Steve Keen Takes on AS-AD

     As we saw recently, Keen is personal non grata among Establishment-Neoclassical-econ. Noah Smith recently took him down on his claim to have predicted the crisis.

     http://diaryofarepublicanhater.blogspot.com/2013/06/noah-smith-vs-steven-keen-who-predicted.html

   You can debate the importance of "predicting the crisis' and Smith makes the point that there are different aspects of this-do you mean the big fall in housing prices of 2006-2007, the financial crisis of 2008 or the Great Recession that actually started in late 2007?

    I think if you really want to quantify this there are degrees of getting it right: for example the notorious Reinhart-Rogoff  did nail it on predicting in their book This Time It's Different that this time it really was different as recessions caused by a financial crisis have much slower recoveries. While they've really hurt their own reputations by becoming the spokespeople of the Austerians in 2011, they were totally right on that book.

     Krugman has been wholly right that they are wrong about austerity; yet they were totally right about it being different this time-and this is something Krugman admits he didn't foresee.

    Noah may have a point about the reason why Keen had predicted a crisis:

    I think he argues he knew a depression-like crisis was possible because:

a) He considered the Efficient Finance Hypothesis to be complete nonsense.

b) He considered rising private debt to be a problem, unlike "neoclassical" models.

c) He considered the non-neutral nature of money.

d) Once the crisis hit, he was confident the money multiplier was a textbook myth.

    "Ahh, but how did he get from those beliefs (a-d) to the conclusion that a depression-like crisis was possible?"

     "He certainly didn't do it by making a model, because the "crises" in his model don't look anything like the Depression."

     http://noahpinionblog.blogspot.com/2013/05/what-does-it-mean-to-have-predicted.html

     This quote is in the comments section.

     I think that what is really important about Keen is his questioning of these aspects of Neoclassical econ Smith listed. Another very important criticism of Keen is of supply-demand models that assume that supply and demand set prices.

     " One of the many schisms in economics is between economists – new and old – who believe that prices are set by supply and demand, and economists – also new and old – who believe they are set by a mark-up on the cost of production."

     Read more: http://www.businessspectator.com.au/article/2013/5/20/economy/seductive-super-models-supply-and-demand#ixzz2V4SAig1x

     He argues that supply and demand wasn't used in the Classical School. However, the Neoclassical School was from the start founded around S-D. A major point of contention is Keen's point that Neoclassicism is wrong that as output rises, profits. fall-diminishing marginal productivity.

    http://economistsview.typepad.com/economistsview/2013/06/the-aggregate-supplyaggregate-demand-model-in-the-econ-blogosphere.html

     Interestingly, Peter Dorman-someone who is much more acceptable to the Establishment; Keen is kind of like someone who passes gas in mixed company, no one really wants to admit to knowing him in the light of day; or this is how the Establishment feels--has now himself sharply criticized AS-AD.  He points out that it's very rarely used in the blogosphere and suggests this is for good reason.

     "Introductory textbooks are supposed to give you simplified versions of the models that professionals use in their own work. The blogosphere is a realm where people from a range of backgrounds discuss current issues often using simplified concepts so everyone can be on the same page."

     "But while the dominant framework used in introductory macro textbooks is aggregate supply—aggregate demand (AS-AD), it is almost never mentioned in the econ blogs. My guess is that anyone who tried to make an argument about current macropolicy using an AS-AD diagram would just invite snickers. This is not true on the micro side, where it’s perfectly normal to make an argument with a standard issue, partial equilibrium supply and demand diagram. What’s going on here?"
 
     
     http://economistsview.typepad.com/economistsview/2006/01/new_support_for.html
with
   
      Dorman sees it as little more than a placeholder, a kind of filler for college students.

     "The dominant macro model, now crystallized in DSGE, is much too complex for intro students. It is based on intertemporal optimization and general equilibrium theory. There is no possible way to explain it to students in their first exposure to economics. But the mainstream has rejected the old income-expenditure models that graced intro texts in the 1970s and were, in skeleton form, the basis for the forecasting models used back in those days. So what to do?"

     "The solution has been to use AS-AD as a placeholder. It allows instructors to talk about both prices and quantities in a rough market context. By putting Y on one axis and P on another, you can locate any macroeconomic outcome in the upper-right quadrant. It gets students “thinking like economists”.

     However, using it as filler is not without peril, far from it:

     "Unfortunately the model is unsound. If you dig into it you find contradictions that can’t be papered over. One example is that the AS curve depends on the idea that input prices for firms systematically lag output prices, but do you really want to argue the theoretical and empirical case for this? Or try the AD assumption that, even as the price level and real output in the economy go up or down, the money supply remains fixed."

     "That’s why AS-AD is simply a placeholder. It has no intrinsic value as an economic model. No one uses it for policy purposes. It can’t be found in the econ blogs. It’s not a stripped down version of DSGE. Its only role is to occupy student brain cells until the real work of macroeconomic instruction can begin in a more advanced course."
        
     "Mark Thoma offers a couple of links of economists who have at least used the AS-AD one of which is Krugman.  Krugman employs an AS-AD model to make a point he's made in other ways-that the EU needs more inflation."

     "So, imagine a currency area with just two countries, Spain and Germany, which I’m going to represent in an aggregate supply-aggregate demand framework."

      "On demand, I’ll make two assumptions I don’t believe. The first is that the ECB can determine nominal GDP for the euro area. Under liquidity-trap conditions, this is a very problematic assumption, and I don’t mean to drop my skepticism for other purposes. For right now, however, it’s useful, I think, to use nominal GDP as a proxy for the whole range of possible expansionary policies the ECB might follow."

    "Spain is deeply depressed, while Germany is close to full employment."

     "How can Spain restore normal employment? The current European strategy is “internal devaluation”, which means expecting Spain to cut wages and thereby restore competitiveness; this can be represented as a downward shift in Spain’s AS curve."

     "The trouble with this strategy is twofold: it’s really, really hard to get wage cuts, and deflation in Spain makes the problem of debt overhang worse."

     "What’s the alternative? Aggressively expansionary monetary policy, which shifts the AD curves of both countries to the right. This raises output and employment in Spain, but leads to inflation in Germany."

    http://krugman.blogs.nytimes.com/2012/07/29/internal-devaluation-inflation-and-the-euro-wonkish/

    After I started this POST I was happy to see that Krugman has already responded to use of the link to make the point that it doesn't mean he puts a lot of stock in AS-AD.

    "As it happens, I’ve thought about this issue quite a lot; it comes up with each revision of Krugman/Wells, where we have to ask whether AS-AD belongs in the exposition. The problem is not that the “real” model is DSGE (New Keynesian theory with intertemporal optimization yada yada); in practice, when it comes to "thinking about macro policy Robert Waldmann has it right:

most have gone all the way back to an IS curve (real interest and output) assuming AS doesn’t matter and with the LM curve replaced with something like a Taylor rule. AS if anything, is an adaptive expectations augmented Phillips curve which matters only because of real interest rates, the monetary authority’s response to inflation and debt deflation/inflation.

     "You can see something pretty much along these lines in this piece from David Romer (pdf).

     "Now, this isn’t AS-AD for two reasons. First, the AD curve is no longer an economic relationship so much as a model of central bank behavior; a rising price level doesn’t reduce demand through its effect on the real money supply, it reduces demand through its effect on the mind of Ben Bernanke. Second, what we almost always talk about is the rate of change in prices rather than their level. (This happens not to be true when we’re worrying about issues of competitiveness within the euro area, which is why AS-AD makes something of a comeback in that discussion)."

     "So why do AS-AD? First, you do want a quick introduction to the notion that supply shocks and demand shocks are different, that 1979-80 and 2008-2009 are different kinds of slump, and AS-AD gets you to that notion in a quick and dirty, back of the envelope way."

     "Second — and this plays a surprisingly big role in my own pedagogical thinking — 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. That’s a relatively easy case to make in AS-AD; it raises all kinds of expositional problems if you replace the AD curve with a Taylor rule, which is, as I said, essentially a model of Bernanke’s mind."

     "So there is a place for AS-AD, although it’s an awkward one, and the transition to IS curve plus Taylor rule plus Phillips curve, which is the model you really want to use for America right now, is a moment that fills me with dread every time we take it on in a new edition."

        http://krugman.blogs.nytimes.com/2013/06/02/a-sad-story-i-mean-as-ad-story-wonkish/

      P.S. Nick Rowe has an interesting piece that compares the monpolitistic competition with Friedman's plucking model
    

    http://worthwhile.typepad.com/worthwhile_canadian_initi/2013/06/monopolistic-competition-vs-the-plucking-model.html

    I think this is enough for one post though, maybe I'll look at this in another one.