Economics

Aggregate Demand Dominance: Aggregate Supply Sycophancy

For more than a week I’ve been chewing on this statement:

I probably should have made clear in my post on sticky wages that I was arguing for stickiness as a central issue in the history of macroeconomic thought, not as a central issue in current policy. I’ve been arguing for years that when you’re in a liquidity trap wage flexibility actually hurts rather than helps; this is the paradox of flexibility, which arises, roughly speaking, because under current conditions the aggregate demand curve is upward-sloping thanks to debt and balance sheet effects.

But if we look at the way the civil war emerged in macro during the 1970s, both sides assumed downward-sloping aggregate demand (the liquidity trap was a distant memory), so the whole focus was on aggregate supply. The key issue then because whether it was acceptable to assume an upward-sloping short-run AS curve even though we had no “microfoundations” for that assumption, just observation of reality. Half the relevant profession decided that although it might be true in practice, it wasn’t true in theory, and therefore couldn’t happen.

The macro civil war led to assumptions like these:

AS – AD model

 

The LRAS is shown as perfectly vertical, reflecting economists’ beliefs that changes in aggregate demand (AD) have an only temporary change on the economy’s total output, and further that, in the long run, a change in the price level will have no impact on GDP.

Key Points

  • The aggregate supply curve illustrates the quantity of goods and services firms sell at any price level.

  • In the long run, the aggregate supply curve is vertical, whereas in the short run, the aggregate supply curve is upward sloping.

  • In the long run, an economy’s production of goods and services depends on the supplies of labor, capital, and natural resources and on the available technology to turn these factors of production into goods and services.

  • Since the price level doesn’t affect the long run components of real GDP, the long run aggregate supply curve is vertical.

  • The only thing that affects the long run supply of goods and services is the economy’s labor, capital, natural resources, and technology.

  • The aggregate supply curve is vertical only in the long run.

I see a massive flaw with this assumption, which I will reveal in just a minute.  I sort of understand why supply-side-dominated economic theory would posit (economists should always understand that theorizing and proving an effect are totally different animals) that changing aggregate demand has only a temporary effect in total output.  Krugman indicates Lucas and his followers eventually abandoned any pretense of taking consumer demand seriously:

Lucas initially argued that unexpected nominal shocks still mattered, because people couldn’t initially distinguish them from real shocks, but that this offered no room for useful policy. Later, freshwater economics rejected even that proposition; the business cycle was all about real shocks, with demand playing no role at all.

But Krugman, a definite Keynesian economist, includes the same depiction of aggregate supply in his texts:

In Econ 101 textbooks (mine included) it’s standard to present the distinction between the long run and the short run with a picture something like this:

 https://i2.wp.com/graphics8.nytimes.com/images/2013/08/02/opinion/080213krugman1/080213krugman1-blog480.png

The classic short-run/long-run picture.

Here AD is the aggregate demand curve; more on that in a second. SRAS is the short-run aggregate supply curve, which is assumed to be upward-sloping because some prices and/or wages are sticky; LRAS is the long-run aggregate supply curve, which is vertical because in the long run price stickiness is assumed to go away.

Anyone else see it?  Here’s the massive flaw: we’re supposed to believe real GDP cannot rise or fall in the long run? Looking at the above supply-and-demand model, one is left with than inescapable conclusion—real GDP must be a set value in the long-term to mathematically draw LRAS that way.  Rising aggregate demand under these assumptions cannot have an effect on increased output, only a rise in inflationary pressures.  But these assumptions are both empirically and logically false—clearly real GDP has risen precipitously during the 230 years since the end of the Revolutionary War.  Am I supposed to believe the long-run horizon is longer than two centuries?

Finite Constraints: Supply Cause and Effect

Rather than analyzing why economics made such a weird assumption about the long-run, I will try to correct the flaw.  Aggregate supply should turn vertical at a certain point—but the initial effect appears during the short-term, not the long-term.

Aggregate supply is quite obviously finite: factories and farms can produce only so much per day.  The aggregate supply curve, which mathematically must run infinitely in the positive direction, turns vertical to reflect the reality that prices rise much faster than marginal output when total output begins to abut the maximum capacity of the current economy’s infrastructure.  However, this is also clearly only an issue in the short-term, because increasing factory and farm capacity (not to mention constructing more factories and farms) is very much an option over a longer time horizon.  In sum, short-term supply becoming a set value reflects the fact that economies have capacity constraints.

It could also be argued that LRAS eventually will contend with the same finite constraints that afflict SRAS, but the effect is quite different because in the long run resource limits, not capacity limits, rule.  The effects on real GDP depend whether the infrastructure is largely regenerative (such as farmland), semi-recyclable (such as aluminum and steel production) or fully extractive (oil drilling and refining). 

Regenerative infrastructure takes the capacity constraints of SRAS to their logical conclusion—the Earth only has so much surface area.  Semi-recyclable turns to regenerative with a massive drop-off in production after the primary extractive element is exhausted (i.e.: we mine all the bauxite and iron in the Earth’s crust, leaving aluminum and steel waste as the only source available).  Fully extractive, not having a recyclable option, simply ceases when the primary extractive element is exhausted.  But resource constraints also depend on resource availability—for now resource availability is limited to what we can take from the Earth, but in the advent of much faster (not to mention cheaper) spaceflight, the resource constraints on LRAS could be significantly reduced.

This description of LRAS might sound more science fiction than actual science, but the reality that fully extractive industries go to incredible lengths to access new supplies (i.e.: Deepwater Horizon), the possibility that humanity might turn toward exploiting resources from the “Final Frontier” rather than permit real GDP to fall cannot be discounted.  At the very least, economics probably should acknowledge calculating where LRAS turns vertical is quite difficult.  For that matter, just calculating LRAS is very difficult mathematically.

How do I defend my last statement?  Simple—LRAS isn’t a curve.  The expansion and contraction of regenerative, semi-recyclable, and fully-extractive infrastructure production means LRAS is a series of data plots.  Those data plots might appear to follow some sort of sequence, but unless science proves that resource distribution is more ordered than random (a dubious prospect in my view), trying to find an equation for LRAS is probably a fool’s errand.  Beyond acknowledging resource limitations, focusing on SRAS (especially how SRAS is changing) is likely far more important.

A New Model for SRAS

 Oddly enough, the chart would look like this:

 

One important caveat: LRAS does not appear.  Aggregate supply rising almost vertically is short-run capacity constraints.  This means the key points are whittled down to just one:

  • The aggregate supply curve illustrates the quantity of goods and services firms sell at any price level.

As the price level takes on an element of preeminence in this model, the most important controlling factor becomes aggregate demand, as a change in AD immediately effects a rise in both real output and the price level.  I will explore aggregate demand in depth next.

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6 thoughts on “Aggregate Demand Dominance: Aggregate Supply Sycophancy

  1. Pingback: Aggregate Demand Dominance: Alternate Thoughts on Nominal Demand and Sticky Wages | In The Corner, Mumbling and Drooling

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  3. Pingback: Aggregate Demand Dominance: the Unknown History of Price Controls | In The Corner, Mumbling and Drooling

  4. Pingback: Aggregate Demand Dominance: False Foundations | In The Corner, Mumbling and Drooling

  5. Pingback: The Significance of Shortages | In The Corner, Mumbling and Drooling

  6. Pingback: Stagflation, 1973-1981 | In The Corner, Mumbling and Drooling

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