Another look at why both AD and AS matter

Often I read blog posts by other economists, using the AD-AS model.  The implicit assumption is that there is either too little AD, or too little AS, but the two problems do not and indeed cannot exist together.  If the economy is well-described by these two curves, that is indeed the implication: if AD is shifted in too far to the left, how can there be too little AS?

I suggest a slightly more complex model.  During the financial crisis the American economy took a big AD hit due to debt overhang, falling asset prices, unemployment, imperfect monetary policy, credit contraction, and several other factors.  After the peak of the crisis there were massive layoffs, largely because of these AD problems, toss in an increase in the risk premium and perhaps higher fixed costs of employing people.  A lot of the labor market problems from this hit still have not been cleaned up, and furthermore with lower net wealth many of these jobs are never coming back, with or without monetary stimulus.

Now fast forward.  These days, the layoffs are no longer so frantic, but the rate of new job creation is slow.  Some of the unemployed (not all) could find new work by moving to North Dakota or Australian mining communities, but few of them will do so, mostly for the obvious reasons.  They are waiting for good, new jobs in areas they are willing to live in.  But slow underlying rates of innovation mean slow job creation and so many of these unemployed continue to wait.  It also means a very low quit rate, which we have observed too, because employed workers can’t so easily step into new jobs.

The economy still has a problem with weak AD.  The economy also has an ongoing problem from weak AS.  Both are true, though you won’t see this if you think those two AD and AS curves sum up the whole picture.  Again, it is about the disaggregated aggregate demand.

Thinking even a little bit hard about the derivation of the AD curve (especially in “p space” rather than “p dot space”) should cure one of the tendency to take these models too literally.  Note also that most AD-As models are not integrated with growth theory, though the Modern Principles text with Alex is a big exception here.

Here is further simple proof, using seasonal data, that both blades of the scissors matter.  Via Matt Yglesias, here is a iscussion of how productivity growth in the recovery — if you could call it that — is lagging behind other U.S. business cycles.