Tuesday, March 12, 2013

It's Both Supply and Demand

John Tamny penned an attack on Market Monetarism and Nominal GDP level targeting.  

He makes all sorts of claims about the basic economics that Market Monetarists supposedly ignore.

The theme of my response is that it's Both Supply and Demand.

Supposedly, Market Monetarists fail to understand the primacy of supply.   First goods must be supplied.   On a desert island, goods must be produced before they can be exchanged.   Supposedly we ignore Say's Law.

Tamny claims that the key role of money is to serve as a measuring stick and claims that gold has historically proven to be the best measuring stick.    Market Monetarists, and monetarists generally, supposedly ignore the "measuring stick" role of money.

"Supply" is important, but so is "Demand."   Even an isolated individual on a desert island supplies products to himself because of his demand for consumption.    In the case of capital goods, such as a net to catch fish, the entire point of the activity is the "demand" to consume those fish in the future.   Production is not an end in itself.   "Supply" is pointless independent of "Demand."

We can imagine people producing goods for themselves, and then after "supplying" the goods, there is an unanticipated opportunity for a barter exchange.   Each supplies a good they already have, demanding the good that the other person already has.     The goods were produced first with no concern for with what others might demand.   And because it is a barter transaction, to offer a good for sale (supply,) is at the same time an offer to buy another product (demand.)

However, even in a barter economy, much of the actual production of fish or coconuts would be based upon anticipated demands by others.   The fisherman doesn't go out to sea to seek already produced coconuts, but rather in anticipation that there will be coconuts gathered.   There is no "first supply" and then "demand."

However, Market Monetarists are not much interested in barter economies except as a foil.   We are interested in monetary economies.   In a monetary economy, nearly everyone is selling goods for money and then using money to buy goods.     Goods do have to be produced for the buyers to have something to spend money upon.   But in a monetary economy, entrepreneurs produce goods now because they anticipate that buyers will be spending money on those products in the future.

Do Market Monetarists ignore "supply" in this broad and abstract sense?

Market Monetarists frequently mention the role of potential output in the economy.   Further, nearly all Market Monetarists from time to time emphasize how important growth in potential output is to human well being.   

Roughly, the level and growth of potential output is what Tammy appears to have in mind when he discusses "supply."   A growing workforce (including immigration) can provide more labor, saving and investment provides more capital goods, new products and production techniques makes it possible for these growing amounts of resources to produce more and better consumer goods and services.

I know of no Market Monetarist who consistently ignores the basic determinants of long run economic growth.   But "supply" is not all that counts.   There is also demand.  In real world market economies, all of which are and always have been monetary economies, all of this output is only potential unless entrepreneurs anticipate that they will be able to sell the goods and services they can produce for money.

It is both supply and demand that counts, and money is central to demand.   Expected future expenditures of money on output is central to the level of current production and employment.   And expected future monetary conditions  are central to expected future expenditures of money on output.

Both supply and demand are also important for understanding money's role as "measuring stick."    Tammy's views on the matter are confused, because he thinks that fixing the price of gold at $35 per ounce makes the dollar like a measuring stick.   A dollar is 1/35 of an ounce of gold.  

A fixed weight of gold is not an unchanging measure of value because the value of gold, like everything else, depends on both supply and demand.   New gold discoveries and improvements in mining and other elements of gold production technology impact the supply of gold.   Gold has a variety of nonmonetary uses, such as dental work, jewelry, and circuitry.   Changes in these impact the demand for gold.   And finally, the demand for gold for monetary purposes can change.  

A decrease in the supply or increase in the demand for gold would raise its value and an increase in supply or decrease in demand would reduce its value.    Anyone who took the dollar price of some good as a stable measure of its value would be mistaken.   It was the gold that defines the dollar that had changed in value.    An increase in the value of gold results in less money being spend on output, and in the long run, a deflation of prices and wages.   A decease in the value of gold results in more money being spent on output, and in the long run, an inflation of prices and wages.  

A paper currency with a fixed quantity would be free from the problems suffered by a gold standard due to changes in supply.   And assuming that paper currency has approximately no alternative uses, then dentistry, circuitry or jewelry would be irrelevant.   With currency solely being used for monetary purposes, it would be changes in demand for monetary purposes that would cause problems for paper currency's role as "measuring stick."

The Market Monetarist view is that the quantity of paper currency should adjust dollar-for-dollar with changes in the demand for money.   However, the relevant demand for money isn't the amount of money those selling goods and services would like to receive.   It is rather the amount of money that households and firms would like to hold.    To hold money is to not spend it.

If the quantity of paper currency adjusts with the demand to hold it, then changes in its value from that source are avoided.   This makes the paper currency a better "measuring stick" of value.  

Monetary disturbances can occur in a variety of ways.  It could be that the problem is caused by a change in the quantity of the paper currency when there was no change in the demand to hold currency.   Or, it could be caused by a failure of the quantity of currency to change when the demand to hold currency did change.   And finally, it is possible that both the quantity of currency and the demand to hold it are changing, but they are just not remaining equal and changing together.

The market process by which imbalances between the quantity of a paper currency and the demand to hold it are corrected includes changes in spending on output and finally changes in the levels of prices and wages.   Market Monetarists favor nipping the process in the bud at the point where spending on output changes by adjusting the quantity of money to the amount demanded.   Market Monetarists favor a level target for spending on output.

Of course, it is possible to instead anticipate the changes in prices and wages.   And while these price adjustments are the final stages of the adjustment process, if they are anticipated correctly, imbalances between the quantity of a paper currency and the demand hold could be avoided as well.

Unfortunately, the price level is also directly impacted by changes in the supply of particular goods and services.     A monetary regime that targets the price level generates an imbalance between the quantity of paper currency and the demand to hold it sufficient to change money expenditures on other goods and services enough to force their prices to change so that some price index remains on target.    A target for the level of spending is less subject to that difficulty.

Interestingly, a target for spending on output has consequences similar to a gold standard when there is a shift in supply for some good or service, (other than gold.)    For example, if a disruption in the supply of oil leads to a higher relative price of oil, there is nothing in a gold standard that forces all the other prices in the economy down so that the overall price level is unchanged.   Oil has become more expensive relative to gold and everything else, and so the price of oil in terms of a gold-defined dollar would rise.    If the prices of other goods (and wages) remain the same relative to gold, there is no tendency for their prices to fall.

To take another example, if productivity grows more slowly for a time, a target for spending on output will result in higher inflation for final goods and services, while leaving the growth rate of money wages relatively stable.   Stabilizing the price level (or inflation rate) would require slower growth in spending on output to keep the prices of final goods and services on target, and require a slower growth rate of money wages.     Unless the slowdown in productivity growth occurs in the gold mining industry, a gold standard would generate inflation in final goods prices similar to target for spending on output.  (Of course, it is possible that this would be a less rapid rate of deflation.)

Is GDP an ideal measure of spending on output?   No.  

But it is not as bad as Tamny appears to think.   He claims that if the government builds a useless "road to nowhere," GDP increases.   No, it doesn't.   The resources needed to produce that road are pulled away from the production of other goods and services.   The road counts as part of output, but the other goods sacrificed are no longer part of output.   What GDP "fails" to do is show the loss in human welfare because resources that would have been used to produce valuable private consumer or capital goods (or maybe some government good or service that was worth at least something) and instead were wasted on the road to nowhere.

Government spending, whether financed by taxes or deficits, causes the least disruption in the context of slow, steady growth of spending on output. Would it be better to create a shortage of money so that spending in the private sector would contract beyond what was already lost because of the tax hikes or government borrowing? Isn't it obvious that it is best for the private sector to reduce its expenditures by an amount equal to the increase in government spending, allowing for resources to be shifted from the private sector to the government?    Sure, it would be better to avoid wasteful govermment spending, but creating a monetary disturbance in response is adding insult to injury.

Tammy claims that increased imports reduce GDP, when really they represent increased investment in the U.S.   No, he is mistaken.   

It is true that imports are subtracted from total spending by U.S. firms, households, and goverment to calculate GDP, but U.S. capital goods purchased by those foreign investors are counted as part of GDP.    For example, suppose U.S. households purchase Chinese socks, freeing up U.S. labor and other resources to build shopping centers in the U.S. financed by Dutch investors.   The Chinese socks are not counted as U.S. GDP because they were produced in China.   But U.S. GDP isn't decreased, it just takes the form of a new shopping center produced in the U.S. rather than socks produced in the U.S.

Again, isn't it obvious that the underlying shifts in resources involved when there is a trade deficit matched by a net capital inflow are best accomplished in the context of steady aggregate spending on output?    People in the U.S. buy foreign goods, freeing up resources to produce capital goods here at home to be purchased by foreign investors.    Less spending on the products of import competing industries and more spending on capital goods.   Total spending is stable.

Market Monetarists don't believe that a larger quantity of money is always better.   Market Monetarists don't believe that increased nominal GDP is always better.   What we favor is slow, steady growth in nominal GDP.   We favor adjusting the quantity of money to the demand  to hold money.     Such a monetary regime enhances the ability of money to serve as a measuring stick of value, without taking it to a disruptive extreme. 

Most importantly, such a monetary regime takes into account both Supply and Demand.


  1. Great post as always!
    Thank you!

  2. Excellent blogging.

    Regarding GDP, I think it slips a few times especially in regards to pollution. If you grew in the 1950s in Los Angeles, the smog literally choked you at times. Today, 98 percent reduced....

    The Internet. Gee whiz, I send baby photos transcontinental...I read blogs...I can go to Wikipedia anytime...or find a close restaurant with reviews....freelance writing jobs....

    I am not sure what this means, as I agree with MM on targeting NGDP growth...but the numbers may be funny..actually suggest we target something else, like employment,,,

    I don't see any of this huge increase in the quality of life being captured by traditional GDP measures....

  3. GDP doesn't measure human welfare.

    With a nominal GDP level target, new environmental regulations would slow the growth of real GDP and result in (higher) inflation for a time. If the regulations were gradually made more an more restrictive, this could be permanent, but likely the economy would settle down on a lower growth path of real income and higher price level.

    But, people might be better off because they like cleaner air more than the material goods sacrificed. Real GDP is lower, but welfare is enhanced.

    If people decide to work less, then real GDP will fall. With a nominal GDP level target, this will result in inflation for a time, and a higher price level.

    If people enjoy the leisure more than the material goods and services sacrificed, then they are better off. Real GDP is lower, but welfare is improved.

    In my view the nominal GDP level target is still the best alternative when environmental regulation is imposed. It is probably less than ideal when people choose to work less.

    But I favor rules. And you pick the least harmful rule for a variety of situations. Suggesting that central bankers do what is best is no rule.