AD curves don’t actually exist

Here’s Nick Rowe:

I got this idea from reading a Matt Rognlie comment on a previous post. (But Matt may or may not agree with what I say here).

A. Suppose the government sells bonds, and finances those bonds by imposing a 10% sales tax on (say) milk.

B. Suppose the government sells transferable milk quotas, and sells just enough milk quotas that milk prices rise 10% above marginal costs.

C. Suppose the government sells transferable local monopoly rights to sell milk, and those local monopoly rights cause milk prices to rise 10% above marginal costs.

A, B, and C are basically [weasel word] all the same.

.  .  .

If you think you understand how fiscal policy works, in a Keynesian or New Keynesian model, you should be able to see the equivalence. Though macroeconomists who believe it is nominal wages rather than nominal prices that are sticky, and think that the AD curve slopes down (e.g. Scott Sumner), will object that increased monopoly power raises P, which moves us the wrong way along the AD curve in a recession.

Because I’m a really shallow person, my brain cells all light up like a police car flashing light whenever I see my name mentioned in another blog.  Hence I need to comment on this.

Nick’s right that I view the AD curve as downward sloping, but I don’t quite like the way Nick phrased this.  It would be more accurate to say I think it’s useful to view AD as a rectangular hyperbola.  But I certainly don’t think Nick is wrong if he prefers something else, say a horizontal line.  I just don’t think it’s as useful.  In my view the AS/AD model is most useful when it tries to separate out nominal shocks (to M*V) and real shocks (which affect the composition of P*Y).

I should add that it’s not quite right to say that I think “nominal wages rather than nominal prices” are sticky.  I do acknowledge that there is substantial price stickiness, but I don’t view it as being very important.

Let me explain my focus on wages with a thought experiment.  Consider the sales tax increase discussed by Nick, and also consider two possible monetary policy targets, NGDP and nominal national income (NNI).  National income is GDP minus depreciation and indirect business taxes.  Thus a sales tax or VAT increase will drive a larger wedge between NGDP and NNI.  In that case, which should the central bank target?  In my view, the level of employment will track NNI/W much more closely than NGDP/W.  If wages are sticky, then a stable growth path for nominal national income will tend to stabilize employment.  If the central bank targets NGDP, then a rise in the VAT will reduce NNI, and with sticky wages this will also reduce employment.  Price stickiness might play a role in this process (by changing the labor share of NNI), but it would be a very minor role.

The preceding suggests that the most useful way of thinking about AD might be as a given level of NNI, not NGDP.  In that case, the vertical axis of the AS/AD diagram is still P, but the horizontal axis is now real national income, not real output. Or call it “real before-tax net output.”

As a practical matter, NGDP and NNI in the US track each other very closely over the business cycle.  Hence there is almost no difference between a monetary policy that targets 12-month forward NGDP growth at 4%, and one that targets 12 month forward expected NNI growth at 4%.  In other countries with national VATs, there may be a significant difference at times.

PS.  Last night I returned from a lot of travel with a bad cold.  I just feel like sleeping.  I do plan to start on Bernanke’s book today, and know that I have lots of catching up to do.  I have a new post at Econlog.



13 Responses to “AD curves don’t actually exist”

  1. Gravatar of Nick Rowe Nick Rowe
    14. October 2015 at 08:36

    Scott: I would prefer to draw the AD curve according to whatever it is the central bank targets. But then the SRAS curve will shift (or not) when taxes change, depending on what it is precisely that is sticky, and what sort of tax is being changed.

  2. Gravatar of Nick Rowe Nick Rowe
    14. October 2015 at 08:37

    P.S. I’m a really shallow person too, which is why I commented here First!

  3. Gravatar of ssumner ssumner
    14. October 2015 at 09:07

    Nick, Yes, I see the argument for that. But suppose you are using the AS/AD model to explain the Great Depression. My view is that you use a hyperbola-shaped AD curve, and have it fall by 50% from 1929 to 1933. Your view is to use the Fed’s target in 1929. But what was that? How do you use the model to show the Great Depression? And today the Fed has a dual mandate, inflation and employment. So is P or NGDP more reflective of that policy target? I’m not sure.

    And with all due respect, I can “out-shallow” you any day of the week.

  4. Gravatar of Postkey Postkey
    14. October 2015 at 09:10

    Everyone ‘knows’ that the AD schedule is vertical?

  5. Gravatar of Ray Lopez Ray Lopez
    14. October 2015 at 17:41

    Nick Rowe, professional economist, lecturer, God-knows-what-else, and Sumner, ditto, are having a public disagreement over a basic staple of macroeconomics. What hope for the rest of us? For this reason it seems the Nobel Committee for the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel are awarding more prizes lately to micro-economists than macro-economists.

  6. Gravatar of Larry Larry
    14. October 2015 at 23:23


    Given that the dollar zone is far larger than the US, would life be better if the Fed targeted NGDP for the zone instead of the country? It seems like it would reduce the violence of adjustments to Fed policy changes. Given that US NGDP would not be targeted, the US might do worse on direct effects. Would the improved global stability offset such damage?

  7. Gravatar of Vivian Darkbloom Vivian Darkbloom
    14. October 2015 at 23:28

    Yes, Ray, it has been my observation here that you never draw lines.

  8. Gravatar of Michael Byrnes Michael Byrnes
    15. October 2015 at 02:28

    Off topic, is this an example of EMH:

  9. Gravatar of ssumner ssumner
    15. October 2015 at 05:48

    Larry, I’d rather not do so, and hope that pushes other countries to stop pegging to the dollar. But if they do continue pegging, then yes, you could make that argument.

    Michael, Could be.

  10. Gravatar of David David
    15. October 2015 at 05:56

    There’s a view in currency markets that with a Fed hike off the table at least until 2016H2, that the dollar rally of the past 18 months is dead. Personally I think dollar has been strengthening because of collapsing by world trade and smaller US trade deficits. Do you have a different take on this?

  11. Gravatar of TravisV TravisV
    15. October 2015 at 09:28

    David Glasner:

    “Bernanke’s Continuing Confusion about How Monetary Policy Works”

  12. Gravatar of Doug M Doug M
    15. October 2015 at 13:10

    There are lots of prices and costs that are sticky.
    In my experience rents are stickier than wages.
    Debt service is even stickier.

    Does it matter which prices are sticker. Can’t you just say some prices are sticky, without identifying what or why, and all of your models will hold?

    The mathematician in me says that the shape of the AD curve outside of a small neighborhood is irrelevant.

    AD / AS is just a model — a tool that helps you to discuss your theory… I don’t think it is really helpful to define it in any more detail than is absolutely necessary.

  13. Gravatar of Scott Sumner Scott Sumner
    16. October 2015 at 07:04

    David, The US economy is stronger than many others, I think that’s the main reason. Also, monetary stimulus in Japan and the EU.

    Doug, I agree that there are lots of sticky prices, but that really doesn’t matter very much.

    Rents on newly rented apartments are not sticky, and those are the only rents that matter for the business cycle.

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