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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