Tyler Cowen links to an interesting post about the deflationary impact of the internet. This is interesting not just because it illustrates how technological change impacts the economy, but because it tells us something about recessions. Namely, it tells us that our current recession - like all of the other ones in recent memory - was caused by deficiencies in demand, not in supply.
Does output falter because people don't want to buy as much stuff, or because we become unable to make as much stuff as we used to? This is a debate that has gripped the macroeconomics profession for many decades. Which is kind of surprising to me, because it is so obvious that demand shocks are the culprit.
The reason is prices. If recessions are caused by negative supply shocks, then we should see falling output accompanied by rising prices (inflation). If recessions are caused by negative demand shocks, we should see falling output accompanied by falling prices (disinflation or deflation).
Draw a supply-demand curve for the whole economy, and it looks like this:
A negative shock to supply - for example, a resource shortage or an increase in harmful government regulation or a "negative technology shock" - will shift either the long-run aggregate supply curve or the short-run aggregate supply curve (or both) to the left. The new equilibrium will have lower output and higher prices. However, a negative shock to demand - for example, an increase in the demand for money - will shift the aggregate demand curve to the left; the new equilibrium will have lower output and lower prices.
In all of the recent recessions, faltering output has been accompanied by lower, or even negative, inflation. This means that demand shocks must have been the culprit. If "uncertainty about government policy" were really the cause of the recession, as many conservatives claim, then we would have seen prices rise - as companies grew less willing to make the stuff that people wanted, stuff would become more scarce, and people would bid up the prices (dipping into their savings to do so). I.e, we would have seen inflation. But we didn't see inflation.
So it seems that the stories that conservatives tell about the recession - "policy uncertainty," "recalculation," or even a "negative shock to financial technology" - are not true. The stories that everyone else tells about the recession - "a flight to quality," "increased demand for safe assets," etc. - look much more like what basic introductory macroeconomics would predict.
Of course, conservatives don't necessarily believe in the graph I included above. They may dismiss the idea of a downward-sloping AD curve (and an upward-sloping SRAS curve), and imagine that the AD curve is just a flat line (or maybe even an upward-sloping line?). In that world, supply changes, and only supply changes, determine the level of output, and demand changes, and only demand changes, determine the price level.
That's where the blog post that Cowen linked to comes in. In a world in which deflationary recessions (such as our current one) are caused by negative supply shocks, then positive supply shocks should also leave prices unchanged. In particular, an improvement in technology would cause us to produce more stuff at the same price, rather than more stuff at lower prices. However, if the internet is deflationary, it shows that positive supply shocks do, in fact, decrease prices. The AD curve slopes down, as it should.
The basic point here is about the dangers of doing what Larry Summers calls "price-free analysis". If you ignore prices, it is possible to convince yourself that recessions are caused by technology getting worse, or by people taking a spontaneous vacation, or by Barack Obama being a scary socialist. If you pay attention to prices - as all economists should - it becomes harder to believe in these things.
So the question is: Do conservative-leaning economists push these stories because they believe that we live in a world that is vastly more complicated than anything that can be described in Econ 102? Or is it just because they choose to ignore Econ 102 completely?
Worthwhile Canadian Initiative: Aggregate supply and relative supply -- and demand.:
Micro and macro are different. We have to be careful about drawing macro conclusions from what happens at the micro level. We can't just extrapolate. This is in response to Casey Mulligan's post on evidence that supply matters. He draws macro conclusions about aggregate supply from micro evidence about relative supply. Draw an Aggregate Demand curve with the Price level on the vertical axis, and real output on the horizontal. Suppose ...that the aggregate price level is fixed (or just very slow to adjust). ...And suppose there's excess supply of output.
The short-side rule says that actual sales are determined by whichever is less: quantity demanded; or quantity supplied. In this case the short side of the market is the demand side. Aggregate output is determined by aggregate demand. Aggregate supply does not affect aggregate output.
That says nothing about the determination of relative output of various sub-sectors of the economy. A change in relative demand may change relative prices and relative output and employment across different sectors of the economy. A change in relative supply may also change relative prices and relative output and employment across different sectors of the economy.
Imagine there's a fixed amount of tradeable permits to produce pollution. That creates a perfectly inelastic demand for pollution. Shifts in the supply curve have no effect on the total quantity of pollution. But because the permits are tradeable, shifts in relative supply and demand will change the relative amounts of pollution produced in different sectors. If people want to buy, or sell, more Eastern goods, we get more pollution in the East, and less in the West, but the total amount stays the same. We cannot extrapolate from micro evidence to macro conclusions. What is true for each of the parts is not true of the whole.
The keynesian/monetarist vision of demand deficiency is just like that. Except we are talking about GDP, not pollution. And the tradeable permits are called "money".
Casey Mulligan has micro evidence that increases in supply in particular sectors cause increases in output and employment in that sector. He uses that micro evidence to draw macro conclusions about the effects of increases in aggregate supply. Those conclusions don't follow.
Of course, we could say that same thing about people who draw conclusions about macro fiscal multipliers from estimates of micro fiscal multipliers. They are mistaking shifts in relative demand for shifts in aggregate demand.
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