Russ Roberts writes
But what are aggregate demand and aggregate supply for an economy? Karl writes that aggregate demand “matches the total amount of goods and services people want to buy with the price level.” I’m not sure what he means by matches. I think he just means the relationship between goods and services and prices. But what does it mean to say that when the price level of all goods goes up, people want to buy less stuff? What’s the behavioral assumption? Is there a budget constraint? Is it meaningful to talk about aggregate demand at all, as if all the goods could be aggregated into a single good with a single price? Are people spending all their money?
And when you add in aggregate supply, that where it crosses with aggregate demand, does where they cross on the vertical axis determine the price level? That would be weird. Where’s monetary policy?
I do mean the relation(ship) between the amount of goods and services people want to buy and the price level.
There are several behavioral assumptions that are embedded in this.
First, is real money balances. The idea is that people hold money because its useful in helping them buy things. Most things are sold in exchange for money. Even things that are on credit are typically paid for on your behalf using money.
If the price level goes up then each dollar will not go as far. Thus, its useful to hold more money. One way to accumulate money is to refrain from purchasing goods and services. So, as the price level goes up people purchase less.
Second, is an interest rate effect. Another way to accumulate more money is to sell assets. As folks attempt to reduce their total holding of assets the interest rate will rise. Because of arbitrage in financial markets this will occur no matter what asset people attempt to sell, but it will probably make the most sense if we think of them as selling bonds.
As the interest rate rises investment will decrease.
Third, is an exchange rate effect. As the interest rate rises, capital will flow into the country. This will cause the value of the dollar to rise. As the dollar becomes more expensive foreigners will buy fewer American goods and Americans will shift towards buying more foreign goods. Thus net export demand will fall.
These three effects are why private demand is sometimes decomposed as C + I + NX.
Now, is there a budget constraint and is it useful to talk about Aggregate Demand as if all goods could be Aggregated?
Yes, and because of that yes.
There is a budget constraint but because we are dealing with multiple people, markets and goods its more useful to think of it as an adding up constraint. If economic agents are increasing their holdings of money then they have to be decreasing their purchases of real goods and services.
To see this you can think of money as just another good that you might receive in a transaction. If people are shifting their demand towards money then they must be shifting their demand away from some other goods and services.
So Aggregate Goods and Services is a way to talk about the set of commodities that are not money. That’s the characteristic that they all share. They aren’t money.
For the final questions:
And when you add in aggregate supply, that where it crosses with aggregate demand, does where they cross on the vertical axis determine the price level?
Where’s monetary policy?
In Aggregate Demand. That’s why the non-neutrality of money is so important to this analysis.
Now on non-neutrality. Russ says
At the end, Karl asks if I think money can be non-neutral in the short-run. Non-neutral means–can have real effects on the economy and the choices people make rather than just affecting the price level.
So, lets see how this works in our story.
The Federal Reserve prints some money which it uses to buy bonds. This affects all elements of our story.
First, in order to purchase bonds the Federal Reserve must purchase them from someone. This person gives the Federal Reserve the bond and in return receives money. What are they going to do with this money? They have three options
a) They can try to re-save the money. This in effect would be an attempt to put it back into the bond market. Even if they try to save the money elsewhere, arbitrage inside of financial markets would send the money back around to the bond market. However, the stock of government bonds is fixed so this effort is ultimately futile and indeed the interest rate on government bonds will fall in order to induce people to stop trying. This will become important later.
b) They can increase their holdings of money. However, now they are holding more money that is optimal. The marginal usefulness of money has falls as the amount of money you have increases. That leads them to do
c) Exchange money for something that is not money. That is buy more real goods and services.
Second, as we saw above any attempts by people to resave simply drive down the interest rate. However, as the interest rate goes down, the desire for businesses to invest goes up. This means that businesses will attempt to purchase goods and services.
Third, as the interest rate falls capital flows out of the country. The causes the dollar to fall. As the dollar falls American exports become cheaper and foreign imports become more expensive. This causes net exports to rise.
So, an increase in the money supply causes the components of Private Aggregate Demand, C + I + NX to rise.
That is, for any given price level people now want to purchase more goods and services.
Now, it could be the case that Aggregate Supply is simply a vertical line. In that case Aggregate Demand would increase but the only effect would be to raise the price level.
Money would then be neutral. An increase in the money supply would simply lead to an increase in the price level. Story over.
However, Russ already says that he believes that money is non-neutral. In particular, the non-neutrality I have in mind is that increases in the money supply will temporarily increase output and decrease unemployment.
What that tells us is that Aggregate Supply is not vertical at least in the short run. I am going to assume that Aggregate Supply is upward sloping. In part, because I think it is and in part because it will make the conversation easier. However, we could do this with a horizontal or downward sloping line. Just so long as its not vertical.
If Aggregate Supply is upward slopping then an increase in Aggregate Demand leads to higher output and somewhat higher prices.
If the story ended there then we could get permanently higher output just by printing more money. Unfortunately that is not the case. In the long run the Aggregate Supply curve shifts backwards as sellers adjust to the change in the price level.
[Note to other macro guys: I think one AS curve that shifts is just a simpler matter than an LRAS curve and an SRAS curve]
Now how does this Aggregate Supply curve work? What behavioral assumptions are imbedded in it? I can tell you some stories and indeed, much of business cycle theorizing is coming up with more compelling stories to explain this. However, the truth is that we believe it simply because it seems to fit the facts. And, a key fact is the non-neutrality of money.
This post is already incredibly long but I will take a stab at giving my explanation of why fiscal policy works given this framework.
So, lets imagine that the government borrows some money. It then uses that money to buy things. What happens.
Well, a couple of things.
a) The government may very well employ some resources that were idle. If this happens that’s great. However, its not really necessary for this story.
b) The government will employ some resources previously employed by others. Now people are not buying those goods and services because the government step in and bought them out from underneath them. So, those people have more money. What are they going to do with it?
They could try to save it, but we’ll explain in a second why they are going to run into exactly the same problem they did above. They could just hold more money but then they are going to have more than the optimal amount of money. Or they could buy something that is not money. That is, they could increase their demand for some other goods and services.
But, what if those are employed,you ask? Well, if they are then your run into the same cycle. Someone else now winds up with more money – because their goods and services were bought out from underneath them – and has to decide what to do with it.
This has to keep happening over and over until the money finds its way to some set of goods and services that weren’t being bought buy someone.
Now we can simplify all of this by noting that Aggregate Demand simply means things that are not money. So, as the government injects money into the economy, economic agents will try to shift their holdings to things that are not money. That is, Aggregate Demand will rise.
So, just dealing with the (a) and (b) part of the story we have the money finding its way to some unemployed part of the economy. However, we still have to deal with where the money came from. So,
c) To raise the money the government must sell bonds. As the government sells bonds the interest rate will tend to rise. At this point the Federal Reserve must step in and buy enough government bonds to send the interest rate back down again.
If the Federal Reserve does not do this then the rising interest rate will reduce investment and will cause net exports to fall. This will pull Aggregate Demand backwards.
So, the success of this entire enterprise depends on the Fed accommodating the government’s increased borrowing.
Indeed, all that is happening is that the government’s fiscal policy is a means through which the Fed can expand the money supply and inject that money into the economy.
OK, but I anticipate a few immediate questions
1) If this is all about the Fed why bother with increasing government spending? Why not just have the Fed increase the money supply and be done with it?
This method only makes sense when the normal methods used by the Fed have been exhausted and even then there is debate about whether this is the best auxiliary tool. In practice, that means fiscal stimulus only makes since when the Fed has reached the Zero Lower Bound.
2) Couldn’t the government just give people the money rather than buying stuff?
There is an issue about whether the hording of money gets to be a problem. To the extent that it is then you have to deal with that issue in a number of ways. One of those ways is by focusing more heavily on the government directly purchasing or encouraging the purchase of idle resources.
There is clearly much more to say, but I think this has gone on long enough for now, and I will stop here.