What happened in 2008? Why didn't the cut in interest rates prevent Aggregate Demand from falling? Was it just that the cut in interest rates wasn't big enough? Or is the rate of interest the wrong thing to look at? Because it's only a relative price, and relative prices only matter for relative demand?
Suppose we had a monetary economy that produced apples and bananas. Let (Pa/Pb) be the relative price of apples in terms of bananas. Would we draw an AD curve with (Pa/Pb) on the vertical axis? Would we say that a cut in (Pa/Pb) would cure a deficiency in AD? Of course we wouldn't say that.
Suppose we had a monetary economy that produced goods this year and goods next year. Let
(1+r) be the relative price of goods this year in terms of goods next year. Would we
draw an AD curve with (1+r) on the vertical axis? Would we say that a
cut in (1+r) would cure a deficiency in AD? Of course we wouldn't say that. Hmmm. That's exactly what many of us do say.
What's the difference?
Say's Law is false in a monetary exchange economy. In a monetary economy that produces only apples and bananas, it is perfectly possible to have an excess supply of both apples and bananas. In a monetary economy that produces only goods this year and goods next year, it is perfectly possible to have an excess supply of both goods this year and goods next year. Because there's an excess demand for money, the medium of exchange. And if that's the problem, a cut in a relative price like (Pa/Pb), or a cut in a relative price like (1+r), is not the cure.
There is no difference.
Suppose we had a model that just assumed, without explaining why, that the market for bananas always cleared, so there was never any excess supply or demand for bananas. In that case we might put (Pa/Pb) on the vertical axis of the AD curve. But that would be a very strange macro model of a monetary economy. It's a micro, partial equilibrium model, of the market for apples.
Suppose we had a model that just assumed, without explaining
why, that the market for goods next year always cleared, so there was never any
excess supply or demand for goods next year. In that case we might put (1+r)
on the vertical axis of the AD curve. But that would be a very strange macro
model of a monetary economy. It's a micro, partial equilibrium model, of the market for goods this year.
Hmmm. That's the standard New Keynesian model. It just assumes, without explaining why, that the future output gap approaches zero. The standard New Keynesian model is a very strange macro model of a monetary economy. It's a micro, partial equilibrium model.
Be that as it may: if the market for bananas did in fact always clear, a micro partial equilibrium model which just assumed it always cleared, without explaining why, might work quite well in practice. And if the market for goods next year did in fact always clear, a micro partial equilibrium model which just assumed
it always cleared, without explaining why, might work quite well in
practice.
Micro, partial equilibrium models of the market for apples, or the market for goods this year, usually work quite well in practice.
Until one year, when the market for bananas does not in fact clear, and the model fails. Then we need a truly macro model of a monetary economy. Because a cut in (Pa/Pb) might simply reduce the demand for bananas, rather than increasing the demand for apples? We need a truly macro model to answer that question.
Until one year, when the market for goods next year does not in fact clear, and the model fails. Then we need a truly macro model of a monetary economy. Because a cut in (1+r) might simply reduce the demand for goods next year, rather than increasing the demand for goods this year? We need a truly macro model to answer that question.
I've talked about only two goods, apples and bananas, but there might be many goods.
I've talked about only two years, this year and next year, but there might be many years.
If people always do in fact expect "full employment" (zero output gap) in the near future, the New Keynesian model might work quite well in practice, even though it is a partial equilibrium model and not a truly macro model of a monetary economy. A cut in real interest rates will cure an excess supply of goods this year.
But if people do not expect a return to full employment in the near future, and fear a continuing recession, the New Keynesian model might fail. A cut in real interest rates might not cure an excess supply of goods. Interest rates are the wrong thing to look at. Interest rates are a relative price that only affect relative demand, not Aggregate Demand for goods this year and goods next year.
Worthwhile Canadian Initiative 
Brian: yes, this does assume away the inventory cycle, for simplicity. You can think of all goods as being services like haircuts, or all goods being produced to order.
But this is not, in a NK model, a market-clearing assumption. (It is a market clearing assumption in RBC models). In a NK model, what C=Y means is that haircuts produced/bought/sold equals haircuts demanded. It says nothing about the supply of haircuts (“supply” means the quantity firms want to sell).
In the NK model, firms are monopolistically competitive, and set a price to maximise profits, and produce and sell as much as buyers want to buy at that price. But they cannot always adjust price in response to changes in demand (by assumption).
this old post, and this old post may help you make sense of this.
Gene: I confess I find it hard to follow MF’s argument at times, and have given up. You may be right. I thought he was saying that prices are perfectly flexible, so that if M changed P would have to change immediately too. Which is at least logical, but then whether all markets can be in excess supply at the same time becomes rather a redundant question, because all markets would always clear.
“I confess I find it hard to follow MF’s argument at times, and have given up.”
Same with me and Heidegger.
In response to Nick Rowe,
Thanks for your response. I will try to digest the articles and compare to the basic models in the text by Gali. As an outsider to the literature, it does not appear elegant that the firms use marginal logic to detrmine their options, while the representative household looks at the global solution to determine the optimising solution.
Brian: “As an outsider to the literature, it does not appear elegant that the firms use marginal logic to detrmine their options, while the representative household looks at the global solution to determine the optimising solution.”
? Individual firms set prices to maximise present value of profits profits taking all things into account; individual households choose consumption to maximise present value of utility taking all things into account.Both firms and households use marginal logic to solve their problems.
I will have to write out in full what is confusing me (with actual equations and stuff like that). Since it probably would take quite a bit of space to explain my thinking properly, I will probably stick the full version of my question on my blog (I need content…).
But to summarise what is puzzling me – the “no-ponzi” condition (as well as other constraints?) puts a global constraint on the solution, and so the maximisation needs to take into account those constraints, for both the firm and household. It may be that the constraints are embedded in the functions you are taking derivatives of, but if that is true, I missed how that was done.
The constraints should not matter for a linearised system, but you need to calculate the solution before you linearise. My copy of Gali is somewhere in a box (renovating my basement), so I will not be able to look at this for at least a few days.
It may be that your posts will have clarified my thinking; I will let you know after I look at the system equations again. Once again, thanks for the response.
Brian: “But to summarise what is puzzling me – the “no-ponzi” condition (as well as other constraints?) puts a global constraint on the solution, and so the maximisation needs to take into account those constraints, for both the firm and household.”
BINGO! (I think)
That (in slightly different words) is what I have been complaining about, when I complain that NK models “just assume” the people in the model expect the economy approaches zero output gap/full employment in the limit as time goes to infinity. If every other individual has this expectation, then my satisfying my “no ponzi” condition means that my planned consumption path satisfies this condition too. But if we all violate this condition together, then no individual violates his own no ponzi condition. It’s like a collectivist version of the no-ponzi condition: “let’s all agree to choose a consumption path that doesn’t cause the economy to explode or implode, OK?”.
I don’t think this has anything to do with linearity.
Nick: “? Individual firms set prices to maximise present value of profits profits taking all things into account; individual households choose consumption to maximise present value of utility taking all things into account.Both firms and households use marginal logic to solve their problems.”
My parents were in business. 20 years later I was. We had no idea of our marginal costs, my parents didn’t even knew the concept. We guessed about the future and groped the present. The lucky ones in the industrial park survived,helped by somewhat better management. (That company was sold and no longer exist…)
As said in yesterday’s NYT “…statistician George E. P. Box: “All models are wrong, but some are useful.”
We get to the result of marginal thinking because it is efficient and only the efficient survives. But we don’t think like that. That’s why we have to teach it. We don’t teach people to breathe.
Hey nick,
Can we get some further discussion on http://johnhcochrane.blogspot.com/2013/09/the-new-keynesian-liquidity-trap.html?m=1
?
Jon: done!
You say Say’s Law is false in a monetary economy. Why? I’m not buying your argument today, and it’s not because I want to hold onto the money.
Tom, your refusal to buy Nick’s argument in no way implies a willingness to buy another, newly-produced.
Kevin: yep, because he might wish to hold more money instead.
Take a simple example. Two goods, apples and bananas.
In a barter economy, where people swap apples for bananas, if I am offering apples for sale I am by definition trying to buy bananas in exchange. So if there are people who are trying to sell apples but can’t find buyers for their apples those same people must be trying to to buy bananas but can’t find sellers. An excess supply of apples means an excess demand for bananas.
Now add a third good, money, and assume monetary exchange, so in the apple market people buy and sell apples for money, and in the banana market people buy and sell bananas for money. It is perfectly possible for people to be trying to sell apples and unable to find buyers and also trying to sell bananas and unable to find buyers. Because everyone is trying to “buy” more money.
Much more involved explanation here.
Mr. Rowe:
Say’s Law, properly understood, says production creates the producer’s capacity to demand (purchasing power) if, and to the extent, revenue (in goods or money) from production exceeds the costs of production. The efficient use of resources (input costs < output revenue) increases purchasing power and makes possible economic growth. The inefficient use of resources (input costs exceed revenues) reduces purchasing power and causes economic contraction. To the extent money makes the exchange or use of resources more efficient, money contributes to growth.
But money (as used in your example) does not subtract from aggregate demand for apples or bananas as “the structure of an economic model that . . . include[s] the interrelated balance sheets and income statements of the units of the economy” would show. The quote is from Minsky. The idea traces back at least to Fisher. And my little observation is that the inefficient use of use of resources, not the existence money, extinguishes demand. Money, in your example, just saves demand for a later day.
As a thought experiment, put labor costs in your apple-banana-money economy, give everyone a balance sheet, make the correct quadruple entries (double entry for buyer and seller or borrower or lender), and then see what happens to net worth on the actor’s balance sheets from one cycle to the next when spending = income (revenue) but costs exceed revenue. If you want to introduce money in the model, include lenders, have the lenders make loans to produce or and consumers of goods, schedule debt payments to make sure you follow effect on purchasing power in subsequent accounting periods, postulate defaults along the way, and remember capital is never income. Before you add the complication that low interest rates (relative to what is a really good question) raise the price of stocks (capital assets) but do not increase the income flows from those stocks, the outlines of the financial crisis become vaguely comprehensible and the paradox of thrift reveals itself as the fallacy it is.
Spending may equal income, but a given volume of spending or revenue is not necessarily equal in balance sheet or economic effects. PK says he can save the economy by spending today to raise aggregate demand today. At the start of the day, PK has a net worth equal to $10 and 2 shovels. He pays one man $5 to dig a hole in the morning and another $5 to fill it up in the afternoon. At the end of the day, PK has no money to use to demand anything else, he has nothing to sell, he has what’s left of 2 worn out shovels. But on the positive side, he does have a GDP report that says, since spending = income, measured GDP went up $10. Thus, to raise today’s measured GDP by $10, PK wasted the labor of 2 men for the day, lowered his own net worth by $10 and 2 shovels in exchange for nothing he could sell or use, transferred his $10 to the ditch diggers (the gift theory of growth), and lowered society’s aggregate net worth by 2 shovels. Potential purchasing power actually went down. PK transferred his $10 to the ditch diggers. The ditch diggers have $10 to spend instead of PK. But purchasing power and output potential both fell because PK didn’t earn enough from the ditch digging exercise to employ the ditch diggers tomorrow for something productive or to replace the worn out shovels. Because the shovels got worn out, PK can’t use them or sell them. And because PK lost all his money digging and filling a worthless hole he has no shovels to use or sell or money to spend, save, or invest in something else today, tomorrow, or the next day.
Curmudgeon: I would put it this way: in a barter economy, or if there were no excess demand for money, Say’s Law would work just fine. If we produce $1 trillion worth of goods a year, we can afford to buy that same $1 trillion worth of goods a year. But if the quantity of money is too low, relative to the velocity of circulation, and relative to the money prices of goods, those goods won’t get sold.
Don’t ditch diggers spend at all? A man’s got to eat.
Kevin: it makes more sense to just give the ditch diggers the money, and tell them to forget about the ditches. Worst case scenario: they dig their gardens instead, or lift weights, whatever, unless they really like digging ditches.
Nick, I agree. Atrios has been pushing that line for some time, and Benassy models fiscal policy as simple cash transfers. I don’t know why that isn’t the standard approach. It bypasses all the usual guff about broken-window fallacies and suchlike.
Kevin,
I think Curmudgeon raises an important point in his last paragraph although I would not put it in those dire terms. You just need to realize that all monetary assets equal all monetary liabilities to understand there cannot be any net monetary savings in a society. All monetary surpluses/savings equal all monetary deficits/debts. All balance sheets must add up to zero. Hence, what is then the net worth of our society? It is the non-monetary assets we have acquired over time using the money we created. Those assets can be material (e. g. houses, cars, tools) or immaterial (e. g. health, education) but they constitute the real wealth of our society.
Thus, when we talk about purchasing decisions we should not discuss how much debt that requires or think about how much money someone can save at the end (saving meaning having surplus later) but what is the non-monetary asset that we will acquire using that money? Will it really add to the net worth of our society? Now you can easily see why digging holes and filling them again is a pointless endeavor but digging a hole and planting a tree will actually increase our net worth. Money then becomes a tool for proper resource allocation. Given a fixed amount of money the less you can spend to create a new asset the more assets you can create overall. The less non-renewable resources you use per item the more assets you can create now and in the future. The more durable the asset is you create the more you increase the net worth over time.
This thinking seems to be completely absent in our policy leaders as you can see in the current discussions about the debt ceiling although it is an accounting triviality.
Nick, I respectfully disagree. The essential point is that if A produces $1 trillion in goods this cycle and B buys them for $1 trillion, but it costs A $1.1 trillion to make the goods, A’s net worth at the end of the first cycle declines, and A’s purchasing power, including A’s capacity to buy inputs for the next production cycle, declines. Demand destruction occurs on the producer side even if B still has $1 trillion to spend. Under this condition, spending = income at $1 trillion in the first cycle portends a lower equilibrium for spending = income (revenue) in the next cycle, even if B’s income and purchasing power remain the same. Raising B’s spending may raise A’s gross income in the current cycle, but if B’s spending “buys” A’s revenue below the cost of production, aggregate demand for the next cycle declines to the extent of the difference.
Now, back to money. We agree, I think, that if there is an insufficient quantity of money to facilitate desired exchanges, the efficient use of resources suffers. But I think this is a different problem than the one you identify as the basis for the invalidation of Say’s Law in a money economy. The decision to hold money, rather than spend it, is a decision to spend now or to spend later, not a decision never to spend. A man with $2 dollars in his pocket can buy as many apples or bananas today or tomorrow as the apple or banana seller will sell for $2, whether the man holding the money spends $1 today and $1 tomorrow, $2 today, or $2 tomorrow. The decision to hold today and spend tomorrow divides the same potential contribution to aggregate demand over 2 days instead of one, but it does not reduce the holder’s potential contribution to aggregate demand or actual contribution over the relevant period. The decision to hold money today is not a decision to hold it forever. The money held remains on the holder’s balance sheet, and the holder can spend it as soon as she decides the utility of purchasing something today exceeds the value of having the $1 available to purchase anything today or tomorrow. Aggregate demand remains the same over the 2 day period. $2 + 0 = $2; $1 +$1 = $2; and $0 +2 = $2. I think the real difference between us is that my apple-banana economy has a calendar and, at least implicitly, yours does not, and I assume money held is eventually spent, and you do not.