Tuesday, August 27, 2013

Macroeconomics: The Illustrated Edition

Noah always tells us to start posts with a picture. We normally pull one off of Google images, but I thought I would draw one instead.

This post is meant to be a short summary of how to think about macroeconomics in terms of general equilibrium. During my conversations with Michael Darda this past summer, it became painfully apparent that clients tend to struggle with how to put money and goods markets together. As a result, I thought I should put together a little piece on my basic approach to thinking through these kinds of "across market" effects, and why it matters for some of the policy debates of our day.

Any macroeconomy can be broken down into two main markets: a real market for current goods and services, and a financial market for claims on future goods and services. For brevity, I will reduce the model for financial assets to the market for money, which, because of money's role as a store of value and medium of exchange, captures the notion of "claims on goods". To simplify further, I take all the markets for goods and reduce them down to one composite market, say, for apples. From this caricature, we can start thinking about how markets fit together.

In normal times, people receive apples and money from the sky in the form of endowments (i.e. their wealth), and they make decisions about how to spend their cash and apple balances. Apples are transacted, bellies are filled, and life is good.

But suddenly, a recession hits. What does this look like? By definition, a recession is when there is a general glut of goods that aren't consumed. In this toy economy, this corresponds to a situation in which some people have apples but choose not to eat them! This may seem peculiar, but remember that the market for apples in this model represents a composite of all goods markets. So it could be the case that while everybody has apples, some want Red Delicious while others are looking for the tartness of Granny Smith. In more formal economic models, this is glibly incorporated by requiring that people do not consume their own endowment and instead trade for consumption. In any case, apples aren't eaten and we have a rotten general glut.

But this seems peculiar -- aren't markets supposed to clear? Not necessarily. Prices don't always adjust instantly, so we can have excess supplies and excess demands. However, economists do have a way to constrain what this non-clearing state looks like. In particular, according to Walras' law, assuming everybody spends all of their wealth, if there are excess supplies (i.e. too much produced) in some markets, then they must add up to excess demands (i.e. too little produced) in other markets. In other words, even if supply does not equal demand in each market, supplies must add up to demands across markets.

The requirement that everybody spends their endowment is crucial. It means that Walras' law doesn't apply just to the market for apples. Not everybody spends all their wealth on apples. Instead, some people may put their wealth into money. But once we include the money market, we do have the condition that everybody spends their endowment, and therefore Walras' law does apply to the entire macroeconomy of apples and money.

This leads to the most important conclusion from general equilibrium theory as related to macroeconomics.

If there is an excess supply of goods, it must be the result of excess demand for money.

The goods market by itself is not enough to generate a recession with a general glut of goods. Only when there is the possibility of excess demand in money markets can recessions actually occur. Therefore the market for money is what gives a macroeconomy its business cycle feel. This is why money is so important for macro -- fluctuations in the money market are the proximate cause for any general fluctuation in the goods market. This is why, as Miles Kimball says, money is the "deep magic" of macro.

While this "apples and money" approach is the canonical presentation of general equilibrium, it is not the only representation. For another interpretation, think about what the financial market really is. Since it represents the entire universe of claims on future goods, finance can be understood as a veil between the present and the future. So instead of focusing on the relationship between goods and financial markets at one point in time, we can cut out the middle man and instead think of general equilibrium as a sequence of goods markets that occur across multiple points in time. In this version, there is no financial market per se, but buying an apple in "tomorrow's goods market" represents buying a financial contract in the canonical model. Therefore, instead of thinking about the markets for goods and money, we can instead think about the markets for goods today and tomorrow.

The same excess supply and demand relationship works in this model. If there is an excess supply of goods today, then it must mean that there's an excess demand for goods tomorrow. So we get a corollary to the first diagnosis of recessions:

If there is an excess supply of goods today, it must be the result of an excess demand for goods tomorrow.

Each of these stories has its own strength. Since the first goods-money model includes actual money, it can help us understand how the price level is determined through monetary neutrality. On the other hand, since general equilibrium is only concerned about relative prices, and since individual dollars are not transacted in the second story, the second story has no "goods/money" relative price -- i.e. the second story cannot pin down an aggregate price level. However, the second story does a better job of being explicit about intertemporal choice. And for now, this intuition about relative prices between the past and the future will be powerful enough that I will focus on this second approach.

In particular, the second approach gives a clear reason why monetary policy solves recessions. Microeconomic intuition will suffice. If we want to reduce excess demand for a good tomorrow, all we need to do is raise its price relative to today. And since the price of an apple tomorrow is just the amount of money I need to save to afford it tomorrow, lowering the rate of interest between today and tomorrow is sufficient to raise the relative price of tomorrow's apple and get me to consume today. Note that this has an analogue in the first "goods/money" story. By lowering the interest rate on financial assets (and expanding the supply of money), this makes financial assets less worthwhile to hold. People then pivot away towards the goods market, and the general glut is consumed.

If recessions are generated by this process, the interest rate story shows why monetary policy can be politically difficult. Monetary policy, in this model, tries to change the relative price of consumption today and tomorrow to resolve the general glut. But this means that just when people most want to save, the interest rate falls and it becomes more expensive to do so! This is part of a more general political problem. Under a price system, the most desired objects are the most expensive. While this may be unpleasant, it's certainly efficient and necessary for avoiding recessions.

Now, one question that arises is why the real rate of interest doesn't automatically equilibrate to solve these excess demand problems. This is actually a very good question, and is the reason why monetary economics is so important. The primary explanation is that the Federal Reserve may not move fast enough to provide enough money to serve as claims on tomorrow's goods, and therefor the real rate spikes when a crisis hits. This is why we invest so many resources into studying monetary economics, because it is the proximate cause of most recessions.

So here we close the loop. From a relatively simple model, we now have a theory of employment (apple recession), interest (relative prices), and money (in the canonical representation).

Now we get to the fun part -- applying this framework to some of the policy debates of the day.

Let's start with monetary policy. By visualizing a macroeconomy through a sequence of markets, it becomes apparent why forward guidance matters. Even if the interest rate for today is zero, future interest rates may not be. Therefore, by promising to hold rates low for an extended period of time, that makes future apples more expensive relative to current apples. Now, the exact adjustment path may not be ideal, but so as long as we lower the interest rate enough to create enough excess supply in the future, we will be able to restore demand today.

Interestingly enough, quantitative easing is not in this picture. The only way to integrate quantitative easing is to think of it as a signal for the future path of rates. This has indeed been found to be a powerful channel through which QE has an effect.

We can also think about fiscal policy in this framework. If a recession is just a sign that there's excess demand for goods tomorrow, then for fiscal policy to work, it must convince people to bring some of their future consumption into the present. The conventional old-Keynesian approach to this (i.e. the Intro macro approach), is to argue that by giving people more transfers today, that makes them want to consume more today, which then directly solves the recession. But the actual mechanism is more subtle, and the efficacy of fiscal policy is entirely determined by its effect on intertemporal choice.

The Ricardian critique of fiscal policy also pops out. Ricardian equivalence, roughly speaking, argues that since consumers will take the future costs of taxation into account, therefore fiscal policy will have little effect. In this model, this future cost of taxation means people don't reduce their excess demand for goods tomorrow. Because they know the government will take away those apples, the agents are trying to save up so as to have enough to eat when tomorrow comes. Therefore the whole Ricardian effects/positive multiplier debate again just comes down to whether fiscal policy is actually effective at changing the patterns of consuming today and tomorrow.

In this context, the Federal Lines of Credit proposal from Miles Kimball makes a lot of sense. By extending lines of credit to those people who need it most, Federal Lines of Credit can persuade people to reduce their demand for goods tomorrow in favor of goods today.

I'm not entirely satisfied with this model. In particular there are the glaring omissions of rigorous foundations for inflation or intertemporal production. However, I do think it does serve as a baseline for understanding why intertemporal choice is so important for understanding macro, and I hope to expand on it in future posts.

Pictures were drawn in Paper 53.


The above post was cross-posted (with edits) from my personal blog, Synthenomics. I wanted to post it here so that all of our readers could get an idea of how I think about General Equilibrium, as I plan on using it to discuss several other issues in monetary policy. But as it is a cross-post, I have the opportunity to address an interesting issue that Basil brought up in the comments:
It looks to me that if the two models are equivalent, then a rise in demand for money is the same thing as a rise in the demand for future goods/services. 
But that's not (necessarily) the case. Sure, as you note, money is a store of value, but lots of things are stores of value. What makes money unique is its role as medium of exchange/unit of account. Seems like most increases in the demand for money are increases in the demand for the *liquidity* that money provides, not for the store of value service that it provides. 
I think the fact that you can't fit quantitative easing into the second model is telling. It can be explained very simply in the first model: QE is an increase in the supply of money to match the increase in demand, in an attempt to restore equilibrium. 
Recessions (defined as output below potential, not as negative GDP growth) cannot occur in pure barter economies. You need money to disrupt things. A recession can occur in your second interpretation, and there's no money.
In sum, Basil argues that thinking about current and future markets cannot replicate all of the features of money. In particular, the notion of claims on future goods leaves no role for a special "unit of account". While I am sympathetic to this view, I wonder if we can't come incredibly close to a money economy through an interest rate construction.

As Basil points out, the real question is whether the interest rate story matches up with the role of money as a unit of account. Well, the reason money's status as a unit of account matters is because of some kind of nominal stickiness - whether through wages or prices. Therefore money's role as a unit of account means that when you print more of it, you can actually get more real expenditures.

But I would argue that a nominal interest rate captures the same dynamic. In the derivation of the New Keynesian Philips Curve (which you can follow along at home with my notes here), a critical step is that firms set price in order to maximize their profits across expected future price levels. In effect, firms set their price on the basis of how much more expensive the future will be relative to the present.

This maps directly into the interest rate framework. By lowering the interest rate between today and tomorrow, this means the relative price of today should be much higher. But since firms are anchored by the Calvo fairy, this means that firms are stuck at a price lower than what the interest rate would suggest. Since consumption in the present is now too cheap, this increases current aggregate demand and the recession is solved. So even though the interest rate is not a unit of account, it does capture the key reason why being a unit of account matters: nominal stickiness.

Liquidity is also a red herring. Assets become illiquid because they aren't being transacted. But if monetary policy can get current demand for goods and services higher, then these assets will become liquid and there's no more demand for money.

As I mentioned above, I will expand on this framework in later posts. Let me know if you have any suggestions on what I should try to draw next!

Update: As a commentator noted, this model is really just a model of demand side recessions. I do apologize for not making that more clear, as I was not really thinking about the supply side when writing this post. For a more interesting take on the supply side, take a look at Frances Coppola's post.


  1. Kudos for writing down a model in words, certainly a great skill. There are some upsides and some downsides to writing a model in words. It leaves me needing clarification on a lot of things. (I'm also really sleepy right now so apologies in advance if I'm just neglecting things or being confused and/or confusing.)

    In your models, "apples" represent a composite good. Are you thinking of them as storable or not? If they are storable, there is no role for the financial market you describe. People can enact their intertemporally optimal plans by the choice of what to consume today and what to save. (Money is a store of value in your model. If apples are a store of value, no role for money.) Other questions: Do people know what future endowments will be in the model? Is there a representative agent? (If no to both): is there aggregate and/or idiosyncratic risk? (If people face idiosyncratic risk, there is a role for a financial market to trade state-contingent claims for insurance purposes, but that does not seem to be what you're describing.)

    In the first model, there don't really seem to be two markets. Apples are exchanged for money in the "apples market." Apples are exchanged for money in the "money market." Are the two markets distinct? If not, they are just one market (affecting what Walras' Law tells you...) Also the Ricardian equivalence part does not depend on the financial/money market. You would have the same thing with a goods market only with storable goods.

    I'm not sure what is different between the two models. The "financial claims" in the second are the money in the first (and again, if the good is storable, then neither are necessary for intertemporal transfers.) Also, you call this a theory of employment, but it's an endowment economy. So I guess technically it's a theory of employment that represents the labor market as non-existent. If there were production with a labor market, things would get a lot different. Depending on how you set it up, you might have some counterintuitive results about employment and wages in what you are defining as a recession...

    Most important I guess: What is an "excess demand for goods tomorrow"? What would cause that? Maybe I have become too over-reliant on needing to be told what agents' objectives and information sets are, but I don't seem to get it otherwise.

    1. >What is an "excess demand for goods tomorrow"

      Here is my understanding of things. Lets imagine, hypothetically, that there was a large group of people working now that all wanted to retire within the next ten to fifteen years. They want to produce today, but they want to continue consuming later when they are no longer working.

      They are setting up an economy where there will be in the future more demand for goods than what can be produced given that less people will be working, thus the excess demand for future goods.

    2. Apples cannot be stored. Indeed, when I was writing this out I had in mind the prototypical model of consumption presented in Intermediate Macro at the undergraduate level.

      "Do people know what future endowments will be in the model?"

      They should have expectations, but there can still be uncertainty.

      "is there aggregate and/or idiosyncratic risk? (If people face idiosyncratic risk, there is a role for a financial market to trade state-contingent claims for insurance purposes, but that does not seem to be what you're describing"

      I wanted to start the model at the highest level of generality (financial claims in general) and go down to a very concrete case (money). Since this is meant more to illustrate broad ideas, the model I describe is amenable to both idiosynchratic and aggregate risk. There can indeed be a market for state-contingent insurance, and there can be the same "excess demand" problem in this market. Therefore uncertainty can generate recessions. However, in spite of this, monetary policy can still have an effect.

      "Apples are exchanged for money in the "apples market." Apples are exchanged for money in the "money market." Are the two markets distinct?"

      Right, but the recession arises when people have apples but cannot exchange for money due to some kind of rigidity or excess demand for money. I also agree that Ricardian Equivalence has little to do here -- that part is just relevant when we start talking about intertemporal choice.

      "Most important I guess: What is an "excess demand for goods tomorrow"?"

      I think the most concrete way to think about an excess demand for goods tomorrow is through a paradox of thrift mechanism. When people all collectively try to save, that represents a very large demand for goods tomorrow. But then since the nominal interest rate is fixed, and then since prices are sticky, then you end up having an excess demand for goods tomorrow, or equivalent for savings.

      You are right -- perhaps I was a bit too glib in talking about a theory of employment. It really is just a model of consumption. But I think the verbal model does do a good enough job of showing the general equilibrium basis of recessions.

    3. Carola beat me to it: "In the first model, there don't really seem to be two markets. Apples are exchanged for money in the "apples market." Apples are exchanged for money in the "money market." Are the two markets distinct? If not, they are just one market (affecting what Walras' Law tells you...)"


      With 2 goods: apples and money, there is only one market (which we call "the apple market", and in that one market the value of the excess supply of apples must equal the excess demand for money.

      With 3 goods: reds, grannies, and money, there are 2 markets: the red market and the granny market. But now there are two excess demands for money. And if people can't sell their reds for money, because there's an excess supply of reds, they won't buy as many grannies for money.

  2. John S2:48 AM

    This is a nice post, thank you. A few comments:

    If we want to reduce excess demand for a good tomorrow, all we need to do is raise its price relative to today. And since the price of an apple tomorrow is just the amount of money I need to save to afford it tomorrow, lowering the rate of interest between today and tomorrow is sufficient to raise the relative price of tomorrow's apple and get me to consume today. People then pivot away towards the goods market, and the general glut is consumed.

    This sounds like Austrian Business Cycle Theory in reverse. If lowering the interest rate in bad times will work to get people to consume more today, then wouldn't holding the interest rate too low in boom times (as some argue the Fed did during the early 2000s) encourage excess consumption, followed by excess production (as firms try to get their share of these profits), and eventually lead to the unsustainable general glut that you cited as the starting point of the business cycle downturn?

    This is David Beckworth et al's contention in their book "Boom and Bust Banking." In the intro, Beckworth writes: "Total factor productivity (TFP) growth averaged 2.5 percent a year between 2002 and 2004, a vast increase over the average 0.9-percent growth for the preceding thirty years... such rapid gains in TFP growth put downward pressure on the price level, expanded the capacity of the economy, and put upward pressure on the neutral federal funds rate. The
    Federal Reserve, however, saw the resulting disinflation and excess economic capacity as symptoms of continuing slack in aggregate demand. It feared raising the federal funds rate. As a result, the Federal Reserve loosened monetary policy and helped turn a beneficial productivity boom into a housing boom."

    [I realize an asset boom is different from a "general glut." However, it seems to me that such a boom could be a concurrent symptom of an overheated economy + excess supply of money/credit.]

    http://www.independent.org/pdf/book_excerpts/boom_and_bust_intro.pdf (pages 3-4)

    Any thoughts on this? Isn't there some merit to the Austrian view that central banks can contribute to booms on the upside (via excess money and credit creation) as well as on the downside (sudden contraction of both, as the NGDP-targeters and GMU Austrians argue happened in 2007-08)? These seem like symmetrical processes to me.

    1. John S2:51 AM

      as well as on the downside --> as well as busts on the downside

  3. Did you mean to make your NKPC derviations public? The link is such that it takes one to one's own dropbox-account where the folder New Keynesian Phillips Curve naturally doesn't exist. I'm an econ student and would be interested in seeing your account of the NKPC. A very nice post!

    1. Fixed. It's not theoretically novel, but I go into more depth on the derivation so as to make the math transparent.

    2. Thanks. The Mankiw piece was good, hadn't read it before, and worked nicely with your derivations

  4. I think the best critique of your second - no money - interpretation comes from Nick Rowe in this post: http://worthwhile.typepad.com/worthwhile_canadian_initi/2013/08/new-keynesians-really-really-need-the-pigou-effect.html

    Most important note: Fall in real rate is not sufficient to say what happens (never reason from a price change). Interest rate is only ratio between now and then. Falling real rate may indicate rising consumption now but also falling consumption in the future with today's consumption staying the same.

  5. Another great post on Not Quite, a great intro for us non economists.

    1. Anonymous11:41 AM

      No, this is not a good introduction for non-economists. You are much better off not reading it.

      This post posits a number of things that *may* be true within this particular model, but are not true in general, as universal facts. If, after this post you believe that "By definition, a recession is when there is a general glut of goods that aren't consumed" then this post has done you a disservice. While this statement appears to be true in this model (maybe), it is not true in the real world. Sometimes we can have supply recessions in the real world.

      This model seems to hinge critically on an undefined sticky price mechanism. It turns out, when you write a model down properly (using math, so that everyone is clear about what is going on) the form of the sticky price assumption can be important to the model. Without seeing how the sticky price mechanism works here, the model is almost useless.

      Bring Noah back.

    2. Good point on supply recessions. The original motivation for this post was to talk more clearly about monetary policy, so I did not have the supply side in mind. I wrote a short update at the end of the post.

    3. Anonymous11:37 AM

      In fact, it is even worse than that. As a friendly EJMR poster reminded me, inventories actually fall during recessions (see http://research.stlouisfed.org/fred2/series/TOTBUSMPCIMSA).

    4. a friendly EJMR poster

      OK, I call bullshit!

  6. Anonymous9:58 AM

    "The Ricardian critique of fiscal policy also pops out. Ricardian equivalence, roughly speaking, argues that since consumers will take the future costs of taxation into account, therefore fiscal policy will have little effect. In this model, this future cost of taxation means people don't reduce their excess demand for goods tomorrow. Because they know the government will take away those apples, the agents are trying to save up so as to have enough to eat when tomorrow comes. Therefore the whole Ricardian effects/positive multiplier debate again just comes down to whether fiscal policy is actually effective at changing the patterns of consuming today and tomorrow."

    This is not correct--although, a lot of people make this mistake. Ricardian equivalence does not reduce fiscal policy multipliers to zero in any model. You can think of the problem into propensities to consume: if the government spends $X on apples (by issuing debt) the first effect is to increase demand by $X, the second effect is to create $X of debt which must be financed. RE then implies that that $X of debt has no effect on macro aggregates because of the offsetting future taxes. In other words, RE implies that there is no difference between tax-financed and debt-financed fiscal expansion, so that the multiplier is exactly one(although any deviation from the ideal weakens this result in a way that would increase the multiplier above one). So RE is not really relevant to the question about whether or not the multiplier is positive.

    Now, to get a ZERO multiplier, in the standard formulation at least,you have to recognize that "the multiplier" is actually "the multiplier net of monetary policy" and that under the proper conditions (i.e. near full employment) monetary policy will fully offset a fiscal expansion. I would think that someone familiar with the "Sumner Critique" would be familiar with that distinction (I once read another one of your posts which mentioned it)... but then again Sumner himself has a tendency to oversell his case in this regard.

  7. Anonymous10:03 AM

    OH! Let me add a caveat, since this is one of the cheats people use to get zero multipliers: If fiscal policy only takes the form of transfers, rather than direct purchases, THAN the multiplier for that kind of expansion is zero with RE. Although, this is only because that kind of fiscal expansion is effectively a negative tax and so it is entirely offset by future taxes.

    Sorry, I shouldn't have said "any model".

    1. This does not compute. If people expect higher taxes in the future they save more which means they consume less now. So any form of debt financed (future taxes) government expenditure (be it transfers or direct government purchases) will be under RE exactly offset by less private expenditure.

    2. Anonymous12:05 PM

      That is not the case. The reason that a transfer can have zero multiplier (with RE) is that the $X is not "spent", but rather some is spent and some is saved. When the government spends $X, that immediately adds $X of increased spending--just as a matter of accounting--you can certainly argue that the standard accounting is the problem, but that's not an argument I, personally, want to get into (as a micro specialist, I feel confidant that I can defend the standard position with micro-level arguments, but I shouldn't have to defend standard practice). In the standard setup, expenditures add to "G" and transfers add to "T" (with a minus sign).

      In both cases $X of debt is created and RE stipulates that this debt is not aggregate wealth--many people seem to think that this means that gov't spending has no effect, but it really just means that there is no growth advantage for deficit spending (when RE holds). In old Keynesian terms, this is a point closely related to the "balanced-budget multiplier" which is that a fully tax financed fiscal expansion has a multiplier in the Old IS-LM model of exactly one. Well, the same argument still applies dynamically except now RE implies that every multiplier is the BBM (again, this is NOT net of monetary policy, which is kinda important) and therefore equal to one if it affects "autonomous" spending and zero if it affects "induced" spending (sorry to use the Old Keynesian lingo, but the new stuff just doesn't have the language to explain the intuition easily).

      If you're still not convinced, read this (http://mainlymacro.blogspot.com/2012/01/consumption-smoothing-and-balanced.html) from Simon Wren-Lewis. He makes the same point using the more modern NK-lingo and in greater detail.

    3. bseconomist is definitely right on this count. If you work through the RE result in a simple consumption model, you see that what RE says is that the impact of spending is invariant of the financing. Because of expectations, there is no difference between debt and tax financed fiscal policy.

      Nonetheless, if it's the case that agents take future taxes into account, it's necessarily true that the spending multiplier is smaller.

    4. Anonymous9:30 PM

      There is no difference between debt financed and lump-sum tax financed spending. But there are no lump-sum taxes.

      I agree with the previous Anonymous -- people are better off not reading this nonsense.

    5. Anonymous2:31 PM

      Is there any evidence that people actually act in this way?
      And I think there is a lot of evidence that very few people
      compute expected future taxation and act accordingly.

  8. "If there is an excess supply of goods, it must be the result of excess demand for money."

    This statement is a simple expression of wealth. Wealth equals goods plus money. It is a mistake to extend wealth to markets without the including more nuances of choice.

    An old farm adage proclaims "The best cure for high prices, is high prices". High prices induce the production of more apples! In the case of apples, you can only eat so many apples, even if the apples are free. Any commodity can be over produced, and demand exceeded, even if the product is offered as "free".

    In conclusion, your post left me uneasy. By extending wealth to markets without nuances, the impression is left that simple monetary policy can cure demand issues. More correctly (in my opinion), money must compete in the market place for acceptance as does every other commodity, and an increase in money supply will have only a marginal increase in commodity demand.

    1. You should feel uneasy because the post presents a solution that is quite easy. But that is something I will talk about in a future post on forward guidance. I suspect your concerns about money "compet[ing] in the market place" have to deal with the liquidity trap, but that was beyond the scope of this one post.

  9. What if leisure is added to the model. And if people have a hyperbolic discounting for leisure meaning they value leisure now other than goods they will consume more leisure than is consistent. If they have normal discounting for consumption and money. Would they end up below total output in a barter economy?

    1. I guess I had not taken this into account. It would be possible that recessions are generated by "great vacations". However, you point out an even bigger problem with the model: there's no model for labor. But that was by design for simplicity.

  10. Anonymous3:27 PM

    Modern General Equilibrium is the exact opposite of disequilibrium ideas like that of the General Glut. You are confusing people when you mix these two together.
    Noah, how did you even let this through?

  11. This article is a good reason we need to continue our search for exoplanets. Someday, we might find one where these kinds of arguments make sense. I'm not saying they are wrong, just that they don't seem applicable here on Sol III. For example, no where do they account for the fact that people need to work in order to get money to buy things that they need. This has been completely elided, despite it being the central fact of existence for perhaps eight or nine billion people.

    Also, please stop talking about "expectations". They are a plot device, not a thing. Science fiction writers, or perhaps economists, made up expectations to get around the impossibility of faster than light travel. I enjoy space opera as much as anyone, but I recognize what "expectations" and "warp drive" are. (Granted, warp drive makes a lot more sense and is used more consistently than expectations, but I'll suspend disbelief for a good space battle.)

    1. The Hat of the Three-Toed Man-Baby9:32 PM

      I had thought that the writer was the dumbest person around, but clearly that is Kaleberg. It takes a lot of stupidity to make this blogpost look good, but man, you've done it.

  12. Anonymous9:03 AM

    I didn't read the comments but you can include money in the inter-temporal choice theory through the endogenous of money. Essentially this says that for any given set of real factors there is only one value of the money supply that is consistent with a given overnight interest rates. Thus in your inter temporal version lowering the short term interest rate is exactly equivalent to expanding the money supply in the present a la the money economy picture.

    Indeed, monetarists would say that the Fed really controls the money supply to affect the interest rate as an epi-phenomenon, and thus that QE is equally effective at the zero bound since the size of the monetary base controls the future expected level of NGDP/the price level.

  13. Cute, very precocious...

  14. Anonymous6:31 PM

    It does matter who has the piles of money saved up for future apples. All potential consumers are not identical. Just an anecdotal observation. The people with savings now are mostly the already wealthy or retirees/near-retirees. Speaking as a retiree, the low interest rates have exactly the opposite effect on me. I have reduced consumption, because, apparently, my retirement income is going to be considerably lower than I have planned or I will have to risk some of my savings. People don't have pensions anymore. We have annoying, self-managed "future apples" in our IRAs. You can see evidence of this in the very high rates of employment among retirees and near-retirees now. We are scared. Scared people do not run out and buy things. They just hunker down and keep working.

    1. Nathanael3:24 AM

      --->It does matter who has the piles of money saved up for future apples.<---

      This, this, this.

      The extreme example: Some people have piles of money which they will never spend and which their children will probably never spend either, and their grandchildren probably won't be able to spend it either. They still hang on to it.

      Distribution of wealth is CRITICALLY important to making a plausible model.

  15. o. nate10:37 AM

    It would be interesting to see the intertemporal model extended to handle debt and deleveraging. It seems that debt is basically the inverse of money: if money represents a "long" position in goods tomorrow, debt represents the "short" position (ie., selling goods tomorrow to buy goods today). If we posit two types of actors in the economy, those who maximize current consumption and those who maximize future consumption, then I guess the deleveraging shock comes when the current-consumption-maximizers have sold as many future goods as the future-consumption-maximizers think they will be able to provide. At that point, the current-consumption-maximizers must curtail their consumption, and unless the future-consumption-maximizers take up the slack, there will be a current demand shortfall (ie., a future demand glut).

    1. o. nate12:14 PM

      This approach also provides a way to incorporate QE into the intertemporal model, specifically the type of QE in which the central bank purchases longer-maturity government debt. This is seen as being equivalent to increasing the demand for future goods, which should raise their price relative to current goods, in the same way that lowering the interest rate would.

  16. Yichuan, yours is a remarkably clear verbalization of how a lot of the best economists actually visualize the problem of recessions. I don't think your model is quite right, however, and disagree with your equation of money and financial assets. This is the post you need to read: http://worthwhile.typepad.com/worthwhile_canadian_initi/2011/04/walras-law-vs-monetary-disequilibrium-theory.html

    (and this one says the same thing more briefly: http://worthwhile.typepad.com/worthwhile_canadian_initi/2010/12/unobtainium-and-walras-law.html)

    (Cross posted on Scott's blog as well.)

  17. This comment has been removed by a blog administrator.

  18. FWIW, I am inclined to think that the core of the sickness that afflicts the discipline of macroeconomics is the believe that recessions (and booms) are deeply and causally connected to problems in the financial market.

    Certainly, screwing up the financial markets is capable of causing recessions and booms, but that empirical case that this is a predominant or important cause of most recessions (as opposed, for example, to technological change, or disruptions in import or export flows, or systemic mispricing of economically important assets like real estate aka price bubbles) seems like a quite weak one.

    General equilibrium theory, it seems to me, is the theory that ate the discipline to the detriment of other really important things that economists should think about but don't very often (like the features of an economy that create systemic risk or make the economy more robust).

  19. I like this post as it is very informative about the relation of today's supply and tomorrow's demand.

    Financial Advice Chiswick

  20. Nathanael3:21 AM

    "If there is an excess supply of goods, it must be the result of excess demand for money."
    This one is right.

    (This is a demand-side recession where there is an excess supply of all goods other than money and similar stores-of-value. A supply-side recession might be caused by an excess supply of most goods, but a shortage of one good like oil.)

    However, this one is wrong:
    "If there is an excess supply of goods today, it must be the result of an excess demand for goods tomorrow."

    There's a second possible cause.

    It can also due to *maldistribution* of money. There may be demand for goods among the 99%, who don't have the money, and demand for money among the 1%, who have already gotten all the goods they can possibly use in their lives ever.