Paul Krugman’s View of Aggregate Demand and Aggregate Supply

Paul Krugman responds to my earlier post.  He has a lot to say that’s worth commenting on.  I think we actually agree on quite a bit though there are points where we disagree.  Let’s take a look. (Paul’s comments in italics).

As I see it, we [i.e., Keynesian macroeconomists] have a general proposition — most recessions are the result of inadequate demand.

I basically agree with this though I admit that I don’t have a particularly clear definition of what we really mean by “aggregate demand.”  I think often this is meant to capture changes in consumer sentiment, fluctuations in government demand for goods and services or other incentives to purchase market goods – incentives which would include tax subsidies, monetary stimulus, … etc.

[…] we have a pretty good model of aggregate demand, and of how monetary and fiscal policy affect that demand. That model is IS-LM, with endogenous money as appropriate. 

Again I basically agree, with the caveat that the IS-LM model is at most just a sketch.  The consumption block of the IS-LM model is much better treated by a modern consumption demand component augmented suitably with credit constraints, some hand-to-mouth behavior and perhaps some myopia.  The investment block needs some serious work. My own sense is that it is also much better handled with a modern formulation rather than a simple relationship between investment and the real interest rate.  I would also stress that while the IS-LM sketch is pretty good as it stands, it desperately needs to incorporate a serious treatment of the financial sector. In a sense there is a third market / third curve missing from the model – one which gives the interest rate / loan terms faced by consumers as a function of collateral, net worth, etc.  We would then get a lot closer to a sketch which could capture important elements of the financial crisis.  (See below for a more precise description.)

We do not have an equally good model of aggregate supply.

I completely agree.

What we have, instead, is an observation: prices and wages clearly are sticky in the short run, and maybe for longer than that. There’s overwhelming evidence for that proposition, but in trying to justify it we engage in various kinds of hand-waving about menu costs and bounded rationality.

On the evidence I am again in complete agreement.  I actually think Paul is being too dismissive of the justifications for why we see price and wage rigidity.  Macroeconomists have invested a huge amount of time and energy into studying price setting behavior and these studies give a pretty clear picture of what is going on at the “micro level.”  It’s not just hand-waiving.  Paul continues…

we can […] be fairly sure that expansionary policies in a depressed economy won’t be inflationary, and we can use the pretty good demand side model to tell us that monetary expansion won’t work but fiscal policy will when we’re at the zero lower bound.

I sort-of agree with this.  Certainly if the interest rate is zero then conventional monetary expansions won’t do anything.  Whether government stimulus is a good move is unclear.  I am sure that government spending increases employment and output to an extent but it is very important how the money is spent. In an earlier post I argued that even in a severely depressed economy, there is rarely a good justification for spending on projects that aren’t socially valuable.  In all likelihood the best fiscal policies will involve some sort of transfer (like payroll tax cuts) or other tax cut rather than government spending.

What the data actually look like is an oldfashioned non-expectations Phillips curve. 

OK, here is where we disagree.  Certainly this is not true for the data overall.  It seems like Paul is thinking that the system governing the relationship between inflation and output changes between something with essentially a vertical slope (a “Classical Phillips curve”) and a nearly flat slope (a “Keynesian Phillips Curve”).  I doubt that this will fit the data particularly well and it would still seem to open the door to a large role for “supply shocks” – shocks that neither Paul nor I think play a big role in business cycles.

Paul ends his post with some bait.  He writes “it remains true that Keynesians have been hugely right on the effects of monetary and fiscal policy, while equilibrium macro types have been wrong about everything.”  OK, I’m again going to try not to take the bait.  Let me just point out that this is a difficult statement to take very seriously.  For the most part, the Keynesians are a subset of the equilibrium types.  Moreover, there are many “equilibrium types” who are not Keynesian but who are instead finance guys who played a crucial role in analyzing the economy during the crisis.  I presume he is taking an obligatory shot at Minnesota / Sargent / Lucas / Mathematical modelling etc. but …. I’m not taking the bait.


APPENDIX: The traditional IS-LM system is something like this:

Y = C(Y,r) + I(r) + G +NX(e)

r = max{-π, aY + b(π) }

the first equation is the IS curve governing the goods market. Consumption demand is increasing in Y and decreasing in r.  Investment demand is decreasing in r and Net Export demand is a function of the (real) exchange rate.  The second equation is the LM curve which I have written as a Taylor rule with the restriction that the nominal interest rate (i  = r – π) is subject to the ZLB.

A simple improvement over this system would be to introduce a different borrowing rate for firms and households – call this rate R.  R is equal to the base rate r plus an “external finance premium.” The EFP could be a decreasing function of asset values A and income Y. We now have the modified system

Y = C(Y,R) + I(R) + G +NX(e)

r = max{-π, aY + b(π) }

R = r + EFP(Y, A)

I’ll call the third equation the FE curve since it provides a condition for financial market equilibrium.  This model will have a spread R-r which will reflect financial stress.  Of course the IS-LM-FE system is again just a sketch.  We still have no explicit role for liquidity, solvency concerns, bank runs, etc. and the FE block would need to be fleshed out.  In fact this model is essentially a static sketch of the financial accelerator model by Bernanke, Gertler and Gilchrist 1999.

Traditional Macroeconomic Models and the Great Recession

A common narrative: analysts who used traditional Keynesian tools to understand the crisis made better predictions and were in a better position to diagnose the problem. This narrative may be comforting to some but unfortunately it’s not correct.

In some sense, the truth of our predicament is even scarier. Macroeconomists were caught completely off-guard by the financial crisis. None of the models we were accustomed to use provided insights or policy recommendations that could be used for fighting the crisis. This is particularly true for New and Old Keynesian models. The New Keynesian model (particularly its DSGE manifestations) was the dominant macroeconomic paradigm in the pre-crisis period and judging by many of the presentations at the National Bureau of Economic Research (NBER) summer meetings, the New Keynesian or Old Keynesian (referred to as “paleo Keynesian” by some of the meeting participants) continue to serve as the primary lens through which we try to make sense of the macroecononmy.

It its standard form, neither the New Keynesian model nor its paleo-Keynesian antecedent feature a meaningful role for financial market failures. As a result, the policy response to the crisis was largely improvised. This is not to say that the improvised policy actions were bad. Improvisation guided by Ben Bernanke was about as good as we could hope for. Nevertheless, for the most part, the models we were accustomed to use to deal with business cycle fluctuations were simply incapable of making sense of what was going on. In one of Stefanie Kelton’s recent podcasts, economist Randy Wray makes exactly this point. While I typically do not grant much credence to heterodox economists, in this instance Professor Wray’s diagnosis is completely correct. Fortunately, as Noah Smith pointed out in an earlier column,macroeconomists have been working, and continue to work, on developing models that can be used to analyze financial market failures.

In addition to the fact that the prevailing business cycle theories did not incorporate financial sectors, the components that were featured prominently were not performing well. The cornerstone of pre-crisis macroeconomic theory was price rigidity. In New Keynesian models, price rigidity results in a Phillips curve relationship – more specifically, a New Keynesian Phillips curve. According to the Phillips curve, if inflation was unusually high then output would be above trend. If it was low then output would be below trend.

The financial crisis of 2007-2008 and the Great Recession that followed proved to be a particularly bad episode for the New Keynesian model. Contrary to Paul Krugman’s assertion that traditional Keynesian models performed well, the key mechanism in the New Keynesian framework – the Phillips curve – was a virtual failure. In a recent post commenting on John Cochrane, Noah Smith plots quarterly price growth during the recession and notes that inflation did fall a bit during the recession. In his words “inflation not only plunged during the recession, but remained low after the recession.” The chart below shows core inflation (inflation for all goods excluding food and energy) since 2004. Clearly inflation fell once the recession took hold. Prior to 2008 annual inflation had been roughly 2 percent. Inflation fell during the recession [1] to roughly 1 percent.


To put this change in perspective, the next chart plots annual inflation for the entire post-war period. The blue line is the inflation rate for all goods in the CPI. The red line is core inflation.


There have been many large swings in inflation during U.S. history. Compared to historical variations in inflation through the post-war, the changes in price growth during the Great Recession were quite mild. Notice that because the large drop in the overall inflation rate is not in the core measure, this movement reflects changes in food and energy (primarily oil prices). If the 1 percent reduction in core inflation is sufficient for the Keynesian model to generate the huge recession we just went through then where was the huge recession in the late 1990s? Where was the enormous recession in 1986?

In his 2011 AEA presidential address Bob Hall proposed modifying the Keynesian model by treating inflation as “nearly exogenous.” One might interpret this modification as a “hyper-Keynesian” element – the exogeneity of inflation arises because the Phillips curve is essentially flat so even minor variations in inflation cause sharp changes in output. Alternatively, one could interpret the modification as a capitulation of sorts. The inflation block of the model is incorrect and so Hall removed it, letting inflation march to its own beat, unaffected by developments within the system.

Traditional Liquidity Trap models predict that inflation should not only be low but it should be falling. Instead, even though interest rates were pushed to zero and even though economic activity contracted dramatically, the inflation rate barely budged. In his paper, Hall writes [of the New Keynesian Phillips curve] “luckily the theory is wrong.” Were the Phillips curve true, inflation would have fallen making the real interest rate even more negative, further depressing output and employment.

While commentators like Paul Krugman are correct to point to a few success stories of some models (like some aspects of the Liquidity Trap), they should also own up to the mounting evidence that the older models (even the paleo-Keynesian models that some prefer) clearly failed on some important dimensions. They couldn’t tell us much of anything about what caused the financial crisis itself and couldn’t really tell us how to deal with it and they made clear predictions about inflation that were supposedly at the center of the New Keynesian mechanism – predictions that never materialized.



[1] I am plotting the percent change in the price indices from year t-1 to year t.

Back to Blogging

Sorry for the long blogging hiatus.  I’m not immune to the tug of summer but  I will start posting again soon.

This week I am at the NBER summer institute in Boston MA.  There are many excellent research papers that I have seen so far this week and we still have two days to go.  The presentation by John Cochrane was particularly lively (not surprising given the controversial message of the paper).