2011-11-08

Mystifying or Demystifying?

Here is Scott Sumner on Aggregate Demand and "nominal gross domestic product."
Arnold Kling and Russ Roberts make AD seem more mysterious than it really is.  When both output and inflation rise, AD has risen.  When output rises and inflation falls, AS has risen. (Oops, replace "inflation" with NGDP growth;)
It is important to always keep in mind that when Scott Sumner refers to "NGDP," he has in mind the total inflation-unadjusted dollar amount spent within a country's borders.

You can think of it this way: nominal GDP is (supposed to be) what dollar amount we spend on everything. Real GDP is (supposed to be) the total net value of the goods and services produced and used within an economy, i.e. "wealth."

Therefore, to restate the Sumner quote above, "Aggregate Demand" rises when people spend more money on everything *and* end up with more goods and services compared to a previous time period. "Aggregate Supply" rises when people spend less money on everything, but still end up with more goods and services.

Note that in both cases, output rises. Therefore, in the two situations Sumner provides, we know we are talking about Aggregate Demand when inflation occurs.

Perhaps the Crux of the Whole Macroeconomic "Problem?"
Can Aggregate Demand rise without a corresponding rise in output? This would occur if society in general demanded more of every product and service at any price. Regardless of the price level, people simply wanted to consume more. This would cause prices to increase and resources to become more scarce.

What is interesting about this fact is that it expresses the most important aspects of Austrian theories of money, credit, and capital. When prices rise and output remains the same, we don't have an increase in Aggregate Demand, not at all. We have nothing more than inflation.

This fact deals a serious blow to Keynesian and Monetarist theories of macroeconomics, because when the government increases the money supply via fiscal or monetary policy, output remains the same. This results in, at first, additional consumption on the part of those who first get ahold of the new money (i.e. bankers). But as the money reaches the rest of us more broadly, we don't end up with more wealth to consume, we simply end up with higher prices.

So, at best, we face inflation. At worst, the initial consumption caused by the monetary distortion makes resources all the more scarce for the rest of us because output doesn't rise.

This is no less true of Sumner's theory of increasing the money supply just high enough to ensure that we're spending exactly the same amount of inflation-unadjusted dollars we spent last year (NGDP targeting).

Conclusion
The whole concept is smoke and mirrors. People believe that they "just don't understand economics," but in reality they absolutely do. The Cardinal Rule of Ryan's Personal Philosophy is that if something doesn't make sense, then it absolutely cannot be true. When people hear or read about these senseless macroeconomic theories, they become bewildered, none of it makes sense, but economists insist that it all makes sense when you have a PhD in economics.

They're lying. It doesn't make sense no matter what kind of PhD you have. And you're not wrong or crazy for realizing this.

For the record, I highly recommend this post from Russ Roberts, which seems to have started it all.