Dont take that the wrong way Russ! I always admire and respect your humility. It’s something thats lacking in the proffesion at least to a casual observer like myself.

Corey October 27, 2011 at 9:51 am

Small aside.

A lot of left leaning economists seem to agree that the stimulus was poorly designed. What makes them think another will be designed any better? Have the economists gained more political clout or have the special interests lost any? I’m not so sure.

Josh S October 27, 2011 at 11:29 am

A left-leaning economist is an economist who hasn’t yet learned that public choice theory is a thing.

PrometheeFeu October 27, 2011 at 12:52 pm

For the same reason Don and Russ keep trying to promote good policy despite their advice never being taken: hope against all odds. I remember hearing Greg Mankiw speak of being on the council of economic advisors. Russ asked him about the difficulty of balancing good economics with the political reality. Greg Mankiw pointed out that if you took political reality too seriously, you would never bother doing anything since the status quo is the result of the political reality and that as an economist you should just advocate the policy you think is best and leave politics to the politicians. (I hope I’m not misquoting Greg) That’s what the left-leaning economists are doing. They are just advocating what they think is the best policy knowing full well it’s unlikely to be implemented correctly. But what other choice is there?

Dan J October 27, 2011 at 9:58 am

That ‘stimulus’ money is ALWAYS misallocated. So, it cannot have as positive effect as encouraged investing and spending thru lesser restrictions on private capital.

Bill Woolsey October 27, 2011 at 10:01 am

Aggregate demand is best undestood as the flow of money expenditure in the economy. You can, if you want, deflate that by the price level and get the real flow of money through the economy.

Anyway, if the typical market for currently produced output is in surplus, then an increase in aggregate demand can raise output, the demand for labor, and employment.

I am not sure exactly why anyone would jump into a discussion of increased government spending at this point, but regardless of who or whether increased government spending might increase aggregate demand, higher aggregate demand can raise output in some circumstances.

If the typical market is not in surplus, but rather clearing or in shortage, then increased aggregate demand would have at best an ambiguous impact on employment.

P.S. Where does the money come from?

Yes, out of thin air.

Alex Salter October 27, 2011 at 10:15 am

^This. Don’t think of aggregate demand as C+I+G+(X-IM). Think of aggregate demand as a particular point on a given MV locus in the equation of exchange, MV=Py. Reduced aggregate demand means reduced money expenditures. Provided the reduction in aggregate demand comes from “cash hoards” (i.e. increasing the percentage of a financial portfolio held in cash) there can be a general glut; Say’s Law doesn’t hold if the money market is in disequilibrium.

There’s no good reason to follow the logic of the C+I+G+(X-IM) pathway, even when nominal interests rates are up against the zero bound, because this short-term rate is not the primary mechanism through which monetary policy operates.

Bill October 27, 2011 at 2:13 pm

“Anyway, if the typical market for currently produced output is in surplus, then an increase in aggregate demand can raise output, the demand for labor, and employment.”

I think you’re missing Russ’ point. You are implying that “aggregate demand” is a “something” that can be consciously pushed around. Russ is saying that makes no sense until you can further define “aggregate demand” to something more tangible. As it stands, the term has little informational content. You’re pushing on the aether.

There are far too many complex and diverse interactions within an economy (and growing!) to satisfactorily define something called aggregate demand. In my mind, to understand the term “aggregate demand” to any meaningful level, you’d have to understand (and solve?) the P=NP problem.

Dan J October 27, 2011 at 4:08 pm

Increased govt spending is supposed to be the solution for lack of ‘aggregate demand’, a.k.a. Underconsumption theory, a.k.a. Voodoo economics.

rhhardin October 27, 2011 at 10:18 am

You want voluntary transactions because each one creates wealth.

The buyer gets something worth more to him than the money. He profits.

The seller gets something worth more to him than the goods. He profits.

Add up those profits on both sides over every transaction, and the standard of living of the nation rises by that amount.

The economy is healthy when the profits, not the transaction prices, add up.

All you have to know about government is that its transactions are usually untimately involuntary. Both sides do not profit. One or both may lose value, in fact. So there are lots of transactions but a net loss of standard of living.

The most it can hope for is voluntary side effects that yield profits.

rhhardin October 27, 2011 at 10:24 am

I think, incidentally, that supply and demand curves obscure the truth that needs to get out.

The curves don’t say how the curves themselves change when you change a price, and that’s the important effect, via other things changing too.

As in thermodynamics, you need the right partial derivatives for the problem you’re doing.

It’s clearer in economics to stay with the consumer surplus explicitly, and take for granted that there’s a spread across the population that should not be reduced to a curve prematurely.

Then, for example, it’s easy to see that a tax makes every transaction less profitable, and cuts off the less profitable transactions completely. A supply and demand curve gets only the latter effect and misses the former, which is bigger.

Michael Paulus October 27, 2011 at 11:17 am

When you make it complicated enough to include all the applicable factors aggregate demand just doesn’t work. I think it’s real purpose is to boondoggle people who go to college and take the minimum econ required for whatever non-economics degree they are seeking. If you learn the simple version and nothing else, you think a multiplier is just how things work.

Bastiat Smith October 27, 2011 at 11:51 am

All this talk about “a” multiplier is a red herring. It comes from the same kind of talk that doesn’t distinguish between units of labor or units of capital. What those in the government spend our money on matters. A multiplier would be far more accurate if it specified the target of the spending, or maybe the result of the dollars spent.

Saying that there is “a” multiplier number is like saying capital is never misallocated because it’s always employed. How capital is employed makes all of the difference between a bust and a boom.

paul October 27, 2011 at 12:19 pm

Right on Bastiat Smith!

Josh S October 27, 2011 at 12:22 pm

One of the things I’ve noticed in these questions is that Austrians like Don and Russ ask a lot of epistemological and methodological questions, and Keynesians don’t even understand that such questions are even being asked, and so interpret the questions as some other kind of question.

The question about aggregate demand here is a(n onto?)logical one. Russ doesn’t see how “Aggregate demand” and “economic activity” are different things and therefore doesn’t see how talking about any causal relationship is even meaningful. But Keynesians in the comments are responding with technical definitions, which are completely missing the point.

Or if you take the earlier post about biases, and the jeering with which Krugman et al. responded, what’s going on there is Russ is discussing epistemology, self-awareness, and the way humans think, while Krugman and pals don’t even seem to grasp that epistemology is even a thing that should be discussed.

Daniel Kuehn October 27, 2011 at 1:56 pm

The ontological question Russ grapples with treats AD as a specific value. What economists refer to when they talk about AD is a schedule of values. I think that should clear up most of the confusion on that question, which is why I personally focused on the multiplier estimates themselves.

Bill October 27, 2011 at 2:26 pm

“What economists refer to when they talk about AD is a schedule of values.”

Then please define this “schedule of values.” The question is whether this can be defined.

I think Russ might say that that this schedule of values is such a massive, multidimensional matrix, that it is beyond current human comprehension. It’s not that he’s looking for a “specific value,” but that the concept has to at least have an ontological basis, and no one has yet shown that. Russ is looking at it in 4 dimensional space-time, and you are looking at it in 2.

Daniel Kuehn October 27, 2011 at 3:24 pm

If massive multidimensional matrices were beyond human comprehension, much of the scientific advances of the twentieth century would not have happened. What I think is better to say is that the internal dynamics of such a multidimensional matrix are beyond detailed comprehension. That I would certainly agree with. That poses certain problems – but it doesn’t pose ontological problems as far as I can figure.

The complex network of cells that make up our body are beyond comprehension in the sense that we don’t know what’s going on everywhere in our bodies. But they’re certainly comprehensible in a general sense – and the extent to which they are incomprehensible doesn’t throw up any ontological road blocks to talking about the human body. So why should we imagine such road blocks exist for the economy? Do you question the ontological basis for weather? For space-time? For the ecosystem of the Amazon?

If you’re going to balk at every massive multidimensional matrix, I think you’re going to run into some problems.

indianajim October 27, 2011 at 8:39 pm

Analogy is sometimes appropriate, but not always. Saying that one multidimensional matrix is understandable, does not mean they all are. If you are saying this, then I think YOU are going to have problems.

Bill October 27, 2011 at 10:03 pm

Did I say “every?” I don’t think I did. And I certainly don’t “balk” at them. I revel in the beauty of emergent order and highly complex systems. But unlike Keynesians, I’m also smart enough to know that I’m not smart enough to replicate highly complex systems. It seems you think all complex and diverse systems are dimensionally the same, and they are not.

Let look at the things you mention. Space-time is fairly simple, being an emergent property of quantum fluctuations and chance.

The ecosystem of the Amazon is certainly highly complex. I could make arguments either way. It is made up of many underlying complex systems, so other than referring to a specific place on the earth, I don’t know that it has meaning, as it is something that doesn’t exists in and of itself.

The human body is an interesting comparison. I would claim that compared to the economy, the human body is rather simple. Imagine if every cell in your body had consciousness; had its own hopes, dreams, made plans for the future and exchanged with other cells. Then I think you’re getting close to how complex the economy is.

When you are talking about a system that complex and diverse, I think Russ is right. The term “aggregate demand” conveys virtually no useful information. Does it have ontological meaning? If it does, I don’t know that anyone has yet shown what that meaning is. I could name my dog “aggregate demand” and it would be as meaningful to real economic analysis as any Keynesian definition of the term.

Josh S October 27, 2011 at 11:21 pm

The biology comparison is apt precisely because biology is so hard to mathematecize, and it’s extremely difficult to construct controlled experiments, especially if you’re interested in evolution and ecologies.

And the knowledge that is mathematicized is generally stated in statistical terms, usually with rather broad error bars. Even the causal link between smoking and cancer must be stated probabilistically. But Keynesian math is the sort that shows up in simple free-body mechanics that engineers use.

You guys really should do an ANVOA or 2-level t-test to figure out the multiplier is a meaningful parameter

Daniel Kuehn October 28, 2011 at 6:10 am

re: “But Keynesian math is the sort that shows up in simple free-body mechanics that engineers use.

You guys really should do an ANVOA or 2-level t-test to figure out the multiplier is a meaningful parameter”

You should read some of the multiplier literature.

Josh S October 28, 2011 at 7:52 am

And you should read some of the literature on mathematical modeling…but that’s probably a lot more math than you’re comfortable with.

Josh S October 28, 2011 at 7:55 am

Like if you’ve got two models that are as different as Romer’s and Taylor’s, you’re in no place to talk about the models being useful yet.

Josh S October 27, 2011 at 11:11 pm

I don’t think that’s really the question he’s dealing with (BTW, if AD is a schedule of values, then your multiplier should be a vector, not a scalar).

It sounds to me like he’s dealing with the question of whether the very concept of A (aggregate demand) and B (the “health” of the economy) are two different names for the same reality. If they are, then talking about “stimulating the economy by boosting aggregate demand” is like talking about “heating the air by boosting the temperature,” or “repairing this car’s motor by fixing the engine,” etc.

Blunt Instrument October 27, 2011 at 12:40 pm

Let’s consult Merriam-Webster, shall we?
Aggregate (adj): formed by the collection of units or particles into a body, mass, or amount.
Demand (noun): something claimed as due.

So a collection of people claim that they are due (entitled to) more wealth and prosperity. The natural response is for the government to take wealth from the more productive parts of society and give it to aggregate. This is called Keynesianism.

What’s so hard to understand?

mcwop October 27, 2011 at 12:42 pm

Isn’t government spending added to the GDP calculation. So yes, increase government spending increase GDP. But, that does not necessarily equate to an increase in employment or demand for aggregate demand for goods.

Fred October 27, 2011 at 2:21 pm

How does government spending increase GDP?
Whatever government spends must first be taxed, borrowed, or printed, in all cases removing money from the economy. Then the drones are paid before the money is added back into the economy.
Nothing of value is produced. There’s no trade.
It’s a net loss.

mcwop October 27, 2011 at 3:15 pm

Fred, I am speaking purely from the GDP formula itself:

GDP = private consumption + gross investment + government spending + (exports − imports).

So all other elements remaining the same an increase in government spending pushes GDP up just because of its use in the calculation.

Fred October 27, 2011 at 3:26 pm

I am criticizing the formula, not you.

How can an increase in government spending not come at the cost of reduced private consumption and gross investment?

mcwop October 27, 2011 at 3:47 pm

Agreed then. My point is of course government speeding works, the formula seems rigged to me. As measured by jobs, things do not look so great.

Fred October 27, 2011 at 4:06 pm

The formula is rigged, for it assumes the government spending variable can increase without a corresponding decrease in the other variables.

It is a false premise, and any thread of reasoning (Keynesian economic theory for example) that uses this as a premise is a fallacy.

Martin Brock October 27, 2011 at 1:00 pm

You do understand aggregate demand.

If falling demand is a problem during recession, paying the recently unemployed to seek new work, with some sort of means test, seems the best stimulus. These payments replace most precisely the demand lost to the recession.

The transfer payments also affect the demand of people still working, and paying unemployed people could have negative incentive effects, particularly when many of the unemployed are near retirement (as presumably is the case now), but I prefer these effects to the effects of other state spending that only draws employed resources away from market organization.

Greg Ransom October 27, 2011 at 1:32 pm

Increasing the number of exchanges does not necessarily imply a more healthy economy — if the government takes something from me which I value more highly than you, and sells it to you, and visa versa, the government has increased the number of exchanges and left us both worse off.

Do I need to explain how his applies to the current situation?

More value pours into the government than pours out, esp. over productive time / production using productive goods requiring time.

“Aggregate demand” goes up and we are all made worse of than we otherwise would be.

Can you say “Solyndra”?

Martin Brock October 28, 2011 at 4:21 am

We’re both worse off, but a national economic statistic is higher, so salute the flag and suck it up.

Mike Sproul October 27, 2011 at 1:44 pm

Russ:

Read up on the issuance of playing card money in Quebec (1685) or paper shillings in Massachusetts (1690). They suffered from a shortage of money, and when they issued new money, the money shortage was relieved and the economy boomed. It’s easy to see how a Keynesian could misunderstand the situation and speak of “Failure of aggregate demand” or “Fiscal stimulus”

Daniel Kuehn October 27, 2011 at 2:07 pm

re: ” It’s easy to see how a Keynesian could misunderstand the situation and speak of “Failure of aggregate demand”

Exactly what do you think is a misunderstanding here?

Another way of saying “money shortage” is “excess demand for money”. Under Walras law “excess demand for money” is synonymous with “shortfall in demand for goods and services”. It’s the same point. I think talking about deficient demand makes more sense because the reason people are demanding money is because they don’t have better alternative things to do (ie – better investment options). So the real source seems to me to be a deficiency in investment demand. The excess demand for liquid assets (among them money) is a symptom of that.

Anyway – this is a good point. This is why the mercantilists at the time were able to make some initial Keynesian insights, and why you had Benjamin Franklin in the early 1700s (when money shortages were still an issue and paper currency was still a hot topic) writing up what was essentially a liquidity preference theory of the interest rate – two centuries before Keynes himself.

kyle8 October 27, 2011 at 4:32 pm

I find it highly dubious to try and tenuously link your messiah to a man of true genius.

Daniel Kuehn October 27, 2011 at 4:52 pm

I gave upon messiahs several years ago… but I still try to keep that under wraps around my family.

Mike Sproul October 28, 2011 at 8:16 pm

Daniel:

A shortage of money is fairly easy to understand. Aggregate demand, on the other hand, is a nonsensical concept. In the case of Quebec, they had no paper money, and coins were depleted by the operation of Gresham’s law and colonial policies to draw back coins to the ruling country. People were reduced to barter, which meant many desirable trades could not happen. The sudden introduction of paper money in a world like this creates an obvious boost to the economy, but unfortunately it also gives Keynesians the false impression that government spending can stimulate the economy. For example, if the government prints new paper money (playing cards, in this case) and spends it, then a Keynesian would understandably think that the resulting boom was caused by government spending, when in fact it was caused by the issuance of new money. In fact, colonial observers commented that the economic stimulus was greater when now money was introduced by lending to private citizens, rather than spent into existence by the government.

kyle8 October 27, 2011 at 4:31 pm

Hey well, then lets just crank up the presses and print more money! All problems solved!

Richard Williamson October 27, 2011 at 2:09 pm

I tend to think of aggregate demand in terms of the aggregate propensity to hold money or near-money versus purchasing goods & services / investment in capital equipment etc. But then I’m not a trained economist…

Jon October 27, 2011 at 2:42 pm

I’ve a question regarding some aspects of government spending as far as wealth creation/growing the economy:

The construction of new infrastructure I can see as valuable (excluding “bridge to nowhere” projects), but will the repair of worn infrastructure add wealth to an economy? I may be wrong (and please correct if I am), but is it not analogous to the Broken Window parable?

Tim Lee October 27, 2011 at 8:12 pm

Why do the people who advocate increasing government spending right now in large amounts act as if there is a free lunch–that aggregate demand will go up by the amount of the spending as if economic activity will go up by the amount of the spending or even more?

Isn’t the answer to that it depends on the state of the economy? When the economy is at full employment, the multiplier is low, so expansionary policies simply produce inflation. When the economy has a lot of idle resources, then expansionary policies put to work resources that would otherwise continue to be idle.

You framed it in terms of government spending, but I think it’s easier to see in the case of a pure helicopter drop. There the government isn’t doing any spending, it’s just providing additional liquidity to private citizens to spend on goods and services they value. If they use the extra cash to buy goods and services from firms with a lot of spare capacity, the result is likely to be a large increase in output and little or no inflation.

The argument for stimulus spending, I think, is that the Fed isn’t actually allowed to do helicopter drops. So when conventional monetary policy fails, Congress becomes the conduit through which the Fed injects liquidity into the economy. In this sense there’s nothing special about spending; Congress could just as easily engage in deficit-financed tax cuts. Either way, the goal is to increase the total amount of liquidity in the economy, which (again assuming idle resources) boosts economic output.

Josh S October 27, 2011 at 11:22 pm

You should be able to statistically verify whether the multiplier is a function of the employment level.

Sonic Charmer October 27, 2011 at 10:00 pm

Why is it that the proponents of more spending by the government to stimulate “aggregate demand” do not ask and then what? How can you increase spending by government and assume that everything else is unchanged?

The core of the problem is here. The reason Keynesians can increase spending by government and assume that everything else is unchanged is the same reason they focus on ‘aggregates’ in general (even though it’s quite obvious that the details inside an economy actually matter): because that makes the analysis easier.

In other words, they choose upfront to alter the object of their study so that it becomes easier for them to study and to draw the conclusions they wish to draw. As such, I am inclined to presume any resemblance of their theories to the actual economic reality of human societies is purely coincidental. I’m not sure what further need be said or that junk, lazy concepts such as ‘aggregate demand’ merit any further brain cell usage.

Scott Sumner October 28, 2011 at 8:13 am

Russ, I think that the government spending multiplier is probably near zero, but I also think you made an important error in your opening two paragraphs. It seems to me you are confusing demand and quantity demanded. Suppose aggregate supply increased while AD was fixed. At the new equilibrium you would have an increase in quantity bought and sold, but no increase in demand (just quantity demanded.)

If you meant nominal purchases in the opening two paragraphs, then it’s OK. But you should probably make that clearer, as I think most people would read that as real quantities.

The reason I think the recession was caused by less AD is that NGDP fell in 2009. Less AS doesn’t have that effect.

Vuk October 28, 2011 at 7:33 pm

I also see a major flaw in the aggregate demand argument, but I’m more puzzled about the channel through which Keynesists expect the aggregate demand increase to boost growth.

According to Keynes’s theory, more money into the economy from the government will increase aggregate demand since investors will now have enough money to start investing (or will feel more confident now that more money is in the economy somehow), businesses will use the stimulus they receive to hire more workers and increase production and consumers will be encouraged (due to newly created jobs) to start spending on consumer goods, creating more demand for the businesses, and hence restoring economic growth. However, it is unlikely to imagine that by creating a temporary job for a fireman or a teacher will make them spend their salaries on buying a new car or a washing machine. The money will more likely be used to pay off household debts. The consumers will be careful in taking new loans and the banks will be careful in issuing them as long as confidence in the economy is low. On the business side there is a similar effect; the money they receive will be spent on servicing their debt, not an increase in production or higher employment. The stimulus will thus only result in a form of social transfer to companies that found themselves in troubles. I find it hard to see the efficient use of the taxpayer’s money if that would be the case.
Finally, concerning the adverse selection problem, is it logical to assume that any government bureaucrat can posses enough information to make a good decision on which company should get the public funds, and which is better off without it?

Doc Merlin October 31, 2011 at 11:51 am

You don’t understand AD, because it doesn’t exist.
In the words of Sims “there is no such thing as agregate demand.”
I’ll use a 3d Edgeworth box to explain this:
Remember in micro that one person’s demand is others’ supply, this means that when we aggregate there is only supply, however, the supply isn’t a function of price and quantity. Its a hill where the z axis is utility and the other axes are quantities of various goods.

When we have a /demand side/ recession it means that the hill has shifted so we are at a lower point in utility.
When we have a supply side recession it means that where we are on the hill has shifted so we are at a lower point in utility.

Jack Hill November 25, 2011 at 10:18 am

What we have today is a aggregate of bad decisions made by government.
No one can make the day to day economic decisions for others and expect wealth creation.The multiplier effect is bogus.

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