The AD-AS model with a vertical AD curve

by on December 4, 2008 at 7:13 am in Economics | Permalink

Paul Krugman creates a simple model of the 1930s, based on a vertical AD curve; Greg Mankiw comments and Krugman adds some explanation.

I have a few comments (under the fold)...

1. In the 1940s, Franco Modigliani showed that this kind of argument required infinite liquidity preference, not just very strong liquidity preference.  This kind of discontinuity matters in most models with liquidity preference.

2. The model suggests that negative supply shocks don’t hurt the economy yet the Dust Bowl was bad for aggregate output.  Arguably the AD curve should be kinked and vertical only after some inflection point.  But then we are back to negative supply shocks mattering.

3. The model implies that labor unions won’t hurt output but the model does not show that labor unions won’t hurt employment and indeed the latter question was the original point of contention.  A sufficiently high legally binding minimum wage will cause employers to lay off workers, vertical AD curve or not.  Maybe capital substitutes for labor or Y stays put for some other reason but employment will go down.

4. I no longer understand Krugman’s overall story.  He notes that the New Deal years saw a good bit of recovery (I agree), he notes that fiscal policy was not very expansionary (I agree), he believes there was a liquidity trap (I don’t agree), and he believes that positive supply shocks run up against a more or less vertical AD curve and thus don’t help output (I don’t agree).  Given all of Krugman’s views, AS doesn’t much matter and AD didn’t much expand.  So what exactly drove the (partial) recovery of the 1930s?

Maybe I am taking the model too literally but without the vertical AD curve there is not much else in the model to interpret.

David Beckworth December 4, 2008 at 7:33 am

Krugman also assumes away any real balance effect and then treats it like a fact. Where is the evidence? Surely there was some real balance effect at work and if so, the there would be some downward slope to the AD as noted here.

babar December 4, 2008 at 8:36 am

I read the krugman post and too was confused. I think he was saying something more along the lines of “proposition X has an embedded assumption of a downward sloping AD curve” therefore “if there is no downward sloping AD curve then proposition X may not hold.† He can’t really say things like “I have good evidence that the AD curve was not downward sloping† – instead he says “what if it was vertical? Then what? Hmm? Then†¦† (He stops short of saying that the AD curve is vertical.)
I’d hazard a guess – based on dynamic system theory, I’m not an economist – that when the slope of a quantity that you generally study becomes zero, the model you want to be looking at is not the model with the zero slope – some other factor becomes more important. You can have discontinuities, etc. Your second derivative becomes important, as does knowing whether you are at an inflection or a min/maxima. So it is problematic to look at this kind of static model at all.

steve December 4, 2008 at 9:51 am

Great link, Tyler! This is a terrific exchange between two great minds both making cogent points quite clearly.

Greg Ransom December 4, 2008 at 12:37 pm

The important thing — important! — is to hold on to this “model” and this picture of how to do macroeconomic “science”.

Nothing else really matters, does it?

(I mean, besides the excuse this brilliant “rocket science” gives for Krugman’s politics).

Steve Roth December 4, 2008 at 1:56 pm

I’ve also found Krugman to be a bit incoherent, arguing positions counter to his own positions in a misdirected effort to debunk other positions that would be better debunked using other arguments.

But condensed, I think (?) he’d say:

The *net* effect of policies ’32-’36 was mildly expansionary but overall rather tepid, insufficient to break the negative cycle and re-establish a virtuous equilibrium.

Net policy effects ’36/’37 were contractionary, causing a resurgence of the still-lurking depression.

European orders starting in ’39 (yes, Tyler, I think he’d give you that one) followed by massive federal deficit spending beginning ’41 finally broke the depression’s back, creating the necessary demand to bring production back up to capacity.

And I’d say: True, consumer demand didn’t really increase during the war years, for reasons unrelated to fiscal or monetary policy (i.e., the war). But savings (E bonds especially) did increase. Once the war’s distortionary effects were removed, with the wheels of the economy spinning, the great prosperity arrived.

Phil P December 4, 2008 at 5:25 pm

Here’s what confuses me. Assuming the existence of a liquidity trap, I thought that means that there’s a floor to the interest rate, not a ceiling. So the aggregate demand curve would only become vertical at some point to the right, not for its entire length. If Krugman’s argument were right, there would be no limit to how high you could push the price level relative to the money supply without affecting output. Or to put it more simply, you could legislate a minimum wage as high as you please without affecting employment. Which doesn’t make sense. Or am I missing something?

Bill Stepp December 4, 2008 at 6:07 pm

Btw, as Alan Meltzer has pointed out (see his homepage for instance), no one has ever seen a liquidity trap.
A certain helicopter pilot has pointed out that there is a technology called a printing press, as well as stuff called paper and ink that the Fed could use to cause inflation. No open market ops required. Back to Meltzer: at least some of the new money would be spent. So much for his post.

DanC December 4, 2008 at 8:06 pm

BTW

Did Milton say something nasty to Krugman that Krugman has such an ax to grind?

pat toche December 5, 2008 at 12:39 pm

The time frame of the model is important. My understanding is that the model is for the next 6 months or so, perhaps one year. In this short time you would not expect capacity to be affected much on the capital side, and a little on the labor side (through layoffs, though existing labor presumably will be working that much harder to offset the loss of labor force in production units that don’t actually close down).

I too would like to know: when do we know for sure there is or isn’t a liquidity trap?

Oh, and one last comment particularly addressed to non-economists: these curves are “expected” curves in the sense that they relate a real quantity (real output) to a price, and that makes a not-too-straightforward interpretation: my understanding (correct me if I’m wrong) is that for every jerk in expectations you’d be jumping about the plane, presumably not necessarily locally but potentially all over the place.

J Thomas December 5, 2008 at 10:30 pm

Our current crisis had two steps. An oil price shock started a mild recession. The Fed seemed worried about inflation. Then a bubble of creatively created mortgages started to reset. Suddenly we saw that financial firms were taking on a great deal more risk then we realized. The core crisis is the huge drop in home values and the impact on the financial sector.

DanC, I believe you’re looking at the wrong questions here.

Sure, the financial sector was basicly running a ponzi scheme on housing, and they got caught with a lot of inventory themselves that they hadn’t passed on to customers. (Or maybe the real ponzi operators got out fine and it’s bankers who got sucked in who were caught.) And sure, the little oil increase made some difference. But there were fundamental problems which were far more central.

The US dollar was not sustainable as a reserve currency, but no one had a good alternative so they limped along with it.

The US/europe balance of trade against east asia needed some sort of resolution, but there was no sign of one.

USA used 1/4 of the diminishing oil, did not produce exports to pay for it. Who should get the oil, the USA or china which produces stuff the USA wants to buy?

Every nation has a comparative advantage. The USA’s comparative advantage was for complex financial derivatives. Demand for these products is low just now; how will we find other comparative advantages so we can produce value to the global economy to match what we consume? Or is that the wrong question?

It’s like, when month after month you spend more money from your checking account than you put in, sooner or later you’re going to bounce some checks. When you do, it isn’t so interesting precisely which checks you bounced.

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