Saturday, May 30, 2015

What is "effective demand" and why do we care?


Chapter three of The General Theory is The Principle of Effective Demand. Keynes opens the chapter with some definitions. I want to skip a few of them and get to the ones where he defines the term "effective demand".

We begin with supply and demand. We begin with the "aggregate supply function" Z and the "aggregate demand function" D:
Let Z be the aggregate supply price of the output from employing N men ....

Similarly, let D be the proceeds which entrepreneurs expect to receive from the employment of N men ....

Now ... if D is greater than Z, there will be an incentive to entrepreneurs to increase employment ... up to the value of N for which Z has become equal to D. Thus the volume of employment is given by the point of intersection between the aggregate demand function and the aggregate supply function; for it is at this point that the entrepreneurs’ expectation of profits will be maximised. The value of D at the point of the aggregate demand function, where it is intersected by the aggregate supply function, will be called the effective demand.

So effective demand occurs at the equilibrium point where the supply curve and the demand curve intersect -- where they intersect in the expectations of entrepreneurs. That's according to Keynes. And I think he's the one who invented the term, so his is the definition I want to use.

To my simple mind, thinking like a consumer, thinking of demand as a quantity demanded -- gasp!! -- the term makes perfect sense. "Effective" demand is given by actual purchases: by how much we spent. I can't think of a better fit for the word "effective". This goes back to Adam Smith:

The market price of every particular commodity is regulated by the proportion between the quantity which is actually brought to market, and the demand of those who are willing to pay the natural price of the commodity, or the whole value of the rent, labour, and profit, which must be paid in order to bring it thither. Such people may be called the effectual demanders, and their demand the effectual demand; since it may be sufficient to effectuate the bringing of the commodity to market.

But as we all know, now, "quantity demanded" is not the same as demand. So, "how much we spent" to buy that quantity can't be demand, either. And that means that "actual purchases" cannot be demand. (Clearly, "actual purchases" are the same as "quantity demanded"!)

Yeah, I have trouble with that. As a demand-side entity, I think I express demand by buying things. I don't think I express demand by woulda-buying more at a lower price and woulda-buying less at a higher price. If your price is too high and I buy little, well, that's the demand I express then. If you think you can get me to buy more by lowering the price, go for it.


Effective demand occurs at the intersection of supply and demand, where supply is

the expectation of proceeds which will just make it worth the while of the entrepreneurs to give that employment

and demand is

the proceeds which entrepreneurs expect to receive from the employment of N men

according to Keynes. Demand in this view is the demand for labor. Supply is not supply at all, but is the minimum acceptable return that brings supply to market. This is altogether supply-side machinery.

So why do I care about effective demand? I guess I don't.

Come to think of it, why do I care about the grand distinction between "demand" and "quantity demanded"? Because economists tell me this distinction exists?? That ain't gonna happen.

I'm easily convinced of things, by good argument. The argument that economists make a distinction, that's not good argument. Seems like an appeal to authority.

Or maybe it's just ego.

Friday, May 29, 2015

Chapter Three, Section Three, Three Paragraphs


The idea that we can safely neglect the aggregate demand function is fundamental to the Ricardian economics, which underlie what we have been taught for more than a century. Malthus, indeed, had vehemently opposed Ricardo’s doctrine that it was impossible for effective demand to be deficient; but vainly. For, since Malthus was unable to explain clearly (apart from an appeal to the facts of common observation) how and why effective demand could be deficient or excessive, he failed to furnish an alternative construction; and Ricardo conquered England as completely as the Holy Inquisition conquered Spain. Not only was his theory accepted by the city, by statesmen and by the academic world. But controversy ceased; the other point of view completely disappeared; it ceased to be discussed. The great puzzle of Effective Demand with which Malthus had wrestled vanished from economic literature. You will not find it mentioned even once in the whole works of Marshall, Edgeworth and Professor Pigou, from whose hands the classical theory has received its most mature embodiment. It could only live on furtively, below the surface, in the underworlds of Karl Marx, Silvio Gesell or Major Douglas.

The completeness of the Ricardian victory is something of a curiosity and a mystery. It must have been due to a complex of suitabilities in the doctrine to the environment into which it was projected. That it reached conclusions quite different from what the ordinary uninstructed person would expect, added, I suppose, to its intellectual prestige. That its teaching, translated into practice, was austere and often unpalatable, lent it virtue. That it was adapted to carry a vast and consistent logical superstructure, gave it beauty. That it could explain much social injustice and apparent cruelty as an inevitable incident in the scheme of progress, and the attempt to change such things as likely on the whole to do more harm than good, commended it to authority. That it afforded a measure of justification to the free activities of the individual capitalist, attracted to it the support of the dominant social force behind authority.

But although the doctrine itself has remained unquestioned by orthodox economists up to a late date, its signal failure for purposes of scientific prediction has greatly impaired, in the course of time, the prestige of its practitioners. For professional economists, after Malthus, were apparently unmoved by the lack of correspondence between the results of their theory and the facts of observation;— a discrepancy which the ordinary man has not failed to observe, with the result of his growing unwillingness to accord to economists that measure of respect which he gives to other groups of scientists whose theoretical results are confirmed by observation when they are applied to the facts.

The General Theory, of course. From 80 years ago.

Thursday, May 28, 2015

I think I learned something from yesterday's post


Just the other day I wrote

It ain't demand if you don't put your money where your mouth is.

Now I'm starting to "get" Scott Sumner's definition of demand, the economists' definition. I guess the stuff we buy measures actualized demand or realized demand or something like that. But it doesn't fully describe the "shape" of demand. For if the stuff we bought had been selling at different prices, the actualized or realized demand would have been different.

Let's say demand is a line on a graph. It runs from high on the left, to low on the right. As it goes from the left to the right, the x-axis value increases. "Quantity demanded" increases.

As it goes from high to low, the y-axis value falls. The price falls.

This graph -- this is the part I get now, that I didn't get before -- this graph is not a picture of demand over some period of time. It is a picture of demand at a moment, at any given time. The present moment, say.

How can there be a whole bunch of different quantities demanded, and a whole bunch of different prices, all at the same time? Because, I think, because it's not a demand-side picture of demand. It's a supply-side picture of demand. The graph is for a supplier who is considering his possibilities: If I sell it for this much, I'll sell this many; if I sell it for that much, I'll sell that many. It makes sense to me, this way.

And, granted, if sellers lowered their prices, we probably would buy more.

It's a "ceteris paribus" graph, nothing else changes but price and (as a result) the quantity demanded. And the line on the graph, the line that shows all those hypothetical quantities demanded at all those possible prices, that line is "demand", according to economists. I still prefer the Keynesian call: it's a demand schedule. But economists just call it "demand". And you have to we have to understand what the economists are thinking, or we get scolded by people like Sumner

The amount of ice cream you want at a fixed price level is quantity demanded. One of the most basic concepts in economics is that one should never confuse demand and quantity demanded.

and David Glasner

Never Mistake a Change in Quantity Demanded for a Change in Demand

(read the Glasner post, for more on this topic) and no doubt by others. And we don't want to get scolded!

//

So. At this writing (26 May) it is less than a week since I said Demand is measured by what we spend. But now I'm singing a somewhat different tune. (Maybe that makes up for some of the fun things I've been saying? Maybe not.) But here's what I learned:

The thing that consumers (like me) call "demand" is not the same as what economists call "demand". What we call demand, Sumner calls quantity demanded. It's a location on the x-axis. It's one of a whole possible range of quantities that would (or could, or might) be demanded, depending on where the price is set.

Let's push this to macro.

GDP is a point on the x-axis. It is a "quantity demanded". It is not "demand", not for economists. For economists, demand (or at the macro level, aggregate demand) is the line on the graph. It includes all the possible quantities demanded at all the possible prices. Possible or reasonable prices. Whatever.

The thing that economists call "demand" is a demand schedule. And the thing that consumers call "demand" -- a single point on that line on the graph -- I'm thinking now that maybe that is effective demand. I'm saying, the point on the aggregate demand curve that corresponds to what we actually bought -- to GDP -- that point gives us "effective demand".

I don't know. I sure hope this is right.

Wednesday, May 27, 2015

I just can't do it in two sentences, Scott


Yup. Still Sumner.

In the comments on his no such thing post, Scott Sumner wrote

The amount of ice cream you want at a fixed price level is quantity demanded. One of the most basic concepts in economics is that one should never confuse demand and quantity demanded.

You're being a dick again, Scott. You're doing that cliquey thing economists do. To somebody who doesn't understand the concept, restating the concept more rigorously doesn't make the concept clear. It just makes you look like a dick.

See how I'm using simple words to get the point across?

As I understand the concept (which may very well be not as economists understand it) aggregate demand means "totaled up" demand. I don't need a degree in economics to understand that, because I know what the word "aggregate" means.

Maybe you guys have invented some other meaning for the word "aggregate". I wouldn't be surprised. I know you have some other meaning for the word "real".

//define aggregate demand

Okay. I looked it up. Pikiwedia says
In macroeconomics, aggregate demand (AD) is the total demand for final goods and services in an economy at a given time. It specifies the amounts of goods and services that will be purchased at all possible price levels. This is the demand for the gross domestic product of a country. It is often called effective demand ...

The first sentence of that excerpt is exactly what I think. The second sentence says something completely different. It's another "compromise" paragraph, written by people who change each others words.

The second sentence refers to goods "purchased at all possible price levels". This is what I think you are referring to, Scott, as "demand" as opposed to "quantity demanded". Something like

  •  If we sell it for one cent, we will sell 100 of them, but
  •  If we sell it for two cents, we will sell 99 of them, but
  •  If we sell it for three cents, we will sell 98 of them, but
  •  If we sell it for four cents, we will sell 97 of them, but
  •  If we sell it for five cents, we will sell 96 of them, but
  •  If we sell it for six cents, we will sell 95 of them, but
  •  If we sell it for seven cents, we will sell 94 of them, but

and so on, for all possible price levels. (Clearly, at Wikipedia they don't know what "all possible price levels" means.) (To shorten the list, I have left out the selling price of 1.10 cents, and 1.20 cents, and 1.11 cents and 1.12 cents, and 1.111 and 1.112 and 1.1111 and 1.1112 cents and infinitely many other "possible" price levels.)

Come to think of it, I don't know what Wikipedia means by demand for final goods and services "at a given time". The total demand for final goods and services during a given time period is GDP for that time period. The total demand at a given point in time is not GDP; it could be something else. Is that what you mean, Scott? Okay, I see it now. But we're talking about when time is stopped, as opposed to when time is moving forward. As I see it, if time is not moving there can be no demand. If we stop time, imaginarily stop time, we can do things like count up the money that's in M1 or add up the total amount of debt outstanding. But you can't buy anything when time is stopped. You can only look at numbers. I don't know if that makes sense to you, Scott. It makes sense to me.

I'm also not sure what Wikipedia means by the word will: "goods and services that will be purchased at all possible price levels." They don't say "could be purchased" or "would be purchased" or "might be purchased". There's nothing conditional about it. They predict the future boldly. If they had been talking about the past instead, they'd have said "goods and services that were purchased at all possible price levels." I really don't know what that could mean, but I'm sure it makes at least as much sense as Wikipedia's version.

// a demand schedule

The nonsense table I made up just above -- if we sell it for 1 cent, if we sell it for 2 cents, if we sell it for 3 cents, etc. -- that's a demand schedule, isn't it. Keynes wrote about that stuff:

... the volume of employed resources is duly determined, according to the classical theory, by the two postulates. The first gives us the demand schedule for employment, the second gives us the supply schedule ...

I was trying to imagine a train schedule, one that lists all the times during the day that a train will stop at the station, and where it will go. Change that to "demand schedule", one that lists all the possible prices we can buy stuff at, and what we will buy at each price. Yeah, that doesn't seem to help. Anyway, it's all hypothetical. The word "will" certainly doesn't belong there.

I looked it up. Investopedia:

DEFINITION of 'Demand Schedule'

In economics, the demand schedule is a table of the quantity demanded of a good at different price levels. Thus, given the price level, it is easy to determine the expected quantity demanded.

They crack me up. It is "easy" to determine the expected quantity demanded, but only after you have created your list of the quantity demanded at every possible price level. Or, not to be a dick, at every reasonable price level.

And it's easy to make up such numbers. Economics textbooks are littered with 'em. But that's not the same as actually knowing how many you would actually sell at each of those price levels.

This demand schedule can be graphed as a continuous demand curve on a chart having the Y-axis representing price and the X-axis representing quantity.

INVESTOPEDIA EXPLAINS 'Demand Schedule'

A demand schedule is typically used in conjunction with a supply schedule showing the quantity of a good that would be supplied to the market at given price levels. Then, graphing both schedules on a chart with the axes described above, it is possible to obtain a graphical representation of the supply and demand dynamics of a particular market. Ceteris paribus, the market will reach equilibrium where the supply and demand schedules intersect. At this point, the corresponding price will be the equilibrium market price, and the corresponding quantity will be the equilibrium quantity exchanged in the market.

So (to refresh our memory) Scott Sumner said

One of the most basic concepts in economics is that one should never confuse demand and quantity demanded.

I think he means that demand (i.e., the aggregate demand schedule) is not measured by how many you sell, but by how many you would sell at all the different possible price levels, or, again, at all the different realistic price levels.

Cliffs Notes seems to resolve a few things:

In macroeconomics, the focus is on the demand and supply of all goods and services produced by an economy. Accordingly, the demand for all individual goods and services is also combined and referred to as aggregate demand. The supply of all individual goods and services is also combined and referred to as aggregate supply. Like the demand and supply for individual goods and services, the aggregate demand and aggregate supply for an economy can be represented by a schedule, a curve, or by an algebraic equation

The aggregate demand curve represents the total quantity of all goods (and services) demanded by the economy at different price levels.

So yeah, Scott and Cliff seem to agree, and I seem finally to understand what they were trying to tell me. But I still don't buy it. "Demand" is measured by what we actually in fact buy. Period. How much we could buy today, once we start the clock, at a whole array of different price possibilities, that is not demand. It is a "demand schedule" -- an imaginary list of possible sales volume numbers for all those different prices.

As far as I can tell, however, this dismal distinction between "demand" and "demand" gives us no clue as to why there may be no such thing as global aggregate demand. So, as far as I can tell, when Sumner said

The amount of ice cream you want at a fixed price level is quantity demanded. One of the most basic concepts in economics is that one should never confuse demand and quantity demanded.

he was simply being a dick.

Tuesday, May 26, 2015

Again, the "natural" rate of output


Which part of this graph would you say shows "natural" output?

GDP Growth Over the Very Long Run
Max Roser (2014) – ‘GDP Growth Over the Very Long Run’. Published online at OurWorldInData.org. Retrieved from: http://ourworldindata.org/data/growth-and-distribution-of-prosperity/gdp-growth-over-the-very-long-run/ [Online Resource]

Before you answer let me say I think there must have been a similar peak in the time of ancient Rome. Smaller than ours, but no less temporary. And probably others.

When a peak rises like that, it's not "natural". It's the result of economic management, coddling, encouragement, and stuff like that. And finance. Not only technology. Probably not primarily technology.

Maybe it's all natural, the extended low, the rise to peak, and the fall back. But then, the rise and fall is only a momentary blip on the screen.

Here's another look, with some old MeasuringWorth data that's no longer available:

Graph #2
This graph only goes back to 1688. The first graph goes back to year one.

//

The graph of MeasuringWorth data is from 2010 maybe or 2011. It's a Google Docs spreadsheet graph, I recognize it. So I searched my old Google Docs files and found it. Exported it to XLS format, added some current UK GDP data for comparison -- the new and old datasets differ! -- and provided a link to the older data that MeasuringWorth no longer provides.

Might not be worth anything: The current dataset begins with 1820. The old dataset contains only five values before that date: 1300, 1688, 1759, 1801, and 1811.

Huh. I wonder why they didn't have a number for 1086. From the Domesday book.

Monday, May 25, 2015

The natural rate of output


Okay, so when I googled it I got 180 million results for the natural rate of output. I thought maybe I'd show them all here. (chuckle chuckle)

Number one on the list, from SparkNotes:

Natural Rate of Output - The rate of output when the factors of production, capital and labor, are used at their normal rates.

"Normal rates". Number one on the list. Plus they had big colorful circles, and pictures of cute girls and stuff.

From one extreme to the other, the second of those 180 million results is from Wikipedia:

In economics, potential output (also referred to as "natural gross domestic product") refers to the highest level of real Gross Domestic Product output that can be sustained over the long term. The existence of a limit is due to natural and institutional constraints. If actual GDP rises and stays above potential output, then (in the absence of wage and price controls) inflation tends to increase as demand for factors of production exceeds supply. This is because of the limited supply of workers and their time, capital equipment, and natural resources, along with the limits of our technology and our management skills.

More than I wanted to know. (If the wikiparagraph seems unfocused, that's probably because it's a compromise written by people who disagree with each other. Everybody gets to say a little of what they want to say.)

So, per Wikipedia, when Sumner writes

... monetary stimulus that boosts output closer to the natural rate.

I should read

... monetary stimulus that boosts output closer to potential.

That makes more sense to me.

I worked with a guy years back who said that if the progress of the world had depended on him, we'd all still be living in caves. I always took him to mean he didn't think of himself as part of what Arnold J. Toynbee called "the creative minority". But anyway: Living like cave men, that's natural. I have no trouble with "potential output" as an economic concept, but I don't think you want to equate it with the cave man rate of output.

Oh, and I didn't bring this up in the earlier post, but what is that awkward construction supposed to mean? "The natural rate of output." Rate of output growth? You'd think. But if Sumner meant "boosts output closer to potential" then I think he means the level, not the rate. But he said "rate". That's just casual conversation, sloppy ... natural conversation.

Sloppy conversation is out of place in a post like Sumner's. Unless he meant the whole thing as a joke.

Hm.

Nah. My response to Sumner, my whole response was a joke, because his argument didn't deserve to be taken seriously; that was my whole point. But Sumner wasn't making joke. He was having a serious disagreement with Rajan, with Nick Rowe, and others.

//

What else we got?

The third hit of those 182 million is from the Fed. That's good. They often have the best answer.

Well, they offer two definitions:

  •  potential output: "the level of output that would prevail under perfect competition"
  •  natural output: "the level of output that would prevail with flexible prices and wages"

I'm not comfortable with either of those definitions. That's how you know when people are economists: They use definitions and terms and names that are supposed to have definite and particular meaning, and nobody outside the clique knows what the fuck they're talking about. Pardon my French.

The fourth hit is for the natural rate of unemployment. So we're done here.

Sunday, May 24, 2015

The natural rate of painting himself into a corner


The most interesting part of Scott Sumner's no such thing post was this right here:

And when those economies are artificially depressed by a combination of low NGDP and sticky wages, then the rest of the world benefits from monetary stimulus that boosts output closer to the natural rate.

The natural rate of output. I never heard of that one. Well... I heard of the natural rate of unemployment. I suppose the two are related by Okun's law: There's a tight relation between employment and output. But that doesn't prove there's any such thing as the natural rate of output.

If you have a natural rate of unemployment, I guess you could have a natural rate of output growth. So the question is: Do we really have a natural rate of unemployment?

I'm not touching that one.

//

Sumner expresses the idea that an economy might be "artificially depressed" by "low NGDP and sticky wages". Well, I'm not an economist so I don't have to have an opinion on whether wages are sticky. But if wages are sticky, that's a natural phenomenon. Not an "artificial" one.

Thus it is fortunate that the workers, though unconsciously, are instinctively more reasonable economists than the classical school, inasmuch as they resist reductions of money-wages...

If wages are sticky, it is because of human nature. That's not "artificial". And if NGDP is low, that's not what makes the economy depressed. It's what we measure so we can tell if the economy is depressed. Sumner depends a lot on his own popularity instead of on clear thinking these days. He used to be better than that.

I agree with Auburn Parks. It is as if Sumner has painted himself into a corner by his prior argument. And now he is stuck having to say stupid things to prop up his entire conceptual framework for understanding the modern economy.

Saturday, May 23, 2015

Two, not of the same kind


Sumner says "There is no such thing as 'global aggregate demand'".

He doesn't say global aggregate demand cannot be measured. He says there isn't any.

That's idiotic.

Sumner also said "Aggregate demand is fundamentally a monetary concept". That's interesting. Keynes complained that "The National Dividend, as defined by Marshall and Professor Pigou, measures the volume of current output or real income and not the value of output or money-income." So, Sumner is child of Keynes on this point: Keynes said we ought to consider nominal demand, and Sumner does.

Keynes also pointed out that "the community’s output of goods and services is a non-homogeneous complex which cannot be measured ... except in certain special cases".

But he didn't say there isn't any.

The Cobb-Douglas production function


At Twenty-Cent Paradigms, Bill C presents the Cobb-Douglas production function at origin, "in a 1928 AER article, 'A Theory of Production,' by Charles Cobb and Paul Douglas." 27-page PDF.

Bill's post is very good. I didn't tackle the PDF yet.