Beyond (aggregate) supply and (aggregate) demand

Posted: 9 November 2013 in Uncategorized
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Much of the debate within mainstream macroeconomics about the current crisis takes place within the limits imposed by the AS-AD model (as illustrated in the video above). Either the problem is aggregate demand (as Keynesians tend to argue) or aggregate supply (the side neoclassical economists tend to focus on). Each side presents an analysis of the cause of the crisis—and, with it, the preferred solution: economic stimulus (through fiscal and/or monetary policy for the Keynesians) or tax cuts and other supply-side measures (basically, additional incentives for the so-called “job creators,” as neoclassical economists see them). And then, of course, there’s the ever-shifting middle position (sometimes more Keynesian, other times more neoclassical) and the corresponding policies: a bit of economic stimulus and a bit of supply-side incentives.

That’s all familiar territory for anyone who’s been following the macroeconomic debates (in both political and academic circles). And it’s certainly the way macroeconomics is taught to thousands and thousands of students every year.

But what has gone largely unnoticed in these debates is the presumption that aggregate demand and supply are independent of one another (not unlike in the microeconomic counterpart, the supply and demand conception of individual markets). In other cases, the only way the initial equilibrium is undone is because there’s an exogenous change that affects either one side or the other: either aggregate demand or aggregate supply (or, at the microeconomic level, market demand or market supply). The underlying cause is on one side or the other.

But what if changes on one side affect the other? In my view, that’s why the recent paper by Dave Reifschneider, William L. Wascher, and David Wilcox [pdf] of the Federal Reserve Board is receiving such attention. What their study shows is that potential GDP “is currently about 7 percent below the trajectory it appeared to be on prior to 2007.” In other words, the future growth potential of the economy (the blue line in the chart below) has been undermined by the current downturn in economic activity (the red line in the chart), both of which are below what might have been the case if past trends had continued (the green line). It’s as if economic resources had been destroyed by not utilizing them in recent years.


In terms of the mainstream model, the collapse of aggregate demand leading to the crash of 2007-08 has also affected the aggregate supply of the economy—thereby shattering the illusion of the independence of the two sides of the macroeconomy. As the authors put it, “a significant portion of the recent damage to the supply side of the economy plausibly was endogenous to the weakness in aggregate demand—contrary to the conventional view that policymakers must simply accommodate themselves to aggregate supply conditions.”

Not only does the destruction of a significant portion of the future growth potential of the U.S. economy challenge the model mainstream economists use to analyze the macroeconomy and to formulate policy; it also forces us to question the rationality of a set of economic arrangements in which trillions of dollars of potential wealth (which might then be used to improve lives for the majority of the population) are sacrificed at the altar of keeping things pretty much as they are.

It represents the indictment both of an academic discipline and of economic system.

  1. […] then, in 2013, I discussed the illusion of the independence of aggregate supply and […]

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