Do AS and AD Intersect in a Recession?
By Arnold Kling
As you may know, I have been recording chalk-talks for my high school economics class. I did macro first, and now I am working on micro (I am now quite a few lectures ahead of where we are currently in the course). After I did the basic factor demand story (wage equals marginal revenue product), I thought it might be ok to introduce PSST. The result is here. Think of it as an introduction to PSST for students who have gone through the rituals of introductory macro and just barely learned basic supply and demand in micro.
In my own mind, PSST is more for a student who understands the 2x2x2 model of international trade. I hope you do not need that level of math, but if I were trying to explain PSST at a graduate seminar, I would want the students to have the intuition of the 2x2x2 model clearly in their heads.
Anyway, what occurred to me while trying to do my talk was that there may be some intellectual swindling going on with AS and AD analysis. More below.I started with the textbook model. There, the only problem in the economy is that the wage rate is too high. Thus, you get an excess supply of labor. Given the too-high wage, there is no excess supply in the goods market (firms are producing where marginal revenue equals marginal cost). But I have two issues with the textbook model.
1. It is nearly an abuse of language to call the problem a shortfall of aggregate demand. That makes it sound as if the problem is a lack of demand for goods, when in fact the problem is an above-market-clearing wage.
2. My verdict is that the textbook model does not hold up empirically. There are too many recessions on record where you do not see the real wage rising as the model predicts. This has nothing to do with whether you like PSST or not. As an empirical matter, if you are trying to explain every change in unemployment on the basis of a reverse movement in real wages, you cannot do it.
In my talk, I addressed these issues by drawing a goods market with excess supply using the standard picture. That is, the price is above the equilibrium price. This avoids the problems (1) and (2). In particular, it implies inelastic demand for labor in recessions, so that workers cannot get their jobs back simply by offering to work at somewhat lower wages.
But now we have two very different pictures of the goods market. The one I just drew to illustrate excess supply shows the economy not at the intersection of supply and demand. Instead, it is a standard analysis of what happens when the price is too high to clear the market.
But this exact same situation in macroeconomics is depicted as an intersection of the aggregate supply and demand curves. So, what we show students is an intersection, and what we have in the back of our minds is a non-intersection. That is what I mean by a swindle.
I think the best way to handle it would be to illustrate excess supply in AS-AD the same we would in micro: as a gap between the demand curve and the supply curve, caused by a too-high price. So, my answer to the question in the title of this post is “No.” I would prefer not to teach under-employment as an intersection of AS and AD.
In the textbook model, workers can get their jobs back by offering to work for less. In the modified AS-AD story above, they can get their jobs back if firms cut their prices to get rid of the excess supply. The PSST story is that the workers cannot get their jobs back at all, because the former production patterns are not sustainable. Only when new patterns of specialization and trade are discovered will we see full employment return.