The War on Demand, and the short-side rule.

Paul Krugman thinks the War on Demand is strange. I think it's weird. But I've got a different take on what's happening.

[Update: Paul Krugman responds.

"Nick Rowe makes a good point: most of the time, in market economies, sellers feel constrained while buyers don’t. I’m somewhat surprised that he doesn’t mention why: it’s because perfect competition is actually rare, because oligopoly or monopolistic competition — in which prices exceed marginal cost — is actually the norm."

I totally agree. This is a point I've been pushing in the past more than once. Just didn't feel like repeating myself again. ]

Let's start with some very basic theory. It takes two to trade. A buyer and a seller. If the buyer is willing and the seller is willing, there's a trade. If the buyer is not willing there's no trade. If the seller is not willing there's no trade. Quantity actually bought and sold is whichever is less: quantity demanded; or quantity supplied. Q=min{Qd,Qs}. That's the short side rule. The short side of the market determines the quantity traded.

Most people figure this out.

Now look around. Not just here and today, but anywhere, at any time. (OK, maybe not Cuba or North Korea.) Everywhere you look you see people trying to sell more. If you want to buy something, and are willing to hand over the money, you can nearly always buy it. The seller is almost always able and willing to sell you one. Very willing. Would you like to buy two?

The short side of the market is nearly always the demand side. Quantity supplied is nearly always more than quantity demanded. It's easy to buy, and hard to sell. Any fool can be a buyer. A job in sales is hard work.

Put theory and observation together. If you increase quantity supplied, without increasing quantity demanded, nothing will happen. But if you increase quantity demanded, even if you don't increase quantity supplied, the quantity bought and sold will increase.

There's a limit of course. If you increase quantity demanded too much, without increasing quantity supplied, eventually quantity demanded will exceed quantity supplied, and the seller will be on the short side of the market. But we so rarely seem to hit that limit.

That's how the world should look to somebody with no economics education. The policy conclusion is that we should almost always increase demand, at least a bit. It will almost always make us better off.

For many people with just a little economics education, the world looks just the same way as well. The Keynesian Cross model teaches the same thing. It is demand that limits output and income, not supply. The Keynesian Cross model is a very dangerous model. It should be kept on the Index of books that only economic Jesuits secure in the true faith should be allowed to read. Instead it is regularly taught to the masses in first year macroeconomics. And the limitations of that model are taught in more advanced courses for those entering the true church.

If there's one macroeconomic model that journalists and educated lay people vaguely understand it's the Keynesian Cross. And that vague understanding filters down into an even vaguer understanding by the masses.

So what's really strange is that we could ever get people to believe that demand is not the problem.

For decades my job has been to teach students that, despite the evidence of their senses, and contrary to their hearsay of the heretical teachings of the Keynesian Cross, aggregate output is basically supply-determined. Which it is. Basically. Though short-run fluctuations in demand can and will cause short run fluctuations in aggregate output around an average level that is determined by the supply-side.

And, for once, the memories of their parents are actually supporting me in my job. Look what happened in the 1970's, when demand increased. Printing too much money and increasing demand really did cause inflation. It really didn't make us all richer. It didn't reduce unemployment.

Now, just for once, we have to switch gears. These times are not normal. Just for once, the demand side really is the problem. Just for once, the overly obvious truth your senses are telling you really is the truth. Just for once, your parents' experience of the 1970's doesn't apply. Just for once, it really is OK to have a drink, even though you are a recovering alcoholic.

Comments

[Determinant]

Hmm, you are forgiven for your heresy on the Thrift threads, Nick.

Determinant turns to leave while humming the Old Hundredth.

[Sandwichman]

"The short side of the market is nearly always the demand side. Quantity supplied is nearly always *less* than quantity demanded."

Did you mean to say "more"?

[Nick Rowe]

Determinant: Let me quote Paul Krugman: "I’m the sort of person who finds the notion that *sometimes* virtue is vice and prudence folly interesting; but it’s clear that a number of people find that notion just plain evil. The world shouldn’t be like that — and therefore it isn’t." (emphasis added).

See that "sometimes"? That's the most important word there. He should have put it in italics.

[Nick Rowe]

Sanwichman: Damn! Yes. Well-spotted. Edited and fixed.

[Patrick]

Krugman says "And you know, they are; once you’ve accepted the idea that inadequate demand is the problem, the role of fiscal as opposed to monetary policy is just a technical detail (albeit one of enormous practical importance)."

Understatement of the year! Seems to me that one thing that could really make a huge difference in the US is the one thing that is absolutely impossible for anyone to do: print a big pile of money and hand it out to people most likely to spend it. The Fed in particular demonstrated that it can step into the breach when part of the financial system blows-up. But nobody has the tools or mandate to really resuscitate the real economy when it gets into severe trouble.

The bomb explodes, they rush to repair the building, but leave the wounded to the scavengers.

Would it play out any differently in Canada? I hope not, but ...

[Determinant]

That would be because handing out money to the masses is a fiscal operation, or at least usually conducted through the tax system, which makes it fiscal.

The problem is we need to go through the parliamentary budget process before the Finance Minister can load the helicopter with money and then start the engine.

[Andy Harless]

The Keynesian cross model works fine in nominal terms (although it's only useful if you know something about what the determinants of aggregate demand actually are). In nominal terms, the demand side of the market is always the short side. Sellers are always willing to sell a greater nominal value of their product; they just may not be willing (or able) to sell a greater real quantity. And surely everyone knows that prices go up when more people try to buy stuff than there is stuff to sell: everyone has seen an auction, and surely, in our culture, everyone has heard that "prices are determined by supply and demand."

As far as the Keynesian cross, I would say it's a nominal model, and it works fine, and leave it at that. Anyone who doesn't believe it (including maybe 95% of economists today) is just thinking about it the wrong way. They've bought into the idea that the aggregate price level and aggregate real output are meaningful concepts, but when I think about those concepts, I often feel obliged to cover my eyes rather than view the emperor in his natural state.

Once you discard those concepts, the question becomes what level of nominal spending (or better, what growth rate) is optimal. Surely people realize that if nominal spending grows too fast, prices will have to rise. If anyone doesn't realize that, it takes about a minute to do the necessary reductio ad absurdum. And surely people also realize (as per the evidence of their senses) that if nominal spending grows too slowly, then less goods and services will be produced. So the problem is to choose a happy medium, where prices don't rise too quickly but a lot of goods and services get produced.

We could devote a lot of research to determining that happy medium, but it seems to me the general range is pretty obvious. In the 1970's nominal spending was growing way too fast. Today it's growing way too slowly. Why can't people see that?

[Greg Ransom]

Hoover & FDR believed the bust could be reversed by increasing wages, thereby increasing demand and returning businessees to prosperity.

How'd that turn out?

Increasing just any old demand is the economics of the crank -- businessmen from time immemorial have said that the road to prosperity is for their customers to have more money.

In truth, the mistake is to forget that costs expended do not create value into the future -- if every expansion of demand creates less value than an alternative stream of trades & demand, then increasing demand in and of itself will not lead to economoc coordination and wealth production. "Stimulated" trades which consume value instead of create it destroy the stock of value and consequently increases the demand for a store of value (money) -- on the other hand trades which increase value have the opposite effect, such trade reduces the demand for money as a store of value, produces increased expenditures through wealth effects, and allows for investment in superior wealth producing processes -- increases in value which can serve to back expansions of tne money supply both as shadow money and directly via fractional reserve banking.

[reason]

Greg Ransom,
this is an often refuted argument. Time doesn't stand still waiting for equilibrium to be determined. People have to eat in the mean time. Producing something, is not as good as producing the optimum, but it better than producing nothing. Keynes summed it up best "in the long run we are all dead".

[reason]

Or another way to answer Greg Ransom, the perfect is the enemy of the good.

[reason]

Greg Ransom,
just a short personal question, don't you get sick of writing nonsensical gobbledygook that nobody but you believes. Try some concrete examples, and see if your abstract still applies.

[Daniel Kuehn]

Nick -
Good post, and a good qualifier to Krugman, but I think the point is "demand" was still the problem in the 1970s. There was just too much of it. It's not that demand is a problem now because we're going through a weird period now. Demand is always the problem in one direction or another because demand is a relatively unstable component.

Better, I think, to stick with the formulation that demand almost always offers us our problems one direction or another around a secular growth trend determined by the supply side - ie, capital accumulation and technological progress.

[Nick Rowe]

Andy: I strongly disagree.

Let's take the simplest KC model and re-write it in nominal terms, taking care not to introduce money illusion (keeping all equations HD1 in nomianl variables):

PC=Pa+bPY

PI=PIbar

The solution is PY=(1/1-b)(Pa+PIbar)=P(1/1-b)(a+Ibar)

You can't determine NGDP unless you already know what P is. But you can determine RGDP without knowing P.

[Bill Woolsey]

Great post, Nick.

[reason]

Greg Ransom,
just out of interest, did you write what you wanted to write? Because it seems to me you are saying, that we need to find a magic product. There is some product out there, that is not being supplied that will absorb all excess savings if only it can be found. You don't really mean that do you?

[Bill Woolsey]

Ransom,

The problem with the policy of raising wages is that a price floor does't raise demand. It raises quantity supplied and reduces quantity demanded.

For a micro analysis, the impact on the volume of spending on the product depends on demand elasticity.

For wages, say for the 2 percent of workers that are least skilled, the impact of a increased wage floor on their wage income depends on the elasticity of labor demand. It could rise, or it could fall. The demand for products by that small segment of the population could rise, or it could fall.

But everyone elses money income and, so, demand for other goods, moves in the opposite way.

If we do macro with constant money expenditures, and we
are talking about something like WAGES, then wage income will hardly be effected. Fewer workers will earn more per worker. The productive capacity of the economy will be depressed. If actual production is already below that amount, then all that happens is that firms selling products are less frustrated by low sales.

If, on the other hand, the demand for labor increases (shifts to the right) this does raise wage income. If other sorts of income stay the same, then total nominal income rises. It is likely that the demand for products would rise too. Of, course, the way the the higher demand for labor is likely to occur is because there is a higher demand for the products of labor.

So, the problem, with the Hoover-Roosevelt policy wasn't the notion that demand should increase, but rather the notion that keeping wages high, or raising them, is a sensible means to raising demand for products.

[reason]

Maybe Greg was thinking of heroine which those wicket Statists have banned. That is what you get for government interference in the free market.-)

[reason]

oops
heroin not heroine and wicked not wicket - shouldn't go to economics blogs after the cricket.

[anon]

"Quantity actually bought and sold is whichever is less: quantity demanded; or quantity supplied. Q=min{Qd,Qs}. That's the short side rule."

Why is there a gap between Q_d and Q_s in the first place? I can think of a number of different mechanisms:

1) Relative prices are stuck at a level which doesn't clear the market, so there's a glut of some goods.
2) Money is too tight, but the general price level has not increased to reflect this, so there is a shortage of the medium of exchange.
3) The market clears, but price has not been set at the margin of production--we are under imperfect competition. Any increase in quantity demanded yields a quasi-rent to the seller. A lower real price would increase efficiency in the short run, but long-run effects are ambiguous.
4) Anything else?

However, the policy implications of each seem to be quite diverse. It may be true that "the demand side matters", but what we should mean by "demand side" is by no means clear.

[anon]

"2) Money is too tight, but the general price level has not increased to reflect this, so there is a shortage of the medium of exchange."

s/increased/decreased, obviously.

[Nick Rowe]

Actually, I think Greg's argument is interesting (not the bit about wages which Bill dealt with, but the bit below that). Interesting, even if not quite right. But I think one could conceive of an increase in government expenditure that was so screwed up it actually increased the demand for money and worsened monetary disequilibrium. Not sure.

[Nick Rowe]

anon: I definitely go with 3 in the long run, aided and abetted by 2 in the short run recession. And only occasionally, in a very big boom, does the negative of 2 outweigh 3. 1 is always present a bit, but only at the micro level.

[Phil Koop]

So what exactly is your "different take?" Are you claiming that Krugman believes the economy is always limited by demand? That claim is easily refuted by his publication record.

Or are you under the impression that italicizing demand would constitute a different take? That seems a stretch - the monetarists whom Krugman thinks are now on his side of the ideological abyss often harp on this point. Paraphrasing Sumner: "I am almost always a supply-side economist but twice a century I think the problem is demand."

Perhaps Krugman merely thought that if you are a professor of economics you ought to be able to read and understand a plain English sentence without special assistance. Do you think that assumption unduly heroic?

[Greg Ransom]

Bill, I get all that.

Sorry I distracted you -- I was simply trying to establish that instinct of the crank can lead to bad policy.

I didn't mean he example to do the work of my argument.

[Greg Ransom]

Bill, there are other ways to raise wages other than a price floor -- you csn tax and subsidize.

[Greg Ransom]

Nick, my argument is a form of Hayek's argument that Keynes don't take scarcity serious and doesn't take marginalist valuation theory seriously. The fact of monetary disequilibrium and non-economic "idle" resources doesn't change the significance of scarcity and the need to expend resources in a matter that generates value rather than consumes it.

A downward cicle of empoverishment via demand that consumes wealth but does not sustain or increase it (e.g. though value enhancing production recalculation & growth) isn't a benign path toward economic re-coordination.

See book IV of _The Pure Theory of Capital_.

[Greg Ransom]

The story of 2006-2010 in America?

"But I think one could conceive of an increase in government expenditure that was so screwed up it actually increased the demand for money and worsened monetary disequilibrium."

[Luis Enrique]

First, I think there's a simply reason why some non-economist people don't like 'demand' explanations, and it's not because they fail to understand how decreased demand may cause recessions and job losses, it's because they think demand has fallen for a good reason, and so don't think increasing demand is a good move. If demand has fallen because people are saving (and need to save) or if demand has fallen because it had previously been fueled by craziness, or if you believe the government is broke, then you don't want to fix things by trying to raise demand, getting households into debt, re-introducing craziness or growing the national debt. So I think you can explain popular hostility to Krugman's demand side solutions quite easily.

Second, I think there's also a simple reason why many economists don't like 'demand' explanations, and that's because none of their models have anything like that in them. I am repeating myself, but most economists grew up with barter models in which 'liquidity preference' general gluts, can't happen. I remember an economist cautioning me against casual reference to aggregate demand in the company of macroeconomists, because they will ask you "what is this thing 'aggregate demand'? What has changed? Have preferences changed? Has production technology changed? Why do people suddenly want to consume less?" Even economists who were happy with models in which prices are sticky and markets don't clear, are not accustomed the idea that economies may suddenly see everybody trying to sell more and buy less in order to accumulate more money / pay down debts (or whatever your favoured explanation is). That's just not something that makes sense within the framework they use to understand the macro economy. I guess models in which that does make sense are now starting to emerge. But I don't find it surprising. Why doesn't Krugman realize he's telling a story that the models don't tell?

[Luis Enrique]

Having written that, I suppose mainstream New Keynesian models include an dynamic IS curve which has something called a 'demand shock' in it, and you can ask your model what to do if the economy experiences a negative realization of this demand shock. But evidently most macroeconomists are not buying that. This is as close to demand-side stories macro models get, isn't it? Or am I wrong ... it wouldn't surprise me.

[Greg Ransom]

Nick -- you missed the other side of the argument.

Consuming value out the store of wealth producing value assets decreases the supply of shadow money -- and has effects on the money decisions of the banking system.

[Nick Rowe]

Phil: "So what exactly is your "different take?" Are you claiming that Krugman believes the economy is always limited by demand? That claim is easily refuted by his publication record."

Of course not! Jeez! Obviously I didn't explain myself clearly enough.

"So what's really strange is that we could ever get people to believe that demand is not the problem."

That's my different take. He finds it strange that people don't think that demand is the problem now. I find it strange that people didn't *always* believe that demand is the problem.

[anon]

""what is this thing 'aggregate demand'?"

I suppose this depends on what you mean by "demand side" per my previous post. If you buy (3) imperfect competition, then "aggregate demand" is the Dixit-Stiglitz effect, which is a coordination problem among producers in the monopolistically competitive sector. If you think (2) is what matters, then a failure of "aggregate demand" is a drop in the velocity of money and is caused by mistakes in monetary policy. If you are a RBC theorist then it's a fall in consumption etc.

There is not much in common between these issues other than the term "demand" and the fact that each of these may reinforce all others.

[Mark A. Sadowski]

Nice post, especially the discussion of "basic theory" which I may borrow someday for demand side macro. However it was this part which twitched my brain most:

"And, for once, the memories of their parents are actually supporting me in my job. Look what happened in the 1970's, when demand increased. Printing too much money and increasing demand really did cause inflation. It really didn't make us all richer. It didn't reduce unemployment.

Now, just for once, we have to switch gears. These times are not normal. Just for once, the demand side really is the problem. Just for once, the overly obvious truth your senses are telling you really is the truth. Just for once, your parents' experience of the 1970's doesn't apply. Just for once, it really is OK to have a drink, even though you are a recovering alcoholic."

There's an economic side to me I rarely reveal. It's Medievalian in its faith in cyclicality. I've always been intrigued by theories of long waves.

It's hard not to believe when you look at a graph of yoy CPI from 1960-2000 and observe an almost symmetric mountain peak ascending and descending as you go from left to right. The preceding 40 years (1920-1960) were of course less symmetric but certainly being punctuated by the Great Depression they present a somewhat inverted picture.

So in a sense the Medievalian part of me wasn't surprised by our current demand side economic predicament. And I'm not surprised at all that the biggest problem we have now is convincing those with memories of the 1970s (and early 1980s), as well as their children, that printing money right now really would help.

Previous generations have had similar struggles. In the 1960s there was a deepseated fear of unemployment by those who had lived through the Great Depression which led them to believe that in the proper management of the demand side lay the solution to all our economic problems. Similarly Benjamin Roth's Great Depression diary reveals a thinking eerily similar to our own time where fears of inflation lurk around every corner and yet there was none to be found.

I wonder, how much of these waves are the result of the widespread persistence of irrational fears induced by painful memories that take a good dose of the opposite to finally cure and unfortunately set off the secular cycle yet again?

[Luis Enrique]

anon,

can you say more? In a Dixit-Stiglitz world, why would AD suddenly slump? In a macro model incorporating a monopolistically-competitive sector, what in the model would generate that sort of dynamic, without appealing to some sort of outside-the-model "shock" to household preferences.

I need some help with 2) too. If you set money supply too low, in some sense, that sets interest rates too high in some sense, and that causes output and employment to be too low ... is that the sort of explanation you're getting at? But in what sense is that a demand side story applicable to current situation?

[Greg Ransom]

Make that:

"Bill, there are other ways to raise wages other than a price floor -- you can subsidize labor."

[calmo]

(Not only) Mark is ruled by (waves) stories, those Medieval precursors to these upstart Modern theories...just try splainin to your toddler son that he is operating under a gravely mistaken paradigm and the next time he empties the cookie jar he will face Dire Consequences. After a few more empty cookie jars, you resort to what has always worked in the past: 'The Devil will get you'.
So many entertaining and engaging comments...Nick has a knack.
Salute!
I'm going to stay with Mark because it's not only convenient but he has no problem borrowing and, moreover, can span half a century of comparisons with his CPIs without even flinching. I need wings like that.

[anon]

Luis Enrique, on (3) there are many articles in the New Keynesian literature, including Blanchard & Kyotaki 1989, "Monopolistic Competition, Aggregate Demand Externalities and Real Effects of Nominal Money".

As for (2), the idea that high interest rates should be identified with tight money is largely a misconception. Loosely speaking, low interest rates mean that money has been tight in the past, and conversely, high interest rates are a sign that money has been too easy. There are monetary transmission mechanisms which have nothing to do with interest rates, such as cash balances and NGDP growth.

[White Rabbit]

Nick:

regarding your simplified KC equation - it's too simplifed (linear), hence it leads you to absurd results! (Simply put you are trying to divide by zero.)

Use a non-linear AS-AD curve instead, something like:

http://www.ewp.rpi.edu/hartford/~stoddj/BE/MACRONOTES1.htm

Then you will see how in the 'keynesian' region supply ceases to be determinate to a large degree: the derivative of the AS/AD curve becomes very large (asymptotically infinite) - you cannot solve the equation. (You will divide by zero.)

As more background here's an AS-AD analysis done by Krugman:

http://www.princeton.edu/~pkrugman/nominal_wage.pdf

The gist of this line of thought is that especially in recessions demand is what controls the RGDP, not supply. So increasing demand gives a lot more bang for the buck moving the economy back to full employment than trying to twiddle any supply side parameter.

If you push the economy up higher then behavior gradually becomes different, hitting another extreme on the other end: the classical model where only supply controls the outcome.

The point of Krugman et al is that we only very rarely reside at the classical end of the AS-AD curve, and are more often in the demand-dominates portions of the curve. They other point they are making is that policy-wise it's a lot easier to exit excesses of supply than to solve the lack of demand. I.e. liquidity traps are sticky, while inflationary periods are 'repulsive': unstable and self-correcting.

In other words, looking at it from the demand side is more meaningful today and is more meaningful most of the time, except for relatively rare (and not particularly hard to resolve) cases like 1970s when too much supply [and an external oil price shock] let the economy run away.

This is as simple of a summary of the topic as is possible IMO - do you dispute it on some fundamental basis?

[Luis Enrique]

anon,

thanks a million for that reference. I think it's the paper I have been looking for. I look forward to trying to understand what kicks off a sudden desire to accumulate money in that model.

ok, I shouldn't have identified tight money with high interest rates. I was trying to understand what story about economic behaviour you could tell is your 2) world that would correspond to a Krugman-style aggregate demand slump story. How would you tell it?

[Donald A. Coffin]

I think the distinction between the long-run and the short-run here is extremely important. (This spins off a comment I tried to post at DeLong's website on Say's Law; I think Say got it right.)

In the long-run, the primary determinants of output are the supply-side determinants, and so the primary determinants of economic growth are supplyside factors.

But in the short-run, most (not all) fluctuations in output are daused by fluctuations in demand.

So in the long-run, aggregate supply is the fundamental constraint, while most of the time, in the short-run, aggregate demand is the findamental constraint.

The real trick is knowing when to focus on which.

[skeptonomist]

"Printing too much money and increasing demand [in the 1970's] really did cause inflation."

This is insane. The Fed did not set out to "print money" at that time (and I think the Canadian bank was the same); the response to inflation was burn money (raise interest rates drastically). Demand in the 1970's did not increase, nor did wages (real wages plummeted). Inflation was caused by decrease in the supply of grains and oil (there was an actual embargo on oil to the US - remember?).

During WW II central banks did set out to print money - the Fed kept rates very low by buying up all the short-term Treasuries issued. There was no increase in demand for consumer goods, but a shortage of supply (though wages did increase). There was inflation at that time, but it was not as bad as that of the 70's and 80's. How can an "economist" get these things so wrong?

[Andy Harless]

Nick,

By "taking care not to introduce money illusion" you're making the model depend on unobservable (and conceptually suspect) quantities. I can't add apples and oranges. Y, a, and Ibar are in units that involve both apples and oranges and therefore don't make sense. And P is in units that are impossible even to describe. The national accounting identity is true only in terms of nominal quantities, and you are artificially dividing those into a real component and a price component.

As to the behavioral equations, it's not clear whether they should be in real terms or nominal terms. Households and businesses often operate with budgets that are defined in nominal terms. You will call this money illusion, but as long as prices don't change too dramatically in the short run, it's probably optimal given limited information processing resources. And when prices do change, relative prices are almost always a bigger problem than the "general price level," so the inaccuracy of stating the model in nominal terms is a minor issue compared to the aggregation problems that I complain about above.

[John]

Nick: I'm one of those people with minimal economic education (PEP and an MBA) but supplemented with 40+ odd years of management including running a company with several thousand employees. In my experience most of the supply/demand process in real life IS conducted in the short term although I wouldn't disagree it's around a mean. I think you need to get up to date, dashes for growth a la 1970's were discredited long ago. In reality most activity is demand driven (ask any production planner) and I speak as someone who has tried to jump the shark more than once and got burned in the process. At least you're facing up to the reality of our current problem, it's time to break open the punchbowl.

[Nick Rowe]

White rabbit: once again, I am AGREEING with Paul Krugman on: the US needs demand now; now is abnormal.

This post is NOT about what PK and I think about the economy. It's about what PK and I think about the strange things that other people think about the economy, and why they think those strange things, and in what ways they are strange.

This is getting to be like Krugman Derangement Syndrome in reverse!

[Nick Rowe]

anon and luis enrique:

Yep, something like the Blanchard Kiyotaki model is what I have in mind. The key point is: it must be a monetary exchange economy though. Because saying that it's easy to "buy" but hard to "sell" only makes sense in a monetary exchange economy.

[Greg Ransom]

Let's be clear. The limit of scarcity and the limit provided by the requirement to constantly re-coordinate all plans and all production processes is constant and ongoing.

The case against "aggregate demand" thinking of the Keynesian type is that it is economics without scarcity, without constant re-coordination, and without non-permanent production processes require continual replacement and upgrading. "Supply" is supplied by a GDP factory, undisciplined by any need to re-coordinate, economize, or concern oneself with any other consequence of the fact of scarcity, changing technology, and the non-permanence of production processes:

Nick writes:

"if you increase quantity demanded, even if you don't increase quantity supplied, the quantity bought and sold will increase.

There's a limit of course. If you increase quantity demanded too much, without increasing quantity supplied, eventually quantity demanded will exceed quantity supplied, and the seller will be on the short side of the market. But we so rarely seem to hit that limit."

[John]

Nick: I for one understand you're AGREEING with Krugman and I'm sure so does White Rabbit since he didn't say otherwise. His and PK's point, I think, is that today's abnormality as you call it is in fact only a matter of degree. Most of the time as I suggested, economic activity takes place in a demand dominated environment.

[Full Employment Hawk]

There is nothing wrong with the Keynesian Cross model that adding a vertical long-run aggregate supply curve to it will not correct. In the short run, the aggregate expenditure function can cross the 45 degree line at a point that is either above or below the long-run aggregate supply curve, so that in the short run output is demand determined. But in the long run, prices will adjust and shift the aggregate expenditure function to the point at which it crosses the 45 degree line at the long-run aggregate supply curve.

But in principles courses first introducing the Keynesian Cross model and then the aggregate-demand, aggregate-supply model totally confuses them. The fact that in the short run output is demand determined but in the long run it is supply determined can be very adequately be explained with an aggregate-demand, aggregate-supply model with both a short-run and a long-run aggregate supply curve.

[Sandwichman]

Luis Enrique wrote: "most economists grew up with barter models..."

That's the first reaction that I had to this post. What struck me about "Q=min{Qd,Qs}" is that it presupposes a foundation of barter exchange, with money and finance erected upon it as a facilitating excrescence. In that view, reversion to barter can be viewed as simplifying.

But what if the relationships of exchange are already far more complex at the time that barter develops? What if, to be more precise, "usury" of a sort is always already a condition of barter exchange, which takes place between strangers at the boundaries of communities, within which gift exchange prevails?

Then, it seems to me, you have two rules, one of which is "Q=Qs", governing gift exchange and the other, dealing with market transactions, always incorporating some kind of discounting for a rate of interest, thereby accounting for the perennial "shortness" of Qd relative to Qs (Qd = Qs discounted by K).

In this more complex story, the boundaries between the "domestic" gift exchange economy and the "foreign" market exchange system are permeable. Thus the effect of a zero or negative interest rate could be to reduce supply on the market rather than increase demand.

The dual rule outlined above is stipulated in Deuteronomy 23:20: "Unto a stranger though mayest lend upon usury: but unto thy brother thou shalt not lend upon usury, that the Lord thy God may bless thee in all that thou settest thine hand to in the land whither thou goest to possess it."

[Jacques René Giguère]

PK is right that in the short run ( which can last long) the world is, in rich money-using countries, demand-constrained and scarcity is not a problem.
Forgetting that, the Austrians and others negate the very idea of recession and forget or don't care or don't even know that shadow prices can drop to zero (Hayek criticising Keynes for forgetting scarcity). They posit models without remembering first to check the behaviour of the economic agents ( the Pierre Fortin principle of "no equation without behavior".) They forget that consumers can decide not to consume for their own $% reasons. Your job is to a) integrate the fact in your model then 2) try to understand what's happening, never to "refudiate" it.
They forget why Keynes called his book "The general theory of employment, interest and money". Using money makes your economy fundamentally different in nature ( not degree) from a coconut island economy. On a coconut island you can starve to death from typhoons, tsunamis, bug infestations and invasions, never from recession. I dare say 90% of economists, even macro, don't understand the consequences of money, that is in a coconut economy production precedes saving but in a money economy saving precede production and so can stop it. Money influences demand and saving but supply not much if at all. Maybe Keynes, following "The economic consequences of the peace" and "The economics consequences of Mr. Churchill" should have titled the GT "The economic consequences of money".
Physicists and other "real" scientists, even the theoretical ones, live by experimentation. When new facts arrive, they have no mental blocks. Apart a few lucky one in behavioral economics,(and they use pigeons or students not real people) we are not accustomed to real experiments. We measure and use data but rarely generate them. Our world is made up of models. We are often ,as a profession and by training, mentally unable to accomodate facts. If it is not already in the models, it doesn't exist.
I remember an old X-Files episode. Two teenagers are captured by the grey crew of a flying saucer. Then another saucer comes in and capture the whole bunch. The next scene is in a cage with the teens and the two greys, humans themselves (CIA?) who have removed their fake alien heads. One of them looks at the real aliens and shake his head , repeating "This is not happening, this is not happening".
This is the state of the debate.

[Sandwichman]

"Using money makes your economy fundamentally different in nature (not degree) from a coconut island economy."

Perhaps. But REAL "coconut island" economies were also fundamentally different in nature from the imaginary ones conjured by economists. Real coconut island economies had money AND they had gift exchange. Barter was an anomaly that took place at the boundaries. The notion of a barter economy is an anachronistic back projection from market economies already incorporating money and debt. Has there ever been a "barter economy"?

[anon]

Sandwichman, very interesting comment. Gift economies are generally modeled as a kind of "reciprocal altruism", in which you make useful gifts to others in the community because these have pre-committed to making gifts in return.

Clearly, gift economies have some advantages in terms of transaction costs/benefits, at least within limited social groups. For instance, we exchange gifts in the holiday season because we like nice 'surprises' and as a form of social bonding. Unfortunately, our knowledge of gift economies is very limited, so we do not know how efficient they are and whether they are immune from conventional demand-side issues.

Yes, monetary issues are clearly irrelevant, since gift economy is basically barter + a vague account of "favors owed". But if money was the only issue, why not advocate complementary community scrip, which is closer to a market solution?

[Min]

Jacques Giguere: "Physicists and other "real" scientists, even the theoretical ones, live by experimentation. When new facts arrive, they have no mental blocks."

And idealization. "Science marches on, funeral by funeral."

[Nick Rowe]

Whether they exist or not. We need to imagine barter economies, for two reasons:

1. Because for some questions money might not matter, and it's simpler to understand it if we ignore money.

2. Because for some other questions money might matter. And we can understand better why money matters if we can imagine a world without money, and compare the two.

[Greg Ransom]

This is economics without scarcity, without re-coordination, and without non-permanent production processes that must constantly replaced and updated.

Are we back to secular stagnation economics?

"Quantity supplied is nearly always more than quantity demanded."

[Nick Rowe]

Greg: no. It's just what you get when you take a standard model and assume monopolistic competition instead of perfect competition.

http://worthwhile.typepad.com/worthwhile_canadian_initi/2010/11/excess-supply-under-monopolistic-competition.html

[Sandwichman]

I see nothing terribly wrong with imagining barter economies. It might well be a useful strategy for finding answers to questions where "money might not matter" (if there are any such questions).

What I'm wondering, though, is whether it is useful to also pretend that such imaginings are realistic, primitive, foundational or really all that simple. They may indeed look simple to us because we already possess the conceptual rudiments of commodity exchange. Starting from that concrete experience, we can easily repress the idea of money and debt and come up with money-less, debt-less barter. Voila! But how simple would it be to explain such a concept be to someone who had no such experience?

I don't think this is a hypothetical or academic question either. There is an extraordinary investment in the myth that Say's Law is the law of nature, which is of course elevating a special case to a first principle. Wouldn't that constitute a fallacy of composition?

[Nick Rowe]

Sandwichman: actually, when you model a barter economy really properly, they can be more complex than a monetary economy. Because they have a lot more markets than a monetary economy. So there isn't just one demand for apples. There are n-1 demands for apples (assuming n goods). What economists call a barter economy is usually really one with a centralised exchange. Where all goods exchange for all goods all at once.

[Sandwichman]

Nick, so then you're conceding my point that a barter economy only appears simpler than a monetary one? Or are you now claiming that a barter economy is BOTH simpler AND more complex than a monetary economy?

[Jacques René Giguère]

I use the coconut-only example as a counterpoint to money-using one as a teaching device.My students are in cegep, not graduate school. They don't read academic journals but newspaper op-ed by Chamber of Commerce type who clearly believe we live in a coconut-only,not a multiple markets + gifts, universe. They don't call it coconut. Usually it's "you economists haven't met a payroll but we really know." I must protect these young vulnerable souls before they succumb to the sirens of Commmon Wisdom punditry and hand them to you undamaged for their BS and PhD...
Behind the "La Presse" paywall (and you can dredge up the same sludge from your favorite ROC or U.S. business publications), I could show you letters from financial types, one even boasting that students should take more economics course so they could understand how Say's law prove there was no recession ( in fact he talked about Bastiat, showing how confused an MBA will leave you...). In business schools, they don't show you what money does, just how to steal it...
Of course there are currently no, and have not been for a long time, real (non-currency using)economies, because money is so useful. Imagining them is not for me but for explaining how the guest on the Newshour will falsely explain what's going on.
Most people still haven't understood the consequences of inventing money. And that those consequences show up only when enough people effectively use money. There were no recession in Imperial Rome or during the Middle Ages. The first one we can clearly identify is in England (1815) and the first where monetary policy was used as counter-cyclical tool was in 1825 (England again).
Same kind of people who could not understand that if you don't accept payment in kind and forbid Germany to export, they won't be able to pay reparations after WW1 ( not that they ever intended to pay but still).
Same kind who rejoice about a trade surplus one week and next week worry that capital is leaving. That "business" columnist was so-bad-it's-funny that at the annual ASDEQ (Association des Économistes Québécois) meeting we had a bunch of us holding a dinner to award him the worst column prize of the year ( he was the sole contestant, nobody could rival him. A Steven Seagal of business punditry).
Same kind who tell you (last week in Le Devoir) that an appliance manufacturer had closed its plant because the public debt is too high.
Those people are in command of the public conversation, not us. Be afraid, be very afraid.

[Greg Ransom]

There's little reason to believe that either construction describes the world -- the problems with the monopolistic competition model are as well known as those with the perfect competition model (or, should be).

Nick writes:

"It's just what you get when you take a standard model and assume monopolistic competition instead of perfect competition."

[Nathanael]

Has there ever been a "barter economy"?

Yes. Ancient Egypt had one, though they had standardized official goods exchange rates ad were pretty much a centrally planned economy (and a successful one, at that), so only the Marxist central-planning economists are likely to study that.

Mesopotamian economies had a pure barter economy prior to the Proto-Sumerian invention of tokens representing goods After that, they developed into an economy with money but lots and lots and lots of different units of money -- cow units, goat units, sheep units, etc. It took quite a long time for generic money to appear, hundreds of years.

[Nathanael]

"Most people still haven't understood the consequences of inventing money. And that those consequences show up only when enough people effectively use money."

Yep. There are an awful lot of ancient economies, even after the invention of money, in which money-shortage wasn't an issue; anyone could and did manufacture scrip or credit as needed, or revert to barter. Only with the rise in trading among people who *didn't know each other well*, and therefore didn't trust that they'd be able to get satisfaction from a witnessed promise, did money become critically important. (That was always what it was used for, deals with distant strangers, but that was a minority of trade in the ancient world.)

[RSJ]

I think the point of dispute here is the comment

"For many people with just a little economics education, the world looks just the same way as well. The Keynesian Cross model teaches the same thing. It is demand that limits output and income, not supply. The Keynesian Cross model is a very dangerous model. "

In reality the economy is almost always less than at full output. It is unable to employ everyone. There is typically large numbers of potential labor hours -- e.g. 15% or so -- that are left idle due to the failures of the free market.

If they don't teach that in grad school, it is a failure of the models taught in grad school.

It's almost always the case that government, if it were to marshall these idle resources or increase demand, would result in more output produced, not just higher prices. The rare case is the one in which additional deficit spending or external demand increases do not result in increased real output. The situation of the 1970s and early 1980s in which rate hikes driving businesses under is actually good for the economy -- that is the unusual situation, the atypical situation.

[Oliver Davey]

Printing too much money and increasing demand really did cause inflation. It really didn't make us all richer. It didn't reduce unemployment.

Yes, but did inflation make us poorer in real terms and did it worsen unemployment? And would the opposite reaction, i.e. 'printing' less money, have made things better? From observing that one particular policy did not work under one particular circumstance it does not, ever, follow, that the opposite policy would have worked better. Supply constraints or external cost pushes that limit the powers of demand management don't mean that demand should have been ignored and supply measures favoured instead. It means that both sides should have been attended to simultaneously.

Demand vs. supply is a false choice. If pushing demand leads to inflation instead of causing unemployment to go down, that is a sign that there are supply-side bottle necks that need attending, not that demand has been pushed too far.

[Nick Rowe]

RSJ: "It's almost always the case that government, if it were to marshall these idle resources or increase demand, would result in more output produced, not just higher prices."

That does not follow, unfortunately. That's what they teach you in grad school (and in undergrad). Even if there is excess supply, it does not follow that shifting the demand curve to the right will increase output and employment. It depends on how prices adjust. And that in turn may depend on whether the increase in demand was expected or not. And that in turn will depend on the whole policy regime, not just this particular instance.

It took us a long time to learn this stuff. Not that we have really learned it. But we have learned that it really isn't as simple as it looks.

[Nick Rowe]

In other words, what we learned is that the question "Will increasing demand in circumstances X have good consequences?" doesn't make any sense. Instead we have to change the question to "Will following a policy of always increasing demand in circumstances X have good consequences?"

It took us a long time to understand the difference between those two questions.

[Nick Rowe]

It's similar to the difference between taking $100 away from someone who drives at 110kms/hr, and passing a law that says you will be fined $100 if you drive at 110kms/hr. They aren't the same. They don't have the same consequences. The first is a policy action. The second is a policy regime. Drivers' behaviour responds to the policy regime.

[Nick Rowe]

It is very easy to build a model in which an action of increasing demand will always reduce unemployment. But where a policy of increasing demand will have no effect on unemployment. And it's got nothing to do with bottle-necks and stuff like that. That's what we learned between 1970 and 1980.

[Nick Rowe]

Yt=Mt-Pt where Yt is output, Mt is money supply, Pt is the price level, all at time t.

Pt=E[Mt/It-1] where E[Mt/It-1] is the expectation of Mt conditional on Information at time t-1.

Mt= m+Ut where Ut is a random variable with E[Ut/It-1]=0

The equilibrium is Yt=Ut

An increase in the money supply will always increase output. But a policy of having a higher money supply (an increase in m) will have no effect on output.

[RSJ]

I understand the points you are making, but look, prior to the Great Depression, the industrial economies, or the non-farm sector of the industrial economies, was persistently unable to employ about a fifth of the labor supply. Government was consuming a tiny sliver of output -- say 8%. After the Great Depression, government consumption of output rose to 20%, with large and persistent deficits, and the trend unemployment rate was cut by more than a half. That was a policy shift.

Now the theories have no explanation (or even acknowledgement) of either the persistent unemployment (in both booms and busts) prior to the big government regime, nor the change that occurred subsequent to that. If they have no explanation for the permanent output gap, then they can't predict the consequences of government intervention. The economy is almost never at full employment -- it's not even near full employment in the best of times. And there is no explanation for why this bottleneck would diminish when government consumes more output, even if the money supply is unchanged.

Given that the theory has so many holes, why do people believe it?

[Nick Rowe]

RSJ: You mean theories of the natural rate of unemployment? There are loads of theories.

[RSJ]

Why do you think the historically observed unemployment rates were the NAIRU rates? And why would these rates fall as a result big government -- did the introduction of minimum wage laws and unions lower NAIRU? Can the theories predict NAIRU? Are they testable?

[Rafael]

Nick,

What if supply is induced by demand (by, say, the interaction between the multiplier and the accelerator - I have sometinhg like Hicks' supermultiplier in mind)?

Hence, increases in aggregate demand would induce increases in the economy's productive capacity.

What's the mistake in this vision?

[Nick Rowe]

Rafael: I think there's some truth in that theory. (OK, yes, "vision" is a better word). But does productive capacity increase quickly enough and strongly enough to catch up with the increased demand?

I've never seen anyone work out a model which did that. (Maybe it's been done, and I didn't see it). But it would be an interesting idea to play with. Full-blown hysterisis. Multiple equilibria.

[Rafael]

I meant view!!! Sorry for my bad english! I was writing quite fast...

[Rafael]

Seriously, Hicks did something like this:

http://www.jstor.org/pss/1910587 - Toward a Dynamic Theory of the Cycle by Alvin Hansen

or you can try this link: http://homepage.newschool.edu/~het/essays/multacc/hicksacc.htm

I think this class of models generate crazy dynamics. Once you simulate them, they give you too wild output swings.

(Now I'm being provocative) There's an obscure economics school called "Sraffians", they and post-keynesians have similar views about some issues. And they write stuff like this book: http://www.amazon.com/Theory-Economic-Growth-Classical-Perspective/dp/184376010X (See Fabio Petri's chapter about demand contrained growth).

And this thesis: http://www.uni-graz.at/schumpeter.centre/download/summerschool09/Literature/Serrano/supermultiplier_dissertation.pdf

[Panayotis]

In a modern capitalist economy, the service and technology/information based industries are dominant. Services are provided on demand and technology/information based production uses forward contracts and "just in time" techniques to supply subject to demand orders. Then supply output is demand determined. Under conditions of imperfection (assymetry, heterogeneity, disintegration, dispersion)and complexity where transactions are not market mechanisms but processes, it can be shown mathematically that supply sets prices and demand sets quantities. Furthermore, prices incorporate a term that expresses the demand variance expected by suppliers adjusted by a response elasticity and calibrated by a surprise factor.