Friday, February 22, 2008

AD vs AS

I'm having an issue with the pro-fiscal stimulus talk: it seems to be based on the assumption that there is insufficient aggregate demand. Here's one example from a source I deeply respect:

In particular, when the economy is particularly weak, the key constraint on short-term economic growth is demand for the goods and services that firms could produce with existing resources. (source)

But insufficient demand cannot be the (main) cause for sluggish growth when combined with rising inflation.

Granted that a (dwindling) minority might want to say "if combined with rising inflation", but the non-inflationary scenario is weakening. Here is a view in favor from the Fed via FT; view in favor from the financial markets (a little old by now, relatively speaking); and yet another view in favor, this from the Economist making the argument that commodity prices are not going to be headed down anytime soon. Then we have the jump in wheat prices, with all the linkages that has (geez, thanks misguided subsidies for corn-based fuels). And I will leave it with the falling US$ and rising costs in China, meaning more expensive imports in the US.

On the other hand, here is a good view against.

I am obviously on the side of the inflationary scenario. Let's accept inflation is a problem. Now, to the basics: in an aggregate supply (AS) and demand (AD) model, a drop in AD lowers both price level and output; a drop in the AS lowers output, but increases the price level. Here's the classic graphical representation of the model. In the long-run equilibrium, the AD and the (short run) AS intersect together and with the Long Run AS (LRAS), which is insensitive to the price level (and assumption to be challenged later). We alternatively contract the AD and the AS and see that it's the second case that mimics what we're observing in the economy:

Of course, it's best to rethink these graphs in dynamic terms and, with a lot of hand waving, substitute inflation for the price level and output growth for the output level. In this case, the curves' positions measure their expansion (the "AD dot" and "AS dot"). I know, there's more to it, but bear with me: the point is that, while both curves may be slowing down, the aggregate supply has to be slowing down more if inflation is rising. Rising input and import prices and the cost of credit will do the trick. Also, rising inflationary expectations would increase expenditure today and reduce supply today, specially if nominal input prices remain constant, because of, say, contracts (buy at a lower relative price today, sell at higher relative price tomorrow).

(Of course, the AD might be contracting too because of fears on unemployment, credit constraints, etc. The point is that the AS must be contracting more.)

The issue is not moot. If the AD is the limiting factor, expand it until it can sustain itself (leaving aside the serious issues of timing and overshooting, and of fiscal deficits). But if it's the AS...

An AD-expanding package like the fiscal stimulus will give a temporary boost to the rate of expansion and then take that boost away. Inflation and growth will be higher for a bit than without it. But what happens next will be a return to long term equilibrium growth in output and, very likely, higher equilibrium inflation. How much higher will depend on what happens with the causes behind the slowing expansion of the AS curve and with inflationary expectations.

In the model above, picture the AS curve moving rightwards (say due to a decrease in nominal input prices, with the price level constant), or the AD curve moving also right (an increase in expenditures at all price levels), or both, until the three curves meet again. Along the way, the price level and output (or inflation and growth) adjust accordingly. In the case of the AS, movements along it up and right are due to a fall in the real prince of inputs (their nominal price remains constant, perhaps due to contracts, and the price level as a whole goes up).

How do we return to equilibrium? If the causes of the contraction of the AS go away before higher inflationary expectations settle in (or if other AS-expanding trends, like productivity growth or an increase in the stocks of inputs, speed up and counteract the contraction), then we are in the happy scenario: we could return to essentially the same long term equilibrium we would have had if the AS curve would have adjusted through unemployment's effect on input prices. So start from the long term equilibrium, AS contraction, now the stimulus (AD expansion, say up to an intersection on the LRAS, and now a well synchronized contraction of the AD as the AS expands so that we slide down the LRAS to the original point. If it can be achieved, we could stay at full employment with only a temporary spike in inflation which would settle down to its original level. Tough, but commendable, the job of economic titans and believers in the efficacy of governments.

But what if what caused the AS slowdown does not go away and higher inflationary expectations settle in? Then the AS does not expand and the AD does not contract back. We end up in a higher inflation equilibrium with the same long term growth as before. And before someone jumps up and says "so what if we have higher inflation, as long as full employment is back?": beyond the inefficiencies inflation brings to the price system (more on that later), keep in mind that movements along the AS curve occur because the real price of inputs is falling as inflation rises faster than wages. That is, in the end, workers are in the same position, real wage-wise, as if the return to long-run equilibrium came about because the expansion of the AS curve due to falling nominal input prices, holding the price level constant. And I say "workers" because, with all others input prices rising, it will be real wages falling disproportionately.

I'll hold on a second to say something in favor of the higher inflation scenario: the return to full employment (via lower real wages, one way or another) is usually faster when it's due to rising price inflation (over wage inflation) than when we wait for nominal wages to fall (or, more realistically, for wages to remain constant given a strictly positive rate of inflation).

But unfortunately, inflation does have a long-run cost. In the long run, perhaps a year from now in this case, workers are likely to end up worse off in the higher inflation scenario. As has been convincingly argued and experienced in high inflation and hyperinflationary environments, the long term AS curve could have a negative slope because inflation reduces the efficiency of the price system. Then we'd end up in a long term equilibrium with higher inflation and somewhat lower growth.

Now, for the full picture: it might be the case that the long term aggregate supply is shifting left (say, due to the end of cheap imported inputs). In that case, efforts to go back to the old growth rate would just be inflationary and unsustainable. Do we need to bite that bullet? I, for one, a natural born pessimist, see us moving into the higher input cost / higher inflationary expectations scenario and, possibly, lower long term growth.

Not a bad scenario to tell the truth, there's still robust growth and lowish inflation... just not as good relative to the last decade or two, in which price-less risk (who, what, how, argh!), cheap imports and inputs, and unlimited demand for US$-assets complemented productivity increases. Even with the same productivity increases, risk-pricing should approach something reasonable now (but I'm prepared to be surprised once again by the capacity of capital markets to live in denial), import/inputs will not help keep inflation down as much, and lower demand for US$-denominated assets might lead to higher interest rates.

A most dismal science.

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