Fukushima Meltdown
IAS 107: March 15, 2009 Lecture: Wrong Models of the Great Recession

Nick Rowe: Where Will the Demand Come From?


Worthwhile Canadian Initiative: "But where will the demand come from?" In praise of older Keynesians: It gets asked in every recession. Recovery requires an increase in demand. "But where will the demand come from?"... Macroeconomics is ultimately about closed systems.... Demand cannot come from outside the system. There is no outside. Demand comes (mostly) from itself. That's the answer that makes no sense whatsoever to most people. It's the logic of the Old Keynesian multiplier. The Hawtrey-Kahn-Keynes-Clower multiplier contains an important truth that is missing from nearly all modern macroeconomics.

The short side of the market determines quantity traded. Quantity sold is whichever is less: quantity demanded; or quantity supplied. If there is excess supply of goods in aggregate, then realised sales of goods, and income from those realised sales, is demand-determined. And if people are unable to realise their plans to sell as many goods as they wish (if they face Clowerian quantity constraints) then their demand for goods will depend on their realised sales, which is demand-determined. Demand creates income. And income creates demand. So demand creates demand. That's the fundamental insight of the Old Keynesian multiplier that was lost in the New Keynesian Euler equation.

Now I'm going to bring together two very unlikely bedfellows: Keynes and Say.

It's income from the realised sale of newly-produced goods that provides the wherewithal to purchase those same newly-produced goods. And if some people save part of their income and lend it to others to spend (on investment or consumption) more than their income it makes no difference in aggregate. Whether spent or lent, (nearly) all income is spent. That version of Say's Law (there are many versions, most having nothing to do with Say), which says that people in aggregate plan to spend all their income, is very nearly right. The marginal (and average) propensity to spend (on consumption plus investment) is (very nearly) equal to one. If the marginal propensity to spend is one (if the slope of the Keynesian Cross AE curve is one), then the Old Keynesian multiplier is infinite. An infinitesimally small exogenous increase in desired expenditure is sufficient to bring the economy to "full employment", where the supply constraint bites and stops further expansion. That, actually, is very close to my view of macroeconomics. It's an ungodly mix of Keynes and Say, seen through a Clowerian lens.

But it's only "very close". It's not exact. And that version of Say's Law, in which aggregate demand is determined by and equal to aggregate income, is only "very nearly" correct. There's something missing. What's missing is money. Add monetary disequilibrium to the mix of Keynes and Say.

None of the above makes any sense in a barter economy. The very distinction between aggregate supply and aggregate demand only makes sense in a monetary exchange economy, where we sell goods for money and buy goods with money. Money is the medium of exchange. As Yeager noted, there are always two ways to get more money: sell more goods; and buy less goods. If you face Clowerian quantity constraints on selling more goods, because there's an excess supply of goods, you can still buy fewer goods if you want to get more money.

It is money, and only money, that makes Say's Law false. If, in aggregate, we wish to hold more money than we currently hold, we will plan to spend less than our income. If, in aggregate, we wish to hold less money than we currently hold, we will plan to spend more than our income. An excess demand for bonds won't falsify Say. If there's an excess demand for bonds we can't buy more bonds, because the quantity of bonds is supply-determined. And if we can't buy more bonds, we have to spend our income ourselves. Or hold more money.

If the desired stock of money were identically equal to the actual stock of money, at all levels of income, then the Old Keynesian Cross model would have an indeterminate equilibrium. Any level of income between zero and "full employment" would be an equilibrium. At any level of income, demand would equal income, and income would equal demand. And so an infinitesimally small increase in the supply of money, or decrease in the demand for money, would be enough to create a self-perpetuating increase in demand, increase in income, further increase in demand, to get the economy to expand to where the supply constraint stops any further expansion. Or where inflation reduces the real value of the money supply, or leads the central bank to take away the punchbowl.

So don't ask where the demand will come from. It comes from itself. And from an excess supply of money.