To slope or not to slope (yet again)

[Tom.Weisskopf@xxxxxxxxxxxxxxx]

As Gil Skillman has noted, PEN-L seems to be an ideal medium in
which to raise issues, but a very poor one in which to resolve
them.  So it seems to be with the downward-sloping AD curve: the
continuing discussion with Peter Dorman, Barkley Rosser et al.
has illuminated many of the relevant factors, but it has not
established a clear case one way or the other.

With this message I would like to take a slightly different tack
on the question, by asking: what would a downward-sloping AD
curve help us to explain, and is that plausible in light of what
we know about the real world?  In macro texts it is typically
used to explain: (1) the impact of a supply shock on real GDP (Y)
in the short-run and (2) the adjustment of Y and the aggregate
price level (P) to an inflationary or deflationary gap in the
long run.  If there is a downward slope to an AD curve, then (1)
an adverse supply shock will reduce Y (not just increase P) and a
favorable supply shock will increase Y (not just reduce P); and
(2) the macroeconomy will adjust to an inflationary gap with
increased P and reduced Y, and it will adjust to a deflationary
gap with reduced P and increased Y.

The parts of the above stories involving reduced P are of course
inapplicable to real-world history (in at least the last 50
years), but they can perhaps be rescued by positing that the
action takes place against a background of an adaptive-
expectation-fed underlying core rate of inflation (accommodated
by a corresponding increase in the money supply) -- in which case
we can interpret an upward movement in P as an increase in
inflation above the core rate and a downward movement in P as a
reduction in inflation below the core rate.

Consider the rest of the (1) story: is it plausible that an
adverse supply shock would reduce Y?  It does appear to have done
so in the US economy in 1973 and 1979.  Here it seems to me that
the most crucial question is whether or not one can expect the
money supply to accomodate the increase in P.  If *not*, then we
would expect aggregate demand to be dampened (via the effect of
higher nominal and real interest rates on net foreign and/or
domestic expenditure).  If *yes*, then we would expect no change
in the real variables.  After 1973 and 1979 we did see higher real
interest rates  and lower Y -- though arguably these resulted from
deliberate government policy rather than some "natural" reaction
to the supply shocks.  Still, which is the better assumption:
(a) that the money supply will generally expand to accomodate the
supply shock, or (b) that the money supply won't accomodate the
supply shock, so there will be increased interest rates and
dampened demand?  If (b), we learn something from a downward-
sloping AD curve; if (a), the AD curve might as well be vertical.

Is it plausible that a favorable supply shock would increase Y?
Arguably this was an element in the US economy's expansion in the
1980s.  In this case it would again seem to be most plausible to
expect that the money supply would not adjust pari passu with the
reduced price pressures, that interest rates would tend to fall,
and that aggregate demand would as a result tend to rise.  In
general, it seems to me that the argument against the downward-
sloping AD curve ultimately hinges on a case that either (1) the
money supply adjusts endogenously to any changes in prices or (2)
interest rates have no effect on aggregate expenditures.  And I
am not convinced that either of these propositions is reasonable.

Turning to the long-run implications of a downward-sloping AD
curve, is it plausible that there is a "self-adjusting mechanism"
whereby a capitalist macroeconomy tends to eliminate inflationary
or deflationary gaps -- i.e., approaches "potential output" (Y*)?
In the present context it does not matter whether Y* (and its
twin, the NAIRU) are determined in more-or-less free labor
markets or by bargaining power.  A downward-sloping AD curve
implies that gaps will lead to price changes that interact with a
constant money supply to produce an adjustment of Y toward Y*.
If the money supply adjusts only partially, the adjustment
process takes longer.  As long as there is not complete money
supply accomodation to price changes, the logic seems to me
reasonable; the fact that so many other things change over time,
however, makes it somewhat absurd to think that we would ever be
able to see the self-adjustment process work itself out in real-
world history.  As a long-run tendency, however, I don't see a
problem.

Note that the same issue arises if we operate in P-dot/U space
rather than in P/Y space.  In the former we have a sloping short-
run Phillips Curve corresponding to the AS curve in P/Y space,
but there is no counterpart to the sloping AD curve.  Such a
curve could be drawn, however, on the basis of a "neutral"
assumption of constant money-supply growth (indeed, I think I
remember Bob Rowthorn doing something like that in a late 1970s
article on conflict and inflation).  In that case we would
observe a similar very-long-run self-adjustment mechanism whereby
the economy gravitated toward the NAIRU.  Again, the logic seems
reasonable, though one wouldn't expect to be able to track this
process in real-world history because so much noise would
overwhelm it.

It might appear that a rise in the rate of price inflation would
be accompanied by reduced rather than increased real interest
rates, since it raises the expected-inflation premium to be
subtracted from nominal interest rates.  But this assumes that
nominal interest rates would be constant, or rise no more than
the rise in the inflation rate.  I think that under conditions
of constant money supply growth (accommodating only the original
rate of inflation) one can show that the progressive squeeze on
the money supply resulting from an unaccommodated higher rate of
inflation will cause nominal interest rates to rise enough to
assure a rise in real interest rates as well.

To conclude this rambling presentation, I end up finding the
downward-sloping AD curve a logical and not unuseful theoretical
construct -- provided that one recognizes and explains clearly
its grounding in a somewhat unaccomodating supply (or growth) of
money, and provided that it is not unreasonable to posit -- with
Keynes -- that interest rates affect aggregate expenditures.

                                   Exhaustedly,  <Tom Weisskopf>