AS/AD: Let’s use it every single day

Tyler Cowen recently linked to a Wonkblog piece by Jim Tankersley. I’m going to use this piece to discuss how we could improve economic journalism.  I have not chosen Tankersley’s piece because it’s especially bad, on the contrary it’s an unusually thoughtful and balanced piece. Rather I’m picking on it because even economic journalism at its best falls maddeningly short in one key area—failure to rigorously apply the AS/AD model.

When I read the piece I was constantly perplexed as to what problem was being examined.  Was Tankersley trying to explain why growth in AD had been so slow in recent years?  Or why robust growth in AD had failed to produce a rapid recovery from the recession?  I’ll just quote one paragraph as an example:

It goes like this: U.S. policymakers have tried for several years to splash gasoline on the flames of growth in hopes of stoking a bonfire. They’ve thrown in the $800 billion of tax cuts and spending increases contained in the 2009 economic stimulus bill, as well as the extraordinary measures the Fed has taken in an attempt to boost employment: holding short-term interest rates near zero for years and buying an unprecedented amount of long-term securities such as Treasury bonds in order to push down long-term interest rates. Warsh’s story is that those efforts didn’t work, and to make matters worse, they dampened the economy’s longer-run growth prospects.

OK, but precisely how did they fail to work?  Did they fail to boost AD? Or did they boost AD, but that failed to boost output?  Those are two radically different types of failures, with radically different policy implications.  Even worse, we have very good data on how fast spending has risen in recent years, so it’s not like we don’t know what’s happened to AD.  So tells us!

I will admit that the AD data is not definitive.  Even if there has been a big AD shortfall, it could be covering up an AS shortfall.  As an analogy, if a 73 year old driver with heart problems drives over a guardrail and is engulfed in flames at the bottom of the ditch, it’s quite possible that the man had a heart attack and died right before losing control. Nevertheless, in any article discussing that possibility, I’d also want the reporter to mention that the body was mangled in a flaming car crash.

I happen to think the US economy has some structural problems, and I think reporters should discuss that hypothesis.  But please tell us what happened to AD as well.  My dream scenario would be for every single paragraph to be concluded as follows:

And so from a AS/AD perspective, this paragraph is saying . . . blah . . . blah . . . blah . . .

OK, that will never happen (Thank God).  But at least write stories in a way such that the reader can figure out precisely what mystery is being examined, in each and every paragraph.  Is it the mystery of too little AD, or the mystery of too little RGDP?

And tell us the data that would allow us to either immediately rule out an AD shortfall, or finger it as the overwhelmingly most likely culprit. (Just as a fiery crash is the more likely cause of death than heart attack, without further information.)

The story contains a wonderful Milton Friedman anecdote:

Warsh likes to quote one of his mentors, the great free-market economist Milton Friedman: “Milton used to say, ‘everything we know in economics we teach in Econ 1, and everything else is made up.'”Š”

Yes, and AS/AD is the main macro model in Econ1.  Let’s use it.

PS.  Marcus Nunes sees too much focus on the supply side in the Tankersley article.

Lars Christensen recently had this to say:

Concluding, the monetary policy rule is the last equation in the model. It is the equation in the model that determines whether we are in a paleo-Keynesian world or in a RBC world.

Yes, and this means you first need to consider the monetary policy situation, before you can even begin an analysis of things like supply-side factors.


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22 Responses to “AS/AD: Let’s use it every single day”

  1. Gravatar of libfree libfree
    3. March 2013 at 18:25

    What percentage of the population do think know about AS and AD?
    What percentage of the population that read these articles?
    Most of my friends have never taken a course in economics, its not required for most degrees…at least not when I was in school

  2. Gravatar of Claudia Claudia
    3. March 2013 at 18:25

    I agree that the demand-side and supply-side issues could have been clearer in the article…and yet for the different stories they don’t separate so nicely.

    Bernanke said at the last press conference that one reason the FOMC was too optimistic in their forecasts of the recovery was they likely underestimated the hit to potential output. (And note this mis-perception about the supply side probably affected monetary policy some.)

    Similarly Warsh talks about lowered expectations. Do you think of more pessimistic income expectations as a demand shock or a sign of something structural? The AS/AD framework may be a clearer starting place, but I doubt it’s where we end up.

  3. Gravatar of Brad Brad
    3. March 2013 at 19:20

    Might be helpful to note at the beginning that AS = aggregate supply and AD = aggregate demand.

  4. Gravatar of Benjamin Cole Benjamin Cole
    3. March 2013 at 19:30

    The mainstream media, and even professional economists, just cannot seem to think about monetary policy first. And when they do, it is to pompously and feverishly pettifog about the perils of inflation.

    The Economist recently had a long piece about Italy and the the EU, and scarcely mentioned the monetary noose the ECB has around Italy’s throat.

    Of course, Western nations should seek the least regs and taxes. We get that.

    But even with that, if money is too tight…..like it is now…..

    BTW, in the 1960s, in the USA, we had regs galore on the financial sector (remember Reg Q, passbook accounts and stockbroker commissions), the transportation sector, in telephones (ATT), and the top tax rate was 91 percent. In that decade real per capita incomes rose by more than 30 percent, despite rapid population growth.

    The Fed had the pedal to the metal—too much so, we ended up with a little too much inflation.

    But the lesson: If you think structural problems alone cause perma-recessions, you need to explain the very robust 1960s.

  5. Gravatar of ssumner ssumner
    3. March 2013 at 19:57

    libfree. If they don’t know about AS/AD they are wasting their time reading Wonkblog–which is aimed at people who have been to college and at least taken Econ1. Maybe wasting their time is too strong. But how could someone even understand an article like that if they hadn’t studied econ? It would be like me trying to read a journal discussing biochemistry. How would someone process the information?

    Oops–now I’m starting to sound like Krugman!

    Claudia, Potential output shouldn’t affect NGDP growth. Lower nominal income expectations is 100% demand shock.

  6. Gravatar of ssumner ssumner
    3. March 2013 at 19:58

    Brad, I’m trying to scare away people that don’t know what it means. 🙂

  7. Gravatar of Geoff Geoff
    3. March 2013 at 20:46

    Dr. Sumner:

    “Yes, and this means you first need to consider the monetary policy situation, before you can even begin an analysis of things like supply-side factors.”

    MMs have a wonderful opportunity! Since MMs have considered the monetary situation in great detail over the years, now is as good a time as any for them to start seriously addressing the supply side factors that plague this country, instead of just mentioning by passing remarks that there are “problems”!

    Anyone? Anyone? Bueller?

  8. Gravatar of Geoff Geoff
    3. March 2013 at 20:59

    Benjamin Cole:

    “The mainstream media, and even professional economists, just cannot seem to think about monetary policy first. And when they do, it is to pompously and feverishly pettifog about the perils of inflation.”

    I’m sure others in the mainstream media, and other professional economists, think the same thing about you. That you cannot seem to think about real side factors first, and that when you do, we get non-serious and vague one liners like “Western nations should seek the least regs and taxes. We get that.”

    If you won’t play their game, why should they play yours?

    Obviously the solution for economists is not to divorce economics into “real” and “nominal” sides, or “micro” and “macro” sides, but to combine everything into one coherent whole science of economics. Make sure that your reasoning and your arguments can apply to both money and real commodities. After all, money is, economically speaking, just the most marketable and most widely accepted commodity in exchange.

    If you start with the a priori assumption that economics should be split into separate factions, then why on Earth are you so surprised and peeved that you see others on “the wrong side” of things? You’re always going to see this if you view economics as a split science

  9. Gravatar of Greg Ransom Greg Ransom
    3. March 2013 at 22:11

    AS/AD analysis is garbage and every macroeconomist knows it.

    Why lie the the public about this.

    Nothing in Econ 1 justifies or is compatible with the made up & pulled out of the back of the back of the pant AS/AD ‘analysis’.

  10. Gravatar of Daniel Daniel
    3. March 2013 at 23:55

    http://noahpinionblog.blogspot.com/2013/03/blogger-smackdown-robert-waldmann-vs.html

    Your thoughts?

  11. Gravatar of Bill Woolsey Bill Woolsey
    4. March 2013 at 04:18

    Scott:

    Regime specifity.

    If you are trully committed to inflation targeting, then decreases in aggregate supply lead to decreases in aggregate demand.

    If you are trully committed to inflation targeting, then the growth path of prices is irrelevant. All that counts is the current inflation rate and expected inflation rates.

    If you are doing a Taylor rule, then the output gap matters too.

    And sure enough, Bernanke worries about inflation expectations being low and the output gap.

    I think someting like aggregate supply and demand is useful in thinking about alternative regimes.

    And it applies pretty directly to some regimes like a gold standard and a money supply rule.

    It also applies well to our preference system. Aggregate demand shocks are policy mitakes and aggregate supply shocks cause unfortunately inversely proportional shifts in output and inflation.

    In new Keynesian models, the policy interest rate this period determines the allocation of real consumption spending the next period and the period after that. Real consumption spending this period determines output this period. And then, the difference between output this period and potential output this period determines inflation next period.

    Where is aggregate supply and demand in that? Real output is identified with aggregate demand this period. Inflation depends on the gap beween potential output and real output last period.

    The interactions between the price level and real output in amn aggregate supply and demand output would only exist because the central bank sets a policy interest rate that causes consumption to change so that real output changes so that inflation is at an arbitrary target.

    That is the model (as I understand it.) Economists is about doing math with the model.

  12. Gravatar of AS/AD: Let’s use it every single day | Fifth Estate AS/AD: Let’s use it every single day | Fifth Estate
    4. March 2013 at 04:24

    […] See full story on themoneyillusion.com […]

  13. Gravatar of Claudia Claudia
    4. March 2013 at 04:36

    Silly me, revisions to potential do not necessarily reveal mis-calibrations for monetary policy since output gaps (or the degree of slack/unused resources) are key. Changes in potential don’t have to change slack. I am a little surprised that potential doesn’t pass through one for one on target NGDP, but I take your word for it (monetary policy not my area).

    I will push back on the income expectations. You could well be right and I think it’s closer to 100% AD than 0% AD. But the source of expectations revision seems important. Suppose households are better forecasters of potential than economists and they sense a slow down in structural growth? Just trying to nudge you off 100%, not really disagreeing.

  14. Gravatar of Benjamin Cole Benjamin Cole
    4. March 2013 at 05:21

    Geoff:

    I don’t split the real from the money side. I say regs and taxes should be as low as possible. Hey, if it were up to me, we would cut federal outlays to 15 percent of GDP (down from 22 or so now) and wipe out ethanol immediately.

    But, if money is too tight, then it is too tight. Suffocating. Even with excellent governance (which we will never have in a democracy. If we get good governance, then that is excellent).

    And that is where we are now. Money is tooooooooo tight, and governance is so-so.

    BTW, thanks for you comment.

    As one Russian dissident said of the KGB, after they were disbanded: “I don’t know that they were so bad. At least they read my stuff.”

  15. Gravatar of ssumner ssumner
    4. March 2013 at 07:20

    Geoff, I have at least 100 posts on supply-side issues. You might want to go back and read them.

    Bill, That’s a good point, but of course lots of other stuff in the article would be nonsense in that case. For instance, regarding fiscal policy they should just say “Fiscal stimulus obviously has no effect on GDP because the Fed is targeting inflation.”

    My primary argument is that the reporters should tell us what’s been happening to AD over the past 5 years.

    Claudia, If you are talking about real income expectations, then I suppose an increase in expected future real income could cause more leisure–triggering a recession.

  16. Gravatar of Geoff Geoff
    4. March 2013 at 07:25

    Benjamin Cole:

    “I don’t split the real from the money side.”

    Are you sure? I mean really sure about that?

    How often have you considered monetary policy without considering the real resources that go into it? How often have you considered “sound” monetary policy without considering the relative inter-market effects on employment and output allocations?

    “I say regs and taxes should be as low as possible. Hey, if it were up to me, we would cut federal outlays to 15 percent of GDP (down from 22 or so now) and wipe out ethanol immediately.”

    Suppose it isn’t up to you, and that increases in NGDP to the level that you want is going to be composed of more government boondoggle spending that you don’t want.

    Would you prefer that over not getting the level of NGDP you want?

    Remember, the more money printing you want, the more you need banks to own treasury debt, which of course means the more the government has to borrow…and spend.

    “But, if money is too tight, then it is too tight. Suffocating. Even with excellent governance (which we will never have in a democracy. If we get good governance, then that is excellent).”

    Suffocating? I don’t understand. If people have fewer dollars, and earn fewer dollars, then those dollars would be worth more. How does one breath better with more zeroes on circulating paper notes?

    “And that is where we are now. Money is tooooooooo tight, and governance is so-so.”

    Money is too tight if you define money tightness in terms of a variable the prevailing value of which is lower than what you want it to be.

    “BTW, thanks for you comment.”

    “As one Russian dissident said of the KGB, after they were disbanded: “I don’t know that they were so bad. At least they read my stuff.””

    That allegory isn’t for me. I put the KGB below the SS. 6 million is smaller than 30 million.

  17. Gravatar of ssumner ssumner
    4. March 2013 at 07:43

    Daniel, Nothing new there. Obviously monetary policy changes have a significant impact on the asset markets, even skeptics like Krugman acknowledge that. I can’t imagine anyone thinking otherwise unless they pay zero attention to how stocks respond in real time to comments by Bernanke, Abe, and other policymakers.

    I would add that while QE may be a “monetarist” policy, it is certainly not the preferred market monetarist policy. I have consistently predicted very weak (but positive) effects.

  18. Gravatar of ssumner ssumner
    4. March 2013 at 07:44

    Did Waldmann really say the Fed had raised their inflation target to 2.5%???

  19. Gravatar of Geoff Geoff
    4. March 2013 at 07:56

    Dr. Sumner:

    “Geoff, I have at least 100 posts on supply-side issues. You might want to go back and read them.”

    For sure, I recall many of them. I was just hoping for more in-depth posts, that’s all. As in-depth as the nominal posts are.

    Yes, I realize I am being ungracious.

  20. Gravatar of Doug M Doug M
    4. March 2013 at 09:08

    AD / AS have little value outside of their use as a pedagogical tool.

  21. Gravatar of ssumner ssumner
    5. March 2013 at 09:11

    Doug, But isn’t that a pretty nice “value.”

  22. Gravatar of Krugman and Avent on the inflation puzzle | Fifth Estate Krugman and Avent on the inflation puzzle | Fifth Estate
    7. March 2013 at 07:38

    […] I think Ryan is missing the point that Krugman was trying to address.  To see why, return to my recent plea for people to use the language of AS/AD.  Avent is saying that the Fed prevented AD from falling […]

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