## Wednesday, September 23, 2009

### Klingonomics 2

Kling's argument that the current recession involves a need to reallocate resources, is plausible. It seems likely that resources need to be moved away from producing single family homes, building SUV's and other low mileage vehicles, and perhaps less financial engineering on Wall Street. The resources need to be redeployed to more valuable uses. Because this adjustment takes time, the productive capacity of the economy will be temporarily depressed.

What is remarkable, however, is Kling's view that the decrease in productive capacity somehow generates a matching decrease in nominal expenditure. He argues that "recalculation" generates a reduction in "y," that is real income. Given "P," the price level, that implies a decrease in "Y," nominal income and nominal expenditure. And given "M," the quantity of money, this necessarily implies a decrease in "V," the income velocity of money. From the equation of exchange MV = Py, V = Py/M.

However, the income velocity of money is equal to the reciprocal of the ratio of real money balances to real income, or k. This decrease in "V" is simultaneously an increase in k. Somehow, the readjustment in the allocation of resources that is temporarily causing depressed productive capacity must be causing people to be willing to hold increased real money balances, despite being made poorer by that lower real income. Not only is this implausible on its face, it would be remarkable that they would be willing to expand money holdings the exact amount necessary to cause nominal expenditure and income to drop with the productive capacity of the economy.

The usual market-clearing, real business cycle approach would be to argue that P instantly and smoothly adjusts so that real expenditure (MV/P) is equal to the productive capacity of the economy. From deep within this perspective, the current value of P is always at the level such that the real volume of expenditures matches the productive capacity of the economy. If observed real output has fallen, then it must be that productive capacity has fallen. From that perspective, real income (y) is always equal to productive capacity, and MV simply determines the value of P needed to make real expenditure equal to that capacity.

If, on the other hand, prices are sticky, then real expenditures are not necessarily equal to productive capacity. If one simply asserts that nominal expenditures drop so that at current prices, real expenditures are equal to capacity, then it is evident that velocity, and more fundamentally, the demand to hold money must be adjusting. Why would people adjust the amount of money they choose to hold so that nominal expenditures exactly track the adjustment in resource allocation from relatively less valued to relatively more valued goods?

The most likely answer is that there is no such reason. Kling is simply mistaken. There is no particular reason to believe that the current level of nominal or real expenditure is equal to the productive capacity of the economy. A great recalculation may have depressed the productive capacity of the economy, but a drop in nominal expenditure may have caused real expenditure and real income to fall well below that productive capacity. The great recalculation may have increased structural unemployment, and so the natural rate of unemployment, but the drop in nominal expenditure, may have caused the unemployment rate to rise above the natural unemployment rate.

#### 1 comment:

1. Bill: it's good to see you blogging!

One wonders what Arnold would draw if forced to draw an AD curve? His AS curve is presumably vertical, but would his AD curve be horizontal? If not, what is holding the price level fixed? And if it is horizontal, what determines its height?