Aggregate Demand Failures

Some time ago, Peter Boettke asked, "What Precisely is Aggregate Demand Failure and How Would you Know it if you saw It.." He was reacting to claims by Lawrence Summers and Christina Romer that the key problem facing the U.S. economy is inadequate aggregate demand. Romer, in particular, described some evidence from labor markets suggesting that structural unemployment is not that serious.

In the comments thread on Coordination Problem, I argued that aggregate demand failure exists when the real volume of expenditures is less than the productive capacity of the economy. I argued that this is the same thing as the quantity of money being less than the demand to hold money. And further, it is the same thing as the market interest rate being greater than the natural interest rate.

After stating basic monetary theory, I went on to suggest that if aggregate money expenditures have fallen, and the price level has not fallen in proportion, then you should suspect that there is an aggregate demand failure. The decrease in real output associated with the drop in real expenditures is due to monetary disequilibrium--aggregate demand failure.

If there is a drop in real output in aggregate, there must be decreases in the production of particular goods. There are some questions to ask about the particular markets where real output drops. If there are shortages of the particular good where output has dropped, then the problem probably isn't inadequate aggregate demand.

If, on the other hand, there were surpluses in those markets, and firms reduced output to avoid producing goods they couldn't sell, then it is still possible that the problem isn't inadequate aggregate demand. Perhaps there are other markets where there are balancing shortages and the problem is a need to redeploy resources between markets. This is the most difficult, and probably the normal, situation. A difficult judgement call must be made to determine if the markets where output has fallen due to surpluses are balanced by the shortages in those markets where resources need to be redeployed. Increases in output that don't occur cannot be observed. Of course, to the degree prices rise to close off those shortages, then the volume of expenditure of those goods provide a rough measure of possibly balancing increases in demand.

If, on the other hand, there are absolutely no markets with shortages, so that demand and production has fallen in every market, then there is no doubt. The demand to hold money is greater than the quantity of money. The reduction in production is due to an aggregate demand failure.

In the comment thread, Richard Ebeling noted that he has long accepted the "Austrian" free banking argument that there is a market process by which fractional reserve banks will tend too expand the quantity of money to at least partially accommodate increases in the demand to hold money. He understands that this reduces the need for the purchasing power of money to rise. However, he remains skeptical that this tells us much about the desirability of expanding the quantity of money in the face of a "secondary" depression.

But this is not the type of situation in which we find ourselves today. Here people are not changing their underlying preferences in the same way as my example, above.

They are responding, partly, to the uncertainties, confusions, and delays in adjustments to distortions resulting from misguided monetary (and related policies -- Fannie Mae and Freddie Mac, etc.) that resulted in misdirections of resources and labor, and capital malinvestments.

(And, by the way, this is the context in which John Stuart Mill in his famous essay "On the Influence of Production on Consumption" restated Say's Law by introducing and viewing money as a commodity that is demanded, and for which there may be temporarily an increased demand relative to other commodities in the wake of the confusions and imbalances of an economic crisis.)

What needs "fixing" in this case, I would argue, is not an increase in money for people to hold, but the necessary price and wage and resource adjustments that will restore the balance and coordination so people can be reemployed, once again have profitable investment opportunities, etc., that have market-based possibility and sustainability.

Those are the "real" factors beneath the monetary surface, and manipulating the amount of money in the economy does does nothing, per se, to bring the economy back into order along the lines I've suggested.

As I said in my earlier comment, this merely runs the risk of superimposing new misdirections of resources, labor and capital on top of the prior ones that are still waiting for correction.

At first pass, I would say that Ebeling is wrong. The injection effects of an increase in the quantity of money can only create malinvestment if it is an excess supply of money. If the demand for money has increased, then the effects of an increase in the quantity of money on relative demands, prices, profits, and production is not malinvestment.

However, there is an important element of truth in his argument. The key to that truth is that the change in relative demands is temporary. Responding to a temporary shift in demand by making irreversible investments in specific capital goods is an entrepreneurial error.

Suppose that the unsettled conditions did not result in a temporary increase in the demand to hold money, but rather in a temporary increase in the demand to hold rifles and bullets. To fund those additional rifles and bullets, people purchase fewer flat screen televisions. By assumption, this shift in demand is temporary. Once conditions are again settled, the demands for both rifles and televisions will return to normal.

In the rifle market, the increased demand will raise prices, profitability, and production. This is simply a allocation of resources to produce what people want most given the actual conditions of the time. If the increase in the demand for rifles were permanent, then adding to the capacity of the rifle industry would be profitable. Specific machinery could be constructed to help produce more rifles. This would allow increased production of rifles and added demand for other, complementary factors of production, such a labor. The prices of rifles would tend to fall, as would profitability, due to these long run adjustments of output to the composition of demand.

If entrepreneurs wrongly perceive the temporary increase in the demand for rifles as permanent, and they undertake this expansion of capacity, they will suffer losses when their expectations are proven false. Hopefully, fear of such losses will motivate entrepreneurs to avoid malinvestments.

If there had been some kind of quota system prohibiting any increase in the production of rifles, then rifle markets could clear through higher prices. There would be no short run or long run increase in the production of rifles. Those entrepreneurs who would have mistakenly perceived the increase in rifle demand as permanent and made malinvestments in rifle making equipment are protected from those losses. The rifle industry is protected from overexpansion. On the other hand, some of the people who wanted more rifles must do without.

If disturbed economic conditions lead to an increase in the demand for money, and banks respond to this increase by creating more loans, then this certainly could result in temporary increase in the demands for goods with relatively high interest-elasticities of demand. Just as with the rifle scenario, this increase in relative demands, prices and profits, would result in an expansion in production and employment for those particular goods. If this change were permanent, then it would be profitable for entrepreneurs to purchase various sorts of specific equipment to further expand production and employment, tending to reduce prices and profits in those areas.

Since by assumption, this change in demand is temporary, these would be malinvestments, and the entrepreneurs would suffer losses when their expectations are dashed. It is the prospect of those losses that will hopefully prevent any malinvestments due to a temporary increase in money demand, and so indirectly, an increase in the demand for goods with highly interest elastic demands.

If there had been some quota, preventing the quantity of money from rising, then this process could have been prevented. The firms that made the error of treating the temporary increase in the demand for their products as permanent would be protected from making those errors.

Any firm that myopically projects the pattern of demands that exist during unsettled times into the future deserves any losses they suffer. On the other hand, being an entrepreneur during unsettled times involves more uncertainty than usual, and so perhaps additional malinvestment is to be expected.

Ebeling's worries about the added disruptions created by an increase in the quantity of money are mistaken, confusing the problems created for entrepreneurs because of the uncertainty created by unsettled conditions with something specific to increases in the quantity of money. On the other hand, what are the benefits of a temporary increase in the nominal quantity of money?

What is the alternative? The alternative is for the prices of various goods and services to fall until the real quantity of money rises enough so that some of those holding money choose to spend some of what are now excessive real balances on particular goods and services. Perhaps these will be goods whose prices have fallen more readily. Or perhaps it will be goods that are especially desirable in the unsettled economic conditions. What is important, however, is that there is no reason to believe that the particular pattern of demands for goods and services that occurs because the price level falls temporarily enough so that the temporary increase in the real supply of money matches the demand will somehow persist after the demand for money again falls and prices rise. If entrepreneurs take that pattern of demands and myopically project it into the future, and make specific investments based upon it, they would have made malinvestments.

The equilibrating process involves a temporary increase in the real quantity of money to match the temporary increase in the real demand to hold money. This can be an increase in the nominal quantity of money at unchanged prices. Or it can be an unchanged nominal quantity of money and lower prices. In either situation, real expenditures on current output are kept equal to the productive capacity of the economy. This could be unchanged nominal expenditures and unchanged prices. Or it could be lower nominal expenditures and lower prices. In neither situation will there be reason to expect particular pattern of demands that occur during the process will be permanent.

So, both processes maintain aggregate real expenditure. But the actual pattern of demands during the period of disturbance are likely to be temporary. The demands for some goods will be temporarily high and the demands for other goods will be temporarily low. Given these demands, consumers are best served by adjusting production to reflect this new pattern of demands. I think that rising nominal expenditure, prices, and profits is the best signal for firms to expand the production of goods with higher relative demands.

The alternative, of falling demands for all goods, and falling resources prices, and profits for those goods whose prices fall less than costs so that production expands is a much dirtier signal. Perhaps it should be no surprise that firms respond to an excess demand for money by reduced production and employment.

Like Ebeling, I believe that there has been substantial malinvestment in housing and that construction should contract and the production of other goods and services expand. To say that housing was overproduced, or more exactly, that continued production at rates of the boom would be overproduction, means that there are other more valuable goods and services being sacrificed. In my view, keeping final sales of domestic product on a stable growth path provides the best environment for these redeployments of resources to occur. Those producing these other goods that people demand more than even more houses, should see growing nominal demands, higher nominal prices, and greater nominal profits. This provides a clear signal to produce more and expand employment. To maintain this environment, increases in the demand to hold money, even if temporary, must be accommodated by an increase in the quantity of money.