Home > Uncategorized > LInks for today (AS-AD-Heterogenous aggregate demand and supply edition)

LInks for today (AS-AD-Heterogenous aggregate demand and supply edition)

Toady, Paul Krugman has a blogpost about Aggregate Demand (AD, business investments, household consumption, government expenditure, net exports) and Aggregate Supply (AS, investments goods including new houses, household consumption goods and services, government consumption and investment goods and services, export goods and services). He states among other things:

Second — and this plays a surprisingly big role in my own pedagogical thinking — we do want, somewhere along the way, to get across the notion of the self-correcting economy, the notion that in the long run, we may all be dead, but that we also have a tendency to return to full employment via price flexibility. Or to put it differently, you do want somehow to make clear the notion (which even fairly Keynesian guys like me share) that money is neutral in the long run.

I.e: prices change in such a way (given an ultra smart central banker and apt central bank policies) that demand is just right to employ everybody. But are economies indeed like that? Do changing prices in combination with a central bank which controls the amount of money lead to an optimal equilibrium? 

I can fortunately outsource comments to J.W. Mason who wrote some months ago about the same problem (go to this post for links to the economists mentioned):

Making monetary policy the sole mechanism by which the economy converges to full employment (or the NAIRU) implicitly concedes that on its own, the capitalist economy is fundamentally unstable. …

As Leijonhufvud notes, it’s a weird irony that sticky wages and/or prices are held to be the condition of effective demand failures, when the biggest demand failure of them all, the Depression, saw the sharpest falls in both wages and prices on record. … As Harrod noted, there are two relations between investment and output: investment influences output as a source of demand in the short run, and in the longer run higher output induces investment in order to maintain a stable capital-output ratio. More investment boosts growth, for the first channel, the multiplier; growth induces investment, through the second, the accelerator. With appropriate assumptions you can figure out what combinations of growth and investment satisfy both conditions. Harrod called the corresponding growth paths the “warranted” rate of growth. The problem is, as Harrod discovered, these combinations are dynamically unstable:– if growth strays just a bit above the warranted level, it will accelerate without limit; if falls a little below the warranted rate, it will keep falling til output is zero. …

Fazzari et al.’s answer to the puzzle, which I personally find persuasive, is that demand dynamics really are that unstable — that taken on their own the positive feedbacks between income, expenditure and investment would cause output to spiral toward infinity or fall to zero. The reasons this doesn’t happen is because of the ceiling imposed by supply constraints and the floor set by autonomous expenditure (government spending, long-term investment, exports, etc.). But in general, the level of output is set by expenditure, and there is no reason to expect desired expenditure to converge to exactly full utilization of the economy’s resources. When rising demand hits supply constraints, it can’t settle at full employment, since in general full employment is only reached on the (unfulfillable) expectation of more-than-full employment.

The formal model here is not new. What’s more unusual is Fazzari et al.’s suggestion that this really is how capitalist economies behave. The great majority of the time, output is governed only by aggregate demand, and demand is either accelerating or decelerating. Only the existence of expenditure not linked to market income prevents output from falling to zero in recessions; supply constraints — the productive capacity of the economy — matters only occasionally, at the peaks of businesses cycles.

I do want to make the situation a little more complex, however. Increasing borrowing can accelerate the increase of demand. And aggregate demand is simply al monetary expenditure on ‘final’ goods’ in a period and it’s financed by income in a period plus (net) borrowing minus the amount of income and borrowing spent on financial assets (including existing houses, antiquities and the like). However – aggregate demand itself is a non-homogenous concept: the pattern of spending changes al the time.  Not all sectors have the same value added/employment ratio as Eurostat calculates (graph 1): when spending on pharmaceutical goods increases employment increases less than when spending on furniture increases.

Graph 1. Employment and value added per industrial sector, European Union, 2011. Source: Eurostat (the graph is from Eurostat, I’ve tried to make it more smartphone proof).


This is not just theoretical: in the UK, service production is up, manufacturing production is down and employment, which should be declining because of increases in sectoral productivity, is about level. Which might be caused by a higher employment/value added coefficient of services (graph 2, total of course also includes agriculture and the like). Waitresses, teachers and nurses instead of engineers, the high productivity sectors are crowded out by low productivity sectors.

Graph 2. Indices of real value added in services, manufacturing and the entire economy, UK.



All these aspects (growth which itself inducesfires more growth or at least more expenditure, investments which shift the AS curve in an unpredictable way, credit as well as the shifting pattern of expenditure in combination with sectoral differences in the employment/value added ratio) wreak havoc with the idea of a simple real interest -level of spending ratio. And Keynesian policies aimed at promoting expenditure should clearly aim to foster labor intensive activities, for instance by lowering VAT on labor – which might be financed by a tax on oil.

  1. paul davidson
    June 3, 2013 at 1:52 am

    All this quote fromKrugman proves is that Krugman never read Keynes.

    In 1935 Keynes wrote an article entitled “A Monetary Theory of Production” [reproduced in volume 13 of THE COLLECTED WRITINGS OF JOHN MAYNARD KEYNES — in which Keynes stated: “An economy which uses money but uses it merely as a neutral loink …might be called — for lack of a better name– an exchange economy. The theory that I desiderate would deal, in contradistinction to this, with an economy in which money plays as part on its own and affects motives and decisions and is, in short, one of the operative factors in the situation, so that the course o events cannot be predicted either in the long period or the short period, without the knowledge of the behavior of money between the first state and the last……Booms and depressions are peculiar to an economy in which …money is not neutral. That is the task on which I am now occupying myself in some confidence that I am not wasting my time”.

    In other words the theory that Keynes was developing in 1935 was one where money was never neutral but did affect the level of out[put and employment.

    Krugman, unfortunately, learned this foolish long run nonsense from Paul Samuelson who insisted that Keynes was merely a general equilibrium theory where wages and prices were sticky in the short -run.

    As I point out in my book THE KEYNES SOLUTION:THE PATH TO GLOBSL ECONOMIC PROSPERITY and in my text book POST KEYNESIAN MACROECONOMIC THEORY — Samuelson in his own quoted words stated he found the General Theory “unpalatable” and therefore merely assumed it was a Walrasian system with sticky wages and prices. [ So much for the so called father of American Keynesians from MIT.]

  2. June 3, 2013 at 5:48 am

    I am developing a new model for AS-AD but it is based on Effective demand, which was one of Keynes’ primary concepts. I actually posted a preliminary explanation of the model today. It has the self-correcting dynamics that Krugman calls for. It is actually interesting timing that this discussion came out as I was publishing the model. Here are two links to the model….



  3. Allen
    June 4, 2013 at 12:01 am

    Like most economists, including those in the heterodox community, Krugman is a deluded growth fan. Ecological imperatives demand cessation and reversal of growth. Just one example: US EROI for oil and gas dropped from >100 in 1930 to 11-18 in 2005. Even in the present recession current levels of economic activity are beyond Earth’s capacity to sustain. When the global economy is in a sustainable steady state, the issue of unemployment will have disappeared because there will be a high aged dependency ratio resulting in large numbers employed in caring for the elderly. This assumes that life expectancy remains high. Economists are wasting their time developing improved growth models. They should be working on models for economic shrinkage which maintains or improves well being. This will probably involve increasing mean real per capita income. Among essential tools for such models are replacement of our current debt-money with interest-free money created by the state, and reduction in population.

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