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C+I+G+NX is a Stupid Way of Teaching Aggregate Demand

March 22, 2015 6 comments

I took another step in my slow transformation into a macro guy this quarter by teaching introductory macroeconomics for the first time. I have taught intermediate once and a little bit of intro in a combined class at a school that was on semesters but frankly, I didn’t cover much macro in that one. So working through the introductory treatment of AS/AD was a little bit of a rough process and I suspect I learned the most out of everyone involved, which is not exactly ideal but has some redeeming value nonetheless.

This was only partly due to my lack of experience. It was also largely due to what I consider to be a severely flawed approach to teaching this stuff at an introductory level. I started out just following the textbook they gave me, but by the end I was sort of blazing my own trail. I am beginning to see what I think is a much better way of doing this. So I am writing this mostly for my own benefit, to help organize my thoughts for future classes. But I welcome feedback.

I have two main gripes with the standard treatment of AS/AD. The first is best illustrated by this question from my textbook.

Describe whether the following changes cause the aggregate demand curve to increase, decrease, or neither.

  1. The price level increases.

  2. Investment decreases.

  3. Imports decrease and exports increase.

  4. The price level decreases.

  5. Consumption increases.

  6. Government purchases decrease.

The reasoning behind this question is probably obvious. At the very beginning of the chapter they define aggregate demand as the following.

AD=C+I+G+NX

So obviously if investment increases, that must increase aggregate demand right? That makes sense if you implicitly assume that C, G and NX all stay constant. But that’s a silly thing to assume. Obviously, each of these things is endogenous. They must be or else there would be no P in that equation and then it wouldn’t make sense to call it aggregate demand. So they must mean:

C(P,….)+I(P,…..)+G+NX(P,…..)

So at the very least, I(P,…) is an exogenous demand for investment at different price levels.   So just saying “investment increases” is reasoning from a quantity change. What you mean by “investment increases” must be “demand for investment increases.” But then you haven’t said anything other than “assume that aggregate demand increases, what is the effect on aggregate demand?” In which case, you haven’t really explained anything. In order to say anything interesting about how aggregate demand changes, you have to say what would cause an increase in demand for investment. And the things that change the demand for investment, sometimes also effect something else in there, and not always in the same way.

For example, you might say that a decrease in interest rates causes investment demand (as a function of the price level) to increase. But now you are reasoning from a price change. Why did interest rates fall? Did people become more patient? If they did, then you have an increase in the supply of loanable funds, a fall in the interest rate, an increase in investment demand and a decrease in consumption demand. Does that increase or decrease aggregate demand? Hmmmm……

On the other hand, what if you have a decrease in expected inflation. Does this change real interest rates? If not, what happens to demand for consumption and investment? If so, why? And then how does it change demand for investment and consumption? What if the central bank is setting a lower nominal rate and this is increasing inflation expectations and also lowering the real interest rate in the short run? This probably means investment demand is increased and consumption demand is also increased since people will want to consume more and save less at the same time that firms want to invest more.  If this is the case, how is it that interest rates are lower again?

These are the difficult questions one has to grapple with in order to figure out macroeconomics. And to be sure, you can’t explain them all satisfactorily in an intro class. You have to make some assumptions that simplify things. But the problem with this C+I+G+NX approach is that it forces students to reason in a way that doesn’t really make sense without them realizing that it doesn’t make sense and it makes them less capable of grappling with these questions in the future instead of more capable because it trains them to think carelessly.  It’s an intellectual dead-end street.

We should be teaching them to think carefully, organizing information in the way that is the most helpful for understanding the essence of the problem and keeping careful track of what assumptions go into that formulation. Instead, it seems like introductory macro is designed to give them as much random information to memorize as possible to keep them from thinking carefully enough about what is going on to realize that it doesn’t really make sense.

For instance, in their quest for more material to memorize, they give three reasons that the AD curve is downward sloping: the wealth effect, the interest rate effect and the international trade effect. These all amount to “when prices are higher, people can’t afford to buy as much” except the first one is this notion applied to consumption, the second is the same concept with respect to investment and the third is sort of the same concept with respect to net exports (I want to avoid going off on a tangent about international trade so I am going to glance over most of the stuff related to that). So why not just call this the “wealth affect” and say that it applies to both consumption and investment?

Next, we come to my other main gripe. When they are talking about things that shift the AD curve, the first thing they mention is changes in real wealth. Here is how they describe changes in real wealth.

“One determinant of people’s spending habits is their current wealth. If your great-aunt died and left you $1 million, you’d probably start spending more right away: you’d eat out tonight, upgrade your wardrobe, and maybe even shop for some bigger-ticket items. This observation also applies to entire nations. When national wealth increases, aggregate demand increases. If wealth falls, aggregate demand declines.

For example, many people own stocks or mutual funds that are tied to the stock market. So when the stock market fluctuates, the wealth of a large portion of the population is affected. When overall stock values rise, wealth increases, which increases aggregate demand However, if the stock market falls significantly, then wealth declines and aggregate demand decreases. Widespread changes in real estate values also affect wealth. Consider that for many people a house represents a large portion of their wealth. When real estate values rise and fall, individual wealth follows, and this outcome affects aggregate demand.

Before moving on, note that in this section we are talking about changes in individuals’ real wealth not caused by changes in the price level. When we discussed the slope of the aggregate demand curve, we distinguished the wealth effect, which is caused by changes in the economy’s price level (P).”

So when prices go up, you get poorer and move along the AD curve. Unless it is prices of stocks or houses, then you get richer and the AD curve shifts to the right. If this seems confusing, then you are probably thinking too clearly.

According to the book, the great depression was caused (partly) by the stock market crash of 1929 and the “great recession” was caused (partly) by the housing collapse of 2008. These are both wrong. The causality goes the other way. Financial markets react to changes in expectations about the future rapidly, so systemic problems with the economy tend to show up first in the markets.

If you are talking about the prices of all real estate or all stocks falling, are you talking about a change in relative prices or a change in the price level? If you are talking about the former, then a) why is that happening? And b) isn’t someone else’s real wealth increasing because they don’t own real estate and now they can buy more of it? How is it that some changes in relative prices make us poorer on aggregate and some make us richer?  The book offers no clear explanation for this.  If it is not a change in relative prices but a change in the price level, then isn’t it a movement along the demand curve, not a shift?  And if that’s the case, does that mean the AD curve is upward sloping?

These are questions you might ask if you were trying to figure out this whole AD thing.  It’s not exactly that they all can’t be answered, but the C+I+G+NX framework doesn’t help you answer them.  It makes it more difficult to wrap you mind around.  If you are trying to actually get to the heart of this thing, this is what you actually need to ask and answer

Q: Supply and demand for apples are measured in other goods that people are willing to trade/accept for apples. What is the demand for all goods measured in?

A: Money. AD represents people’s willingness to trade money for goods (consumption, investment, whatever). This means that it is all about the willingness of people to hold money. It’s all about money.

Now, why is AD downward sloping and what shifts it? To see this, instead of starting with Y=C+I+G+NX, ignore that because it doesn’t tell you anything worthwhile about what aggregate demand means or how it works, and instead start with this:

MV=PY

The equation of exchange. Like the first equation, this is also an identity. It must be true. Unlike the other equation, it highlights what actually matters. For starters, it has Y and P in it, so a student can easily derive an AD curve from it for a given V and M and see why it must be downward sloping. In short, this is because of the “wealth effect” described in the textbook, but now you can clearly see that it is just one effect which applies to money. If prices are higher, for a given amount of money and a given velocity, people can’t afford to buy as much stuff. This applies to both consumption and investment (and net exports as long as you assume they have to be purchased with domestic currency). So the downward-sloping part is pretty straightforward (again, assuming, for now, that velocity is constant).

Why does it shift? Well we can see easily that (for a given V) if you increase M, it will shift to the right. You don’t have to try to explain that increasing M lowers the interest rate and lowering the interest rate increases investment and deal with all of the implicit assumptions that are hidden in there. All of those assumptions are replaced by the assumption “V is constant.”

Similarly, if you hold M constant, then anything that shifts the AD curve must do so by changing velocity. This is the type of fundamental insight which is completely absent from the C+I+G approach. So take the things that the book says shift AD:

Real wealth: as we have already established, this is dumb.

Expected future prices: If people expect future prices to be higher, they will want to hold less money, they will want to buy more stuff today, velocity will increase and AD will shift to the right.

Expected future income: It’s actually not entirely clear that this should increase AD but here is what must happen if it does. Either it must make people want to hold less money at a given price level (and increase velocity) or it might increase the money supply. If banks are not reserve constrained, then people may borrow more and increase the broader measure of the money supply (or if you prefer, increase the velocity of M0).  Or if the central bank is targeting an interest rate, it might increase the money base as demand (supply) for loanable funds increases (decreases).

Furthermore, you can take government spending.  Instead of just saying “well it increases G so that’s an increase in AD right there” which is dumb.  You have to ask yourself difficult but interesting questions.  For instance, where does the money come from?  Maybe you increase taxes.  In which case shouldn’t that just crowd out private consumption? Yeah probably but how much does it decrease consumption?  Well you can go through the whole spending multiplier thing and argue (notice I’m not saying “show”) that when the government takes your money and spends it, it causes more total spending than if they just let you spend it.  Why?  Because you will hold less money that way, or in other words, it will increase velocity.

Alternatively, they could borrow it.  Who do they borrow it from?  If they borrow it from the private economy then won’t this crowd out private investment?  Yes.  To what extent?  Well, try to make some kind of argument that it will increase or decrease or not change velocity.  What if they borrow it from the central bank?  Then it’s an increase in M (and it’s really monetary policy) and it’s very clear how this will affect AD.

You wanna talk about “animal spirits?”  That’s basically just a way of saying that velocity drops for some reason we don’t understand and can’t explain.

Now of course, it is equally true that V probably won’t remain constant when the money supply changes, but now you have focused attention clearly on the important thing. Remember AD is all about peoples’ willingness to hold money.  And this is also the essence of Velocity. So we can start with the quantity theory (constant velocity) of money and then start asking what would cause velocity to change. And if you want, you can make velocity a function of the price level.

Let’s say that you think that velocity will be lower if prices are higher because when the price level is higher, it will take more dollars to equal the same amount of real money balances. You can explain that the AD curve will still be downward-sloping as long as the price elasticity of velocity is inelastic. At this point your intro class will probably look at you with glazed-over eyes but the point is that everything about AD depends on the quantity of money and velocity. All of the things that textbooks talk about shifting the curve by increasing investment or something like that are either wrong or they affect velocity. Instead of teaching them to think about C+I+G+NX, we should teach them to think about PY=MV. You can make velocity a function of whatever you want. But then you are concentrating on what matters. The fundamental forces which drive aggregate demand.

C, I, G, and NX are not the fundamental forces driving aggregate demand, they are just categories that you can divide it into. The fundamental force driving aggregate demand is the willingness to spend money on goods. It doesn’t matter if those goods are consumption or investment. The only thing that matters is how much money there is and how willing people are to hold that money instead of spending it on something. If you can grasp this concept, you get aggregate demand. If not, you don’t. If something affects AD, it must affect one or both of these. If you can see how it does that, you get it. If not, you are probably confused.

Now, this is all consistent with the model of aggregate demand taught in introductory macro, it’s just a better way of teaching it, in my opinion. When you get to intermediate, I have a similar set of gripes. So I am coming up with a better way of doing IS/LM. Coming soon.

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Land Theory of Value

March 15, 2015 2 comments

Nick Rowe has (tongue-in-cheek) post about the land theory of value.  I know he isn’t pushing that theory but as an exercise, let me try to address his ultimate question:

Plus, the Land Theory of Value is worth considering in its own right, or simply as an exercise in studying value theory. Why is it wrong? What are we looking for in a theory of value? What counts as success?

Bound up in this question is the question “what is value anyway?”  I think what most classical, and modern mainstream economists are looking for in a theory of value is a way to explain (relative) prices.  In other words, when they say “theory of value” they mean “theory of relative prices.”  They take for granted that prices are a measurement of “value” and try to construct a theory that explains how this is true.  This seems to be what Nick is after.

On the other hand, in my opinion–and internet Marxists will probably argue with this– the Marxist version of the labor theory of value is an attempt to define “value” independently of prices and then construct a theory which says that market prices are not representative of “value.”  If this is the case, then you have a way of claiming that mutually voluntary (or, in other words, free) trade can be exploitative (someone wins and someone loses) and this is a foundational assumption underlying most Marxist rhetoric.

So if you take the latter approach and assume that all value comes from labor, then nobody can prove you wrong.  If they say “okay, but what about this diamond, it is highly valuable but it takes very little labor to produce it,” you just respond “no, it isn’t highly valuable, because it didn’t take very much labor to produce it.”  And if that makes you uneasy, then maybe you make up alternate definitions of value like “use value” and “exchange value” so that you can avoid reconciling your definition of value with the actual prices of things.

So I think most economists find the latter approach unappealing.  The standard (subjective) theory of value also defines value independently of prices.  Value means the quantity of other goods (somehow measured) which someone is willing to give up for something.  This value is subjective and there is no attempt to explain where it comes from.  We merely assume that people have some willingness to trade goods for other goods.  A nice feature of this definition of value though is that, once you use it to explain prices, you find that prices are, in fact, a measure of value (specifically marginal value).  So if, when you say “a theory of value,” you really mean “a theory of prices,” then this theory works for you, because it does explain prices.

Now what Nick seems to be describing is a theory of prices.  He (or technically, his Dutch ancestor) is basically arguing that you can explain the prices of things in reference to land.  It is not an independent theory of “value” (meaning independent of prices).  It takes for granted that price is a measure of “value” and seeks to explain these measurements.  But the theory described here does not explain these at all, it only shows that prices can be measured by a standard unit of land.  This should not be surprising if you believe in the standard (subjective value) theory.  In that model, you can measure the value of any good in terms of any other good.

Take this part.

You have to consider the marginal land, that is exactly on the margin between producing wheat and producing barley. If that marginal land could produce two tons of wheat or four tons of barley per acre, then the value of one ton of barley must be half the value of one ton of wheat. That way we can compare the value of land that only grows wheat to land that only grows barley. And the market prices will themselves tell us the relative values of all different sorts of land, so we can convert them all to standard land.

So you can observe the marginal rate of transformation between wheat and barley and that will be equal to the price.  That’s fine.  But that does nothing to determine why the margin is where it is.  If there is a concave PPF, then the marginal rate of transformation between wheat and barley depends on how much of each the society chooses to produce.  How do they determine how much wheat and how much barley to produce?  Well if you believe in subjective value, then they buy whatever they value more until, on the margin, they are indifferent between $1 worth of wheat and $1 worth of barley (or if you prefer, you can measure the market price in any other good).  This subjective value, along with the various production possibilities, determines a price.

If you wanted to, you could take some wheat land and use it to raise cockroaches.  Assuming that no land is being used for this and the market price of cockroaches is negative (you pay to get rid of them).  Do we conclude that the true “value” of cockroaches is determined by the amount of cockroaches you could raise on a “standard” unit of land?  If so, is the price wrong?  The lack of an existing margin also presents other problems but it’s not necessary to go into them.  The point is that chickens are more valuable than cockroaches not because they take more land to produce but because we subjectively are willing to give up other goods for one and not the other.

Now, of course, if things work the way the standard theory says, then the relative price of wheat and barley will be equal to the marginal rate of transformation between the two.  So if you can observe the marginal rate of transformation, you can observe the price.  But this is different from explaining the price.  In order to do that, you have to explain why the margin is where it is.  And in order to do that, you need subjective value.  Of course, Nick pointed this out to his ancestor and his ancestor made a meaningless reply.

Preferences! We cannot observe preferences. Land is real and objective. And the margin of cultivation between wheat and barley is real and objective, and we can observe it. We don’t need no stinking preferences to determine value!

But, again, the only difference between preferences and the margin of cultivation is that the latter is observable and the former isn’t.  So if all you want in your theory is a way of observing value, then this works fine.  But if you want to explain value, then you need subjective preferences.  And besides, if you just want to observe value, you can just look at prices.  So what is the point of a supposedly deeper “theory” based on land which only amounts to a more difficult way of observing the same thing?

The same argument applies to Van Rowe’s argument about crop rotation.

If there are three different crops, and three different ways of rotating them that are not linearly dependent, and all three rotations produce the same rate of profit, as they must, it is trivial matrix algebra to solve for the values of each crop.

There is no sense, independent of market prices, in which all 3 rotations must have the same profit.  They must have the same profit only if prices are such that the farmer is indifferent between them.  In a large market like those that people like me imagine, this will always be the case somewhere for someone and therefore, in theory, if you could find all of the marginal farmers and observe their production matrixes, you could back out the market prices.  But, again, you would not have explained why those margins are where they are.  In order to do that, you need a market to determine prices and that requires a demand curve, and that requires preferences.

All of this is ultimately equivalent to saying: “Supply determines the price, you don’t need demand.  See, we can always just look at the marginal cost of production and figure out the price.”  That’s nonsense, and so is this theory.

 

 

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