Saturday, May 31, 2014

A Keynesian Look at the Great Recession

               Recently there has been a prolonged period of productivity increase without a corresponding increase in labor income.   The result is that the supply of goods and services throughout the economy has increased, while the purchasing power of labor has not. We analyze  the consequences of this from a Keynesian point of view.

In Diagram  0 we show the classical Aggregate Supply curve AS. It is just a vertical line at the size of the economy, the size of the Gross National Product of the economy.  The thinking behind the classical AS curve is that production is independent of price level.  If money is added to the economy, or the velocity of money increases, prices merely rise, or inflate, but production does not increase.  Similarly, if money leaves the economy, or the velocity of money decreases, prices merely decrease, or deflate.  Production does not decrease.  The actual price level at e is set by the intersection with the Aggregate Demand Curve AD, which is the relationship between the total demand for goods and services and the price level.  If the price level goes up, things are more expensive, and people can buy, or choose to buy,  a smaller quantity of goods.  If the price level goes down, things are cheaper, and people can buy, or choose to buy, a larger quantity of goods.  So for a given quantity and velocity of money, at a given supply of goods and services, there is feedback: An increase in quantity demanded, above Q drives the price level back up toward e, and a decrease in quantity demanded  below Q drives the price level back down toward e.  

This is the same sort of feedback that sets the equilibrium for the intersection of ordinary supply and demand curves:  If the price of a good goes up, manufacturers want to make more, but people want less of it.  If the price goes down, manufacturers want to make less, but people want to buy more.  These two tendencies settle where the supply and demand curves intersect.

Diagram  1  shows the Keynesian Aggregate Supply   AS curve, as opposed to the classical Aggregate Supply curve.  The rationale for the Keynesian AS curve bending  back is the idea that, if the price level goes below this level, production decreases dramatically because wages (and actually some other prices, too, under oligopoly,) do not decrease rapidly.  They are considered 'sticky,' for various reasons, and so instead of wages going down, employment decreases.  That is unemployment increases. Fewer workers implies, in the short run, production of goods and services decreases.  That is, Aggregate Supply decreases.  Meanwhile, the Aggregate Demand curve shifts to the left, because fewer workers have  money to purchase things. This is the situation during a depression or recession.   (Shown in red. The AD curve is about in the position it was during the Great Depression, when first demand, and then production, decreased by about a third.)  The capacity to produce is still there.  It is still at Q, but it isn't being utilized. Actual production is reduced to Q'.  The GNP is smaller than it could, and should be.

The curved region of the AS curve represents the idea that, as the economy approaches full capacity, resource bottlenecks appear, as some sectors reach full capacity before others, driving up the price level. The closer to full capacity, the greater the number of bottlenecks, and the more the price is driven up.  We show the equilibrium point, where the economy is actually performing, part way up the curve, at less than full employment, and at less than full utilization of capital and resources. We would expect this situation in a growing economy. An economy only rarely operates at 'full' capacity.

In Diagram 2 we see what happens when wages increase along with labor productivity.  More is being produced, so the AS curves shifts to the right, and more is being demanded, since wages have also increased.  Both curves shift a comparable amount , so employment remains  high, as does the utilization of capital.  Other things being equal, the price level stays the same, while the economy, the GDP, grows from Q to Q'.  (We are implicitly adjusting for any inflation.)  

 Next, in Diagram 3,   we consider when wages do not increase at a rate equal to the increase in labor productivity,  Since productivity increases, more is being produced, so the AS curve shifts to the right.     The Aggregate Demand curve also shifts to the right, but not as much.  This is because income which would have gone  to labor instead goes to the owners of capital, who save a greater proportion of their income.  Saving more, they spend proportionately less.

  Since it moves less, it is now further back along the backward bend of the Aggregate Supply curve, into the recession region.  Because labor borrows, in order to maintain its living standards, this does not happen gradually.  This borrowing temporarily shifts the AD curve along with the AS curve, as in Diagram  2.  But this can only be temporary, because eventually labor's credit runs out, and this happens suddenly.  When it happens, the AD curve shifts back to the left (the red AD" curve), and we have a recession. (Diagram  4.) 

            Here the economy produces at quantity Q", less than the potential Q', which the real economy has grown capable of producing.   With labor productivity increased, but demand down, the economy becomes locked into a high unemployment mode, with reduced demand.  It also becomes locked into a mode of low capacity utilization of capital and resources.  This discourages investment.  

            There still remain questions. One is why haven't prices declined significantly?  Well, one of the things that has been happening is that the economy has been running a trade deficit for a number of years.  So for a long time now, many sectors have already been running at below capacity.

           Another, more ominous possibility is that the consequences of Quantitative Easing are slowly being felt in the real economy.  People have wondered why, with an apparent increase in the money supply, there hasn't been inflation.  But if the money is trapped outside of the real economy,  then the quantity (M x V) hasn't changed much.  This is  because although M has increased, V, in reality, counting all the QE money outside of the real economy which has zero velocity, has become very low, and is only slowly increasing as more money slowly enters the real economy.  One of the reasons this money is slow to enter the real economy is the dearth of investment opportunities, a consequence of the fact that, although nominally the economy is growing, from the point of view of employment, and labor income, and thus consumer demand, it is still in recession.