Wednesday, December 3, 2008

Paul Krugman and the Vertical Aggregate Demand Curve

Paul Krugman is all over Amity Shales's argument that the New Deal's high wage doctrine reduced employment and ultimately output. He blasts her here, here, and here. His main beef with Shales is that her argument assumes an downward slopping aggregate demand (AD) curve which he asserts was not possible during the early-to-mid 1930s. In his words:
[I]n normal times the AD curve slopes down, we think, because other things equal a higher price level increases the demand for money, which drives up interest rates, which reduces desired spending. (In terms of IS-LM analysis, higher P leads to lower M/P which shifts LM left.)

But in liquidity trap conditions, the interest rate isn’t affected at the margin by either the supply or the demand for money – it’s hard up against the zero bound. And as a result the usual explanation for the downward slope of the AD curve doesn’t work.
As a result, Krugman claims that instead of a downward slopping AD curve there was a vertical slopping AD curve. This, in turn, means any leftward shift of the AS curve from the high nominal wages should have no effect on output. Here is his money graph:There is a problem, however, with Krugman's story. It assumes there is no real balance (or pigou) effect and if there is one Krugman claims it is swamped by the impotency of the interest rate channel effect and the effect of debt deflation. This assumption is highly controversial. I can buy that there was some steeping of the AD curve, but to forcefully conclude that it was perfectly vertical and, thus, high nominal wages had no effect on employment and output seems too extreme. Where is the conclusive evidence?

What is really remarkable is that despite this empirically-unsupported assumption, Krugman concludes as if it is truth and, therefore, claims that those observers who think otherwise are not "thinking it through":
The key point, then, is that the reality of a liquidity trap in the 1930s has crucial implications for what we think about the effects of policies like the NIRA. People who assert that New Deal support for wages made the Depression much worse aren’t thinking it through. They’re implicitly assuming – not demonstrating – that the AD curve had a “normal” slope, even in the depths of the Depression. But it didn’t.
Krugman may be correct in his assumption about the real balance effect, but I think one can reasonably disagree with him on this point until there is conclusive evidence.

Update: Tyler Cowen also questions Krugman's vertical AD curve.

Update II: Paul Krugman explains why he dismisses the real balance effect.

6 comments:

  1. Krugman is a rocket scientists.

    What kind of person asks a rocket scientist for evidence?

    >>can buy that there was some steeping of the AD curve, but to forcefully conclude that it was perfectly vertical and, thus, high nominal wages had no effect on employment and output seems too extreme. Where is the conclusive evidence?

    What is really remarkable is that despite this empirically-unsupported assumption, Krugman concludes as if it is truth and, therefore, claims that those observers who think otherwise are not "thinking it through"<<

    The empirical evidence against various iterations of the Keynesian cargo cult have been been piling up for more than 40 years.

    Why would would evidence stop Krugman now?

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  2. I thought AD - AS modeling and IS-LM analysis had been abandoned to the TA's teaching freshman macro.

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  3. AD-AS is taught in Principles classes, but the IS-LM is usually only taught in intermediate macro.

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  4. Round and round we go...didn't we have this debate circa 1950? And it did not go in favor of vertical AD curves....Krugman appears a poor historian of thought.
    But its surely an irrelevant debate anyway because the stabilizing effects of rising real money balances are outweighed by the destabilizing effects of debt deflation argued by Irving Fisher.
    Falling prices reduce revenues so that borrowers are unable to meet cash commitments, leading to defaults which shift the AD curve to the left.Asset price declines reduce collateral and this stymies lending.
    Its this leftward shift of AD that is critical, not movements along it.

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  5. ECB:

    I agree,the bigger issue is the AD curve shifting left, not its slope. Still, Krugman's use of a vertical AD to justify his view couldn't be ignored.

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  6. Krugman is on record saying he has no stomach for economics written, say, before his time in graduate school -- anyone who's read Krugman's "criticisms" of Friedrich Hayek knows well that Krugman hasn't read of word of the great economist.

    I'm guessing the same is true of most every other economist in the history of economic thought.

    Krugman looks to me like an early version and paradigm case of the "idiot savant" the AEA committee on graduate education was telling us about in the early 1990s.

    "Krugman appears a poor historian of thought."

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