Cowen on Say's Law

Tyler Cowen argues that even in aggregate demand is too low, supply still matters.

In a world of unemployed resources, imagine a company called Apple invents a device called -- improbably -- an iPad. That's a positive supply shock. People will be lead to spend more money. The inventors and their employees will have more money to spend. There will be a positive multiplier throughout the economy, as analyzed by W.H. Hutt. First aggregate supply went up and then aggregate demand went up. It's all one step on the way to economic recovery.

Why don't the people buying the ipads spend more on ipads and less on other goods? Naturally, one would think they would spend less on substitutes for ipads.

From a flow perspective, Cowen is assuming that the ipad consumers are choosing to reduce saving. This raises the natural interest rate. If the market interest rate is unchanged, say because of central bank policy, nominal and real expenditure expands. This expansion ends if and when higher current income raises saving again and so the natural interest rate equals the market interest rate.

From a stock perspective Cowen is assuming that the ipad consumers choose to hold less money. Given the quantity of money, nominal and real expenditure expands. This process ends when real income rises enough so that the demand to hold money again rises to the existing quantity of money.

The flow and stock perspectives are consistent, though perhaps the flow approach is more appropriate if the central bank adjusts the quantity of money to target market interest rates. In both, nominal expenditure and aggregate demand depend on the quantity of money and the demand to hold it.

Perhaps it is sensible to assume that the introduction of a new good will cause a decrease in the demand for money. And so, it will raise aggregate demand.

On the other hand, surely most of the effect will be a shift in the composition of consumption and unchanged desired money holdings.

Ignoring this immediate effect, consider the multiplier Cowen describes. What I always call the "Yeager" effect becomes important. The increase in ipad production raises output. Assuming money is a normal good, the increase in income raises money demand. If the quantity of money is unchanged, the resulting shortage of money results in people reducing nominal expenditures. If this Hutt/Keynes multiplier results in those with greater income spending more, and additional production in response, the demand for money is rising at each step. In other words, this process is impossible.

The true "multiplier" effect is just the fundamental proposition of monetary theory. Individuals with excess money balances spend them and people accept them in payment not because they want to hold more money, but in order to spend them in turn. The process ends when demand for money adjusts to the quantity.

If the demand for money changes, and the quantity of money is unchanged, the fundamental proposition of monetary theory suggests that one person adjusts spending and then another, until the demand for money returns to its previous level.

If there is insufficient aggregate demand, a increase in supplies of goods and services that causes lower prices will increase the real supply of money, which raises aggregate demand. And, I don't disagree that the introduction of a new good would plausibly cause a substitution away from many other things, and that one of them is money, and so it would help a bit.

But monetary disequilibrium-- the quantity of money and the demand to hold money--is central to understanding inadequate aggregate demand.