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Relative Price Adjustments and Aggregate Demand

Some persons understand the role of relative prices — understand that prices work only if they are permitted to adjust in order to reflect relative scarcities — understand that the hardships that sometimes accompany such adjustments are the necessary price to pay for the fact that persons yesterday got the once-good jobs and built the once-good businesses that are so painful to lose today.

Other persons, upon encountering an unusually large number of price adjustments occurring simultaneously, worry that catastrophe looms.  To avoid this awful outcome, they demand more demand.  They demand either more money be injected into the economy, or more direct spending by government.  The idea is to raise demands across the board to levels that will make the old prices — the pre-adjustment prices — work as they worked before the underlying reality changed.

"If only people spent as much as they spent before, all would be well," these demand-more-demand people imagine.

One of the many blind spots in this view is that it causes its adherents to overlook the underlying changes in reality that sparked the price-adjustments in the first place.  It’s dangerous business to ignore this reality by trying to recreate, as a kind of facade, the economic outcomes that prevailed before the underlying reality changes.  It’s ultimately futile as a means of restoring vigor to a market economy.

Amity Shlaes in today’s Wall Street Journal does a great job explaining some faulty reasoning of those who insist that the problem with economic downturns is inadequate aggregate demand.