So you think Paul Krugman is a Keynesian? I’ll be dipped!

2 June, 2013 at 22:48 | Posted in Economics | 5 Comments

On his blog today, Paul Krugman tries to explain why we should still use the neoclassical hobby horse Aggregate Supply-Aggregate Demand model:

So why do AS-AD? … We do want, somewhere along the way, to get across the notion of the self-correcting economy, the notion that in the long run, we may all be dead, but that we also have a tendency to return to full employment via price flexibility. Or to put it differently, you do want somehow to make clear the notion (which even fairly Keynesian guys like me share) that money is neutral in the long run.

Actually, this is the same unsubstantiated stuff you find in all of the “fairly Keynesian” Greg Mankiw’s textbooks.

Well, this “fairly Keynesian” guy is not impressed. And I doubt that Keynes himself would have been impressed by having his theory being characterized with catchwords like “tendency to return to full employment” and “money is neutral in the long run.”

One of Keynes’s central tenets – in clear contradistinction to the beliefs of classical economists – is that there is no automatic tendency for economies to move toward full employment levels in monetary economies.

Money does not matter in neoclassical macroeconomic models. That’s true. But in the real world in which we happen to live in, money does certainly matter. Money is not neutral and money matters in both the short run and the long run:

The theory which I desiderate would deal … with an economy in which money plays a part of its own and affects motives and decisions, and is, in short, one of the operative factors in the situ-ation, so that the course of events cannot be predicted in either the long period or in the short, without a knowledge of the behaviour of money between the first state and the last. And it is this which we ought to mean when we speak of a monetary economy.

J. M. Keynes A monetary theory of production (1933)

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  1. “money matters in both the short run and the long run”

    I suppose that’s why Zimbabwe is doing so incredibly well!

  2. Is there any reason to believe that money is “nuetral” in either the short term or the long term if you do not believe that money arose as an extension or facilitator of a barter system? And I guess I should ask whether it makes sense to believe that money exists as an extension of barter systems.

  3. AD-AS is one of the better mainstream textbook models, in my opinion. I mean, it’s a good introduction to the macroeconomics. One might be able to explain macro with it to his grandma and at least not get it catastrophically wrong.

    Though, it is sad that practically nobody goes to the deficiencies of the AD-AS model, like:
    1) What is the slope of AD curve? Of AS curve? Do they even intersect if they are sloped the same way?
    (While most economists really believe that deflation is contractionary, they usually go with negatively slopped AD curve in their models for some obscure reason. The possible slope of AS curve is also questionable)
    2) How do we observe what is happening to the curves when we only ever have the data on GDP, which does not even define a point on the (P,Q) plane?
    3) Are AS and AD independent? (Sraffa 1925, 1926) If not, then how is it possible to use partial equilibrium methods in modeling a general equilibrium system?

    I believe that posing and answering those questions is essential for the understanding of economics, but AD-AS is a nice place to start, a sort of a stepping stone.

  4. I agree with Lars’s doubts about what Krugman says. Ever since I started studying economics 30 years ago, loud alarm bells always rang in my head whenever I saw AS and AD portrayed in similar fashion to the demand and supply curves for apples, etc.

    There is actually a self correcting mechanism for the macro economy: it’s the Pigou effect. That is, given excess unemployment, wages and prices fall, which in turn means the real value of the monetary base and national debt rises. And that in turn means a rise in the real value of private sector net assets, which in turn raises private sector spending. But the Pigou effect obviously takes far too long to work, amongst other reasons because wages are “sticky downwards”.

    Pontus: I think you’re a bit out of date with Zimbabwe. Inflation has been well under control there for several years now.

  5. Ralph:

    Perhaps you need to read up on what “neutrality of money” means.

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