A while back Scott Sumner said

A few weeks ago there was some discussion about the prospects of a double dip.  I try to stay out of the fortune-telling business, as I don’t believe I or anyone else can predict the cycle better than markets.  But one line of reasoning that I found less than convincing was the argument that monthly car sales and monthly housing sales are already quite low.  And other parts of GDP aren’t that cyclical.  We know from the 1930s that things can get a lot worse.  If NGDP falls sharply, RGDP will also fall sharply.

But it’s only fair to point out that a month or two later those making the optimistic case (for avoiding the double dip) seem vindicated (knock on wood.)  If so, I’d point to another factor—monetary policy.

This deserves a more thorough reply than I am going to give it, but since I was one of/the one who pushed this line of reasons I thought I should say something.

So, I think looking at important aggregates and basic models gives us strong intuition into how the economy should be have. How, the results of these models have to manifest themselves in actual markets and the choices of actual consumers, producers, etc.

So what does it mean when we say the public possess excess money balances?

In part, we mean that for some families the extra sense of security they have from having a larger buffer in their checking account is not worth quite as much as having an additional car in the driveway. We should expect more families to feel this way as the vehicle fleet ages and their cars become less reliable and quite frankly as more and more just crap out.

When this happens families are much less likely to be selling an existing used cars and more likely to look for an additional used car. We should see the price of used cars rise.

This in turn means that a potential new car purchaser gets more for her trade-in. That buyer has also been driving her car for a while and is really ready for a trade. She can get good financing (as a result of excess cash balances elsewhere) and the net cost of the car is less than it would have been. So she buys a car.

A similar phenomenon happens with young adults and their parents. They might move back when money is tight (and they need a higher real balance) but things have improved a bit. They have more cash in the checking account. Maybe its time they got their own place. Not a new home of course but a rental. So we see rents rise.

When we write this on the black board we say a couple of things

We say the marginal product of capital is rising because the capital-to-labor ratio is falling due to deprecation (craped out 97 Mazda) and spreading over a larger N (kids back in with their parents).  At the same time as real money balances rise (that checking account buffer) the marginal utility of cash is falling (I think I can afford to strike out on my own now).

As a result Aggregate Demand rises (lets trade in this old car; I think I’ll get my own place.) This slides out along Aggregate Supply, increasing output (sales were strong this month lets re-up our order; vacancies are declining rapidly we may want to consider breaking ground on that Lake Front project we had on hold.)

So along with every move in NGDP, RDGP, expected inflation, etc, there is a human story. We can look at the world sometimes and see whether or not that human story is unfolding.

How old is the vehicle stock? What’s happening to used car prices? What’s the household to population ratio? What happening to vacancy rates.

From this we can see the actual process of monetary policy working and we can predict near term effects that we might not be able to see if we just thought about the Aggregate Curves.

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