Aggregate demand is not consumption
By Scott Sumner
I occasionally see commenters talk about how monetary stimulus and/or low interest rates would merely shift demand from the future to the present. That claim never made any sense to me. Now I see that Paul Krugman is equally perplexed:
[Mervyn] King is, however, having none of it. Under his leadership, the Bank of England was aggressively engaged in monetary easing by keeping interest rates low–the bank was as aggressive in this respect or even more so than the Bernanke Fed. Now, however, King seems to condemn his old policies:
Monetary stimulus via low interest rates works largely by giving incentives to bring forward spending from the future to the present. But this is a short-term effect. After a time, tomorrow becomes today. Then we have to repeat the exercise and bring forward spending from the new tomorrow to the new today. As time passes, we will be digging larger and larger holes in future demand. The result is a self-reinforcing path of weak growth in the economy.
Is this argument right, analytically? I’d like to see King lay out a specific model for his claims, because I suspect that this is exactly the kind of situation in which words alone can create an illusion of logical coherence that dissipates when you try to do the math. Also, it’s unclear what this has to do with radical uncertainty. But this is a topic that really should be hashed out in technical working papers.
I wonder if people making this argument aren’t confusing aggregate demand with consumption. Recall that Keynesians often speak as though demand is “spending”. At that point many non-economists get confused, equating “spending” with consumption, as in “spending, not saving”.
But that’s not as all what Keynesians mean by “spending.” This is easiest to see in a closed economy context where S = I, by definition. Keynesian aggregate demand is not C, it’s C+I+G. Rather than think of that concept as spending, it makes more sense to view it as production. It is the total dollar value of output, in a given year. If people save more (ex post), then they also “spend” more on investment goods.
In contrast, in our daily lives we think of there being a choice between spending today and deferring spending into the future. But in that case we are using the term ‘spending’ in a very different way from how it used by Keynesians. We are referring to consumption, not total nominal output. If we consume more today, we will have less wealth available to purchase consumption goods in the future.
At the macro level, however, things look very different. If low interest rates lead to an economic boom, then investment spending tends to actually increase as a share of GDP. Not only does the higher level of current consumption not come at the expense of future consumption, it actually leads to more future consumption, as our capital stock is larger. Of course it must come at the expense of something, and that something is leisure time. Our sticky wages (or money illusion) fool us into working more.
King would have been better off talking about “bringing forward” labor effort. If we work harder today we might burn out, and not want to work as hard in the future.
I think this is part of a general problem in macroeconomics, where people try to visualize things using common sense analogies from their daily life, when thinking about macroeconomic policy. But it just doesn’t work. Thus many people visualize monetary stimulus as low interest rates leading to more “spending”. But monetary stimulus is more likely to raise interest rates, and the actual effect occurs due to a combination of higher NGDP and sticky nominal wages. Unfortunately, those concepts don’t relate as easily to everyday life, and hence people use false analogies, such as, “I’ll be more likely to qualify for a mortgage if Janet Yellen cuts rates”.