Reviving the Knife-Edge with Effective Demand, response to JW Mason

05/12/2013

Reviving the Knife-Edge with Effective Demand, response to JW Mason

By way of Steve Randy Waldman at interfluidity.com there was a piece written by JW Mason back in February called "Reviving the Knife-Edge: Aggregate Demand in the Long Run". The piece is brilliant.

JWM refers to many papers throughout his piece. Yet the main idea is "we don't have a story about what role, if any, aggregate demand plays in the longer run."

He only mentions Effective demand once in the article in referring to a book written by Axel Leijonhufvud on Keynes.

JW Mason says...

"... in periods when demand is persistently pushing against potential... “excessive” demand may lead to only temporarily higher inflation but permanently higher employment and output, and conversely."

It is good to push up against the LRAS curve as is implied in this quote. My view is that the main problem we have is that inflation targeting in monetary policy has damaged this beneficial dynamic of temporary higher inflation.

But anyway, Here is the point I want to make. The model of Effective demand that I am presenting on this blog explains the long-run dynamic of aggregate demand in terms of the LRAS curve (long-run aggregate supply), NAIRU, full-employment, the effective demand limit on growth of output and ultimately, the ability to graph that long-run point. As I have shown just recently with this graph...

In this model, we can see where aggregate supply is heading within the constraint of effective demand.

In the standard aggregate supply-aggregate demand model, both curves for demand and supply move together at a crossing where output equals expenditures. As aggregate supply increases, aggregate demand thus obviously increases with it. But there is nothing the AS-AD model to tell you where the limit of effective demand is. The crossing point just moves in its own economic space without context of the constraints around it.

You could too easily add a line in the above graph for aggregate demand. The line would simply cross where the blue dot is on the aggregate supply curve. What would doing that really tell you? Only that the output was purchased. Then you can break down the components of purchasing into households, investment, government and net exports. Ok, but you would not see any broader context.

So then what broader context does the effective demand curve give? It will show you automatically where the LRAS curve is. It will show how much potential output growth is remaining in an inflationary gap. It will tell you how much rate of utilization for labor and capital is still available. And the list goes, but the idea is that effective demand tells us the role of aggregate demand in the long-run that JW Mason mentions.

JW Mason states...

"I think the vision of cycles and crises as endogenous to the growth process, indeed constitutive of it, is a better, more productive way to think about the evolution of output than a stable equilibrium growth path occasionally disturbed by exogenous shocks. The idea of accelerating demand growth that sooner or later hits supply constraints in a more or less violent crisis, is just how the macroeconomy looks. Consider the most obvious example, unemployment:"

This is exactly what I wrote about at the end of March. In a piece titled "Limit of Inflationary Gap Determined by the Unemployment Rate". The Effective demand model gives the supply constraint with the effective demand curve, just as JS Mason writes about.

This graph plots the rise in real GDP against capital utilization, but the post shows the math to determine the supply constraint based on the unemployment rate. Here is the equation from that earlier post...