Thursday, February 9, 2017

On the AS/AD model and the micro/macro relation

I promised to discuss Nick Rowe's claim that one must start with Aggregate Demand and Supply (AS/AD) to explain macroeconomics. Nick's argument is that the AS/AD model is useful to analyze monetary economies, and he quite correctly points out that money must be part of the discussion from the start. In his words:
And if you don't start with money, monetary exchange, and AD and AS, you are doing macro wrong. Because the only thing that makes macro different from micro general equilibrium theory is the fact that macro incorporates the fact of monetary exchange, which microeconomists ignore.
While I tend to agree that macro should deal directly with monetary economies, it's far from clear that the only difference between macro and General Equilibrium (GE) micro is the existence of money. But before I get to that a few things about the AS/AD model in general and Nick's suggestions.

Sure money matters, but it's worth remembering that the basic macro principle, the idea of effective demand and the multiplier can be described without directly discussing money. Sure, Keynes noted that effective demand works in a monetary economy of production, and suggested that it was similar to Marx's capitalism (M-C-M') in the drafts of the General Theory (GT). But that was just to note that that the process of production is not about consumption, but about accumulation, something relevant for debunking Say's Law.

But the idea that investment (in this case as a proxy for autonomous spending) determines savings, and the adjustment process results from increases in income, does not require a previous discussion of money. So much so that Keynes himself suggests that he only came up with the theory of liquidity preference, and the monetary rate of interest, after the development of the multiplier (and his version the psychological law, and the propensity to consume below one; Kalecki does it by the share of income going to wages below one, and with workers consuming all their income).

So why is AS/AD important in my view, you may ask. I actually start with the Quantity Theory of Money to provide an AD curve (as suggested by Nick; but he prefers to make M endogenous as in a Wicksellian model), and a simple production function and labor market story for a vertical AS at the natural level of output to describe the neoclassical model. Exactly to show that in this case output is supply constrained and money does not matter. And that would contrast with the Keynesian view of a demand determined level of income and employment, and a world in which money matters.*

The worst part of using the AS/AD framework is that most students will mechanically believe in something along those lines, and in particular the notion that the two curves are independent. And even though by the end of the course I try to emphasize that the AS (potential output) can be moved by changes in the AD, along the lines of the Kaldor-Verdoorn, it is harder once they have been using both curves independently.

That leaves the issue of the micro/macro relations and Nick's notion that money, which he sees as a medium of exchange in typical neoclassical fashion rather than as a unit of account that represents the power of the State, is the main difference with micro. In my course, the first thing I discuss is the different views of what macroeconomics is, simply the aggregation of individual rational behavior, or as in Keynes' notion of the fallacy of composition something beyond simple aggregation. One example I use is Keynes' notion of financial markets as a beauty contest, that is, the idea that agents in financial markets are concerned with the average view of where the markets should be. So the behavior of one agent affects the behavior of others.

But the main problem with the notion of conventional neoclassical micro is more complicated than the lack of interdependence of preferences, or the lack of money for that matter, but the very core notion of the principle of substitution. I only discuss this in my course, briefly when I have to deal with investment behavior and Keynes' acceptance of the marginal efficiency of capital. And yes, that requires some understanding of the capital debates.

* I should add that I make the distinction that you could have short run effects of money in the simple neoclassical story, but not in the long run, in which cycles are dominated by technological shocks (phlogiston as Romer would aptly call them). In my view, in the long run the main effect of money would be on the level of the normal rate of interest, and it's impact on income distribution and the dynamics of debt. But those are discussed only cursorily in the undergraduate course.


  1. Nice post.

    I'd agree that you don't need to discuss money to talk about effective demand and the multiplier. But I think it's hard to give anything other than a trivial explanation without looking at the relevance of monetary exchange.

    A position of insufficient effective demand implies that there are further exchanges that could in theory take place which would make all parties better off. Workers would like to work more and consume more; firms would like to employ more and sell more.

    If all exchanges can take place including barter, there's no real explanation as to why they don't take place. Sure workers might prefer to save some of their additional earnings as financial assets, but if the only deal on the table is being paid in goods today, they'll take that deal. (If they would rather not take that deal, then it's not really an effective demand problem).

    So you really need to invoke the much more restrictive set of transactions which you have under monetary exchange to explain why these exchanges do not take place. Where all exchange is monetary, it may not be possible to achieve those optimal end results through a series of bilateral exchanges each of which is acceptable to both parties.

    In my opinion consideration of monetary exchange is very different from consideration of money and I think that Nick too readily conflates the two.

  2. Thanks Matias!

    "Sure money matters, but it's worth remembering that the basic macro principle, the idea of effective demand and the multiplier can be described without directly discussing money."

    That's where we disagree. The Keynesian multiplier (we can quibble with the details) is an important insight in macro. But in my view monetary exchange is essential to understanding the multiplier. In a barter economy (or an economy with a centralised Walrasian market) the unemployed worker is ipso facto demanding goods by offering labour. Supply *is* demand. But in a monetary exchange economy he is demanding money, and will not demand goods unless he actually gets that money, which he doesn't get.

    Actually, I think it is production and employment that are not essential to understanding the multiplier. We can have the multiplier and principle of effective demand in a pure endowment-exchange economy too, provided exchange is monetary exchange. In fact, I derive the Keynesian Cross upward-sloping AE curve in just such an economy in this old post:

    1. Hi Nick. Thanks for your reply, and sorry for my delay. As I said, I guess cryptically in the post, Keynes was aware that you need to be in a monetary economy to assume effective demand. Meaning it's not a barter economy in which you want to exchange commodities (C-M-C') in which presumably if you supply a commodity is because you want to demand one. So he was talking of a monetary economy of production (M-C-M') in which money, accumulation, is the object of desire. My point is that you do not need any explicit discussion of what is money at this stage, and in fact, Keynes opted to do so and describe the multiplier before he discussed liquidity preference.

      Not sure of what you mean to have a multiplier without production and employment though. Will read your post.

  3. Unless I missed it, you overlook the TOTALLY DIFFERENT effect of two types of money: base money / high powered money and in contrast, private bank created money.

    The former (as pointed out by MMTers) is a NET ASSET for the private sector. Ergo increasing the stock of that kind of money boosts spending. In contrast, privately created money is the RESULT OF a desire to do business, to borrow, etc. It therefor of itself has no effect.

    1. I avoid the discussion of base money and broader measures of money at this stage. And sure base money is an sense exogenous, but that does not preclude the exogeneity of the interest rate and endogenous money.


Inequality and Stagnation by Policy Design

By Thomas Palley (guest blogger) This paper argues the mainstream economics profession is threatened by theories of the financial crisis a...