Tuesday, 17 February 2009

"In the real world...": aggregate demand versus price

"(In the real world things are more complicated, but never mind.)"
The rallying cry of economists through all history. This time it comes from Paul Krugman (the paper is a few months old but he points to it in today's column), but I don't mean to pick him out unfairly. It's just a less formal way of saying "we need to simplify our models otherwise we don't know how to work with them". Sometimes, though, it would be useful to be explicit about how far from the real world we believe our models are.

I just want to take up one point in the paper. Paul assumes that, under normal circumstances the AD (aggregate demand) curve slopes down and the AS (aggregate supply) curve slopes up. His point is that in a liquidity trap (like now and in the 1930s) the AD curve may not slope downwards after all, so standard results about the equilibrium point are not applicable.

Fair enough. But I would question whether the AD and AS curves behave as described even in normal times.

It may be another example of the one-versus-all fallacy. The demand curve for a single product will of course slope downwards (with rare exceptions such as Giffen goods). But this is because, for a given amount of income, we can choose between buying one good and another. Thus, the price of a product in the standard demand graph is the price relative to other products.

In the case of the aggregate demand curve, total demand is meant to be based on an average price level, but a price relative to what? If this describes total demand in the whole economy, what is the substitute good that we are supposed to buy instead?

One might say that demand for goods is a substitute for wealth - i.e. that the average price level is taken relative to the balance in our bank accounts. But I question whether this is really a substantial effect. While a hypothetical rational agent would annuitize their wealth at a certain rate and spend from it, the real-life phenomenon of mental accounting indicates that we spend mainly out of income, with little effect from total wealth. And income, according to our favourite accounting identity, is the same as aggregate demand.

If this is true, then the AD curve would be vertical all the time, not just in a liquidity trap. The effect of wealth, while small, is non-zero and so the curve may veer slightly off the vertical. But as Professor Krugman says, "never mind".

Intuitively, this does make sense. Price is, after all, just a number. It is there to arbitrate the relative value of things and not their absolute value. There can be no meaningful price for "all the output of the world economy" because if I wanted to buy everything, what could I trade you for it?

By analogous reasoning the aggregate supply curve is near-vertical too. And thus, on this theory, the total levels of production in the economy are not determined by price at all - not only in a recession but at all times.

So what does determine total production? In the short run, I believe real-time dynamic factors dominate - including the momentum of existing production and agreements, changes in prices (not absolute levels) or expectations of such changes, and people's perceptions of their need for goods relative to the immediate past or future. In the long run, it should be determined by trade-offs between absolute quantities: chiefly, I suspect, the relative preference for leisure versus goods.

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