Home > Macro/Monetary Theory > C+I+G+NX is a Stupid Way of Teaching Aggregate Demand

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

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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  1. March 23, 2015 at 1:30 am

    Good post. I feel very much the same way. But I don’t do much about it.

    Unlike you, I must have taught intro macro about 30 times in my life. I suffer cognitive dissonance when I start with AD=C+I+G+NX, knowing it would make more sense to start with something like MV=PY, and talk about things that change V. The AD curve is a monetary phenomenon.

    If I wish I were younger and had more gumption.

    • Free Radical
      March 23, 2015 at 5:05 am

      haha, thanks Nick. It’s nice to know I’m not lost in the wilderness here. I’m anxious to see if you like my alternative to IS/LM, it’s actually shaping up nicely. It’s too bad I will probably never teach it. I don’t have quite enough gumption at this point to go that far (plus it would probably be pretty irresponsible). Have finals in the next few days and it will probably take a while to type it out but I should get it up later this week.

      • March 23, 2015 at 1:29 pm

        You are definitely not lost in the wilderness. AD only makes sense in a monetary exchange economy. It’s about people’s willingness to sell money to buy goods.

        Let me know when you do your ISLM alternative. Put an off-topic comment on my blog, or email me.

        There’s a big coordination problem in teaching intro and intermediate, where we don’t want to teach anything that doesn’t fit with what everyone else is teaching. (Sympathy for the really heterodox, who have it much worse.)

      • Free Radical
        March 23, 2015 at 7:14 pm

        Yeah, that’s why I said it would be irresponsible (sigh). I think my focus on the equation of exchange will still basically fit with the standard treatment. To be honest, I’m sort of giving myself a little leeway because I feel like practically nobody learns anything in introductory macro (except stuff like what GDP means etc.) so I feel like I can’t do that much harm. Maybe that’s a little too cynical but I don’t feel like I knew anything about macroeconomics when I graduated with an econ degree, and I was a pretty good student. I walked out of my first micro class feeling like I really had a good handle on supply and demand. I walked out of every macro class thinking “I don’t think any of this actually makes sense but I can’t really figure out why….?” (At least regarding IS/LM and AS/AD) But taking that kind of cavalier attitude to intermediate may be going a bit too far, so for now the IS/LM thing is just a mental exercise.

  2. May 15, 2017 at 12:11 pm

    Hi, I&;#v1782e been reading your blog for a while now. Glad you are having fun in Vegas and it is great that you could renew your vows! Enjoy, and good luck in the marathon. Give Lynn my love.

  1. December 31, 2016 at 1:12 am

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