Why is Aggregate Demand So Confusing?

It’s possible that I’m the one that’s confused.  But since it’s my blog, I’ll write the post as if others are confused.

Picture the AS/AD diagram.  Now shift AS to the right, due to population growth, capital accumulation, resource discovery, or technological developments.  What happens to AD?  I guess it depends what you mean by “AD.”  I’d say nothing happens, although the quantity demanded rises at a lower price level.  When I read others I often get the impression they have in mind some sort of “real AD” concept, which would drain AD of all meaning.  After all, if it’s quantity demanded, then any and all changes in output are changes in aggregate demand.   This would allow no debate as to whether recessions were caused by AD shocks, as a recession is defined as a significant fall in output.  It becomes a tautology!   Yet I get the feeling reading people like Stiglitz that he views AD is a real concept, not a nominal concept.

Or consider an increase in AD when the economy is at capacity.  The textbooks say you just get inflation in that case.  But if you used a “real AD” concept, then there would have been no increase in AD in the first place.  That’s right, even in Zimbabwe AD did not rise, because output didn’t rise.

Why does this confusion exist?  Perhaps because we have two radically different ways of thinking about AD; the monetary approach (M*V) which is obviously a nominal concept, and the Keynesian approach (C+I+G+NX) , which could be visualized in either nominal or real terms.  Most people are Keynesians, and think in terms of actual purchases of goods and services.  To take a micro analogy, most people views the terms ‘consumer purchases’ and the term ‘demand’ as being synonymous.   Even though purchases are also sales, and could just as well be termed “quantity supplied.”    (Remember those graphs of “oil demand” over the next 50 years?)  When I read popular writers on macroeconomics I see them break the economy down into sectors, and talk about things like “December demand for US made cars,” what they really mean is “quantity demanded.”

The deeper problem is that the Keynesian and monetarist worldviews are nearly incommensurable.  It’s very hard to mentally toggle back and forth between the two approaches, because they are so radically different.

When I read the following quotation from Tyler Cowen, I initially wondered whether he was confusing AD with real quantity demanded:

Weak job creation remains at the heart of America’s unemployment problem.  Accepting this hypothesis does not require the rejection of Keynesian economics; for instance you can think of weak job and start-up creation as one reason why AD is not recovering so well on its own, with causation running both ways of course.

(BTW, commenters should not complain that his first sentence is tautological, he’s talking about gross job creation, not net job creation.)

I see economic dynamism, creative destruction, as something that affects AS, not AD.  Yet in the very next line he shows that he’s not confused.  Like me, he views AD as a nominal concept:

Remember — monetary velocity is endogenous to perceived gains from trade.

But I’m still not happy, because I don’t agree with his implicit assumption that velocity shocks affect AD.  They do under Friedman’s 4% money growth rule, and they do under a gold standard.  But velocity shocks have no impact on AD under the following monetary regimes:

  1. Inflation targeting.
  2. NGDP targeting.
  3. A  Taylor Rule.
  4. A hybrid policy where the central bank does just enough QE to prevent inflation from falling below 1%, but no more.

I’m not quite sure what sort of regime we have today, but my hunch is that it’s closer to the 4 items on that list, then it is to either a 4% money rule or a gold standard.  If I had to guess I’d assume Tyler might have made the following error:

  1. He developed a real theory of unemployment (no problem there.)
  2. Saw market monetarists looking over his shoulder, or perhaps felt uncomfortable with empirical evidence that AD matters too, and decided that the theory was in some way compatible with AD theories of the recession.  But I don’t think you can do that.  An AD theory must be 100% nominal.  That means it must move the monetary policy process front and center into any explanation.

This doesn’t mean that real shocks can’t matter.  For instance, I speculated that in 2008 and 2011 the oil price shocks made monetary policy more contractionary, which reduced AD.  In both cases the Fed saw high headline inflation rates, and became squeamish about monetary stimulus.  In both cases they tightened enough to reduce NGDP growth, even as inflation was still above target.  The slower NGDP growth slowed the economy.  It’s possible that a similar explanation could be developed with Tyler’s job creation story.  But I don’t think it’s enough to tack on a “velocity might fall” explanation.  To me, that seems too much like someone working out a real theory of AD, and then assuming nominal AD must move in the right way to make it work.  As when Keynesians convince themselves that fiscal policy must affect AD, and then offhandedly suggest that velocity will move in the right direction to make it happen.  Maybe so, but the theory needs to be developed in terms of actual central bank practice, i.e. changes in M*V, not just a add on assumption about velocity.

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About Scott Sumner 492 Articles

Affiliation: Bentley University

Scott Sumner has taught economics at Bentley University for the past 27 years.

He earned a BA in economics at Wisconsin and a PhD at University of Chicago.

Professor Sumner's current research topics include monetary policy targets and the Great Depression. His areas of interest are macroeconomics, monetary theory and policy, and history of economic thought.

Professor Sumner has published articles in the Journal of Political Economy, the Journal of Money, Credit and Banking, and the Bulletin of Economic Research.

Visit: TheMoneyIllusion

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