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Nick, I've only just scanned it, it's pretty long, but my first thought is: very good post.

Thanks Adam! Unlike some of the other stuff, macro with monopolistically competitive firms is actually a topic on which I've got my intuition more or less straight. Really wish I could figure out how to draw and post the diagrams, because I have some neat ones that I haven't seen in the literature. Will maybe do a second post on the diagrams, when I do.

If you can get MS Paint to generate image files (,jpeg, .png, .pdf, etc), you should be able to post them.

Or draw it by hand, and scan it into jpeg etc. The hand need not always be invisible.

Very interesting analysis.

The dynamics of a real economy are diverse, of course. Some sectors are closer to perfect competition while others are monopolistic; and where there is monopolistic competition, there may not be as much as 10% (in your example) gap between current and potential output. Even if there is, there will still be a time lag between seeing extra demand and being able to satisfy it.

This is especially true if the extra demand is for savings (that is, for investment). The delay in being able to identify new investment opportunities and lend to them is what creates the excess demand for the medium of exchange which you often mention. Your theory of loan officers from a couple of weeks ago I think expresses this time lag quite well.

Perhaps these lags are equivalent to the recalculation argument - with monopolistic competition and sticky prices being specific causes of the lags, rather than being the fundamental cause of recessions in themselves.

p.s. feel free to email me your Paint files if you want help in converting them to PNGs and uploading - but you should be able to use "Save As" from MS Paint as Stephen suggests.

For really nice graphs get Mayura draw and then save in a variety of formats.

This program looked kind of nice to me for drawing teaching graphs, and there's a free trial. I am surprised it is hard to add graphs. Seems like there would be an "insert image" button wherever you write your post; that's what most other blog services have.


On paint, click 'save as' and try one of the formats Steve suggested. Or go into the print menu, and in that box towards the top of the menu, see if it allows you to choose Adobe acrobat .pdf or some such as a printer. I think you can probably do that on your work computer, anyways.

you might try uploading your graphs at google docs, then post a link to the page that contains a specific graph. Haven't tried it but the advantage over uploading a pdf i think is that you can edit it in realtime even after uploading. you can tweak and edit without having to re-upload each time, and your links will always display your latest tweaks.

So what happens when the goods and services market is monopolistic and the labour market is monopsonistic?

My guess is that labour market issues drive AS down. There is much trying to paper over the cracks but eventually recessions get triggered.

To be 'fair' to Cuba, I've heard different over the last year from my friend Manuelo who would not move back as he is a healthy, young worker in his prime. His story matches this link

He says working Cubans receive a small peso monthly wage, approx 20 pesos with which to buy 'extras'.

Basic services are free. Rent, health care, education etc. AS exceeds AD. Definitely not true in U.S. the 'market economy' given our masses of homeless, sick and uneducated.

Vouchers come each month for a certain amount of nutrition. People that are inclined to eat more go hungry unless they have a way to barter/foreign exchange for more food and this tends to keep people skinny.

Purchases of 'luxuries' requires currency. AD exceed AS.

Your post makes it seem like no one wants to 'net save' in Cuban Pesos. Does everyone in Cuba have money but they have no goods to buy? I don't believe that is true or else how could Cuba peg their currency to the dollar? Do you have black-market exchange rates?

I'm want to see the graphs!

Great blog. I am an economics graduate - now an economics consultant.

i've written many articles on my blog relating to economics too. Please check it out and follow me:


Cuba runs 2 currencies. Cuban pesos and convertible pesos. Cuban pesos are officially not supposed to be converted. There is an official exchange rate (Cuban<=>convertible), the rate on the street is higher than that.

To make money in Cuba you work in the tourist trade, that includes renting rooms and running local restaurants.

Leigh, this statement, I think, is wrong: "This is especially true if the extra demand is for savings (that is, for investment). The delay in being able to identify new investment opportunities and lend to them is what creates the excess demand for the medium of exchange which you often mention. "

There is a good reason why variation in investment drives the business cycle but it has nothing to do with the delay's in identifying investment opportunities.

Start with an economy in equilibrium at full-employment, this means that the current real interest rate is equal to the natural interest rate and satisfies two conditions:

1) consumption Euler equations are satisfied.
2) the risk-adjusted expected return on the marginal investment project equals the real rate.

Now suppose a shock drives us out of equilibrium, in particular suppose the natural rate falls or the real rate rises, either way so long as they are no longer equal and the real rate is too high.

In principle consumption can fall immediately, people just stop buying stuff, and conumption falls until it is low enough relative to future expected consumption so that the Euler equation is again satisfied.

Investment falls immediately too, but this does not raise the marginal product of capital because the marginal product of capital depends on the level of the capital stock. The marginal product of captial rises only slowly as depreciation reduces the capital stock. Thus investment falls further than consumption and stays depressed longer.

In the absence of a monetary response to bring the real rate down the recession won't end until the capital stock falls to the point that the marginal product of capital, and hence the natural interest rate, again equals the real rate, at which point full-employment is restored.

Thanks everyone for the comments, and the helpful advice on how to do graphs. Sorry I've been so slow responding. Yesterday afternoon was very abnormal. I had to do an unscheduled drive to Toronto and back (didn't get home till 3.30 this morning) through snow and high winds (and dealing with total transmission failure on daughter's car). So now I'm catching up on sleep, and preparing for lectures tomorrow morning.

To continue Adam's point above:....which explains why investment demand is so very sensitive (elastic) with respect to the rate of interest, expectations, and everything else.

Will return later. (And with your help I have figured out now how to post paint, but need to practice painting good diagrams.)

Nick: Suppose a bank increases the provision of credit. Under your assumptions AD shifts. It continues to do so until P=MC. At this point the economy becomes supply constrained and the recalculation theory applies.

Consequently, I would conclude that your analysis demonstrates a much weaker conclusion that you submit. Namely, that a modern market economy can tolerate a certain amount of credit expansion; however, I don't think your conclusion holds for a very large credit expansion.

Mises's description of the credit cycle depends on the credit expansion lowering the real rate; however, if P always rises faster than the slope of the MC curve this will never occur. I.e., the expansion must generate inflation only. But if real-rates do shift (owing to a scarcity of information, sticky prices, whatever) this also implies that the P rises more slowly than the MC curve. Which in turn leads to the supply-constrained situation you describe.

I'd say you've inadvertently made a very strong case in favor of Mises's narrative being possible.

Excellent post. Unfortunately it's late and I need to think about it for a while.

Nick said: "Start instead with monopolistic competition, where each firm faces a downward-sloping demand curve. Start in equilibrium, where the firm maximises profits by setting output where Marginal Cost = Marginal Revenue, and sets a price above MC."

From a stock perspective, is that equivalent to gross margin and revenue maximization?

Also, what scenario(s) lead to cost minimization and output, pricing, and gross margin maximization?

Nick said: "In a monopolistically competitive economy, there are really two LRAS curves, a separate curve for each of those two roles. The first LRAS curve tells us where the economy will adjust to, in the long run, if prices eventually adjust up or down. The second LRAS curve, at a higher level of output, acts as a supply constraint."

Does the first LRAS have a lower level of employment?

Finally I find some time to respond to comments:

Too much Fed: "Does the first LRAS have a lower level of employment?"
Yes. Lower employment and output (unless the labour supply curve is perfectly inelastic, and wages are perfectly flexible).

"From a stock perspective, is that equivalent to gross margin and revenue maximization?".
No. Firms maximise profits, which is total revenue minus total costs. The "gross margin" (if that means the markup of price over marginal cost) is determined by the elasticity of demand. It's determined by: P = MC/(1-1/E) where E=elasticity of demand, IIRC. So in the limit, as E goes to infinity, as under perfect competition, we get P=MC.

Scott: Thanks! There's no way I can keep up with your rate of producing great posts.

Jon: "Suppose a bank increases the provision of credit. Under your assumptions AD shifts. It continues to do so until P=MC. At this point the economy becomes supply constrained and the recalculation theory applies."

Agreed. Unless prices increase first, which they probably will, unless it's a very big and very fast rightward shift in the AD curve. But we don't normally see cases in market economies where people want to buy more stuff than firms are willing to sell. Rationing of buyers happens, (and you can always find a few special cases), but it seems to be rare, though less rare in a boom. WW2 (in the UK anyway, more so than in Canada?), when there was a very big increase in AD and prices were held down, is the exception that proves the rule. Normal booms don't approach the supply constraint for most goods. (That's my sense, anyway.)

Back to practicing with Paint!

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