A commenter on Lord Keynes’ blog recently called my attention to something rather interesting; namely, that Steve Keen seems to be using some sort of supply and demand framework to determine price in the macroeconomy in his models. Let me just say that I do not follow Steve’s work all that closely and so I apologise if this is old news and has since been overcome. With that caveat, a few comments.
The moment I heard this I thought, “Ah, Steve must be using the old aggregate supply/aggregate demand (AS-AD) framework…”; indeed, I responded as such to the commenter. He then directed attention to the following article in which Keen explains that when he was integrating prices into his debt model he found himself with a number of paths that he could take.
He could take the neoclassical path and equate marginal revenue with marginal cost. But that would, as Steve well knows, be cheating. Alternatively, he could adopt a Post-Keynesian perspective and use a mark-up pricing framework. He says that this would have been a ‘fudge’ but does not say why. I would imagine that he thought that this would be a fudge because it would have been very difficult to get substantial price movements in, for example, financial markets if there was a crash.
He instead opted for a third path which he describes as such:
The one way I could do that was to argue that the price level would adjust under the pressure from the flow of monetary demand on one side, and the pressure of physical supply on the other.
This seems to me to be identical to the old AS-AD framework which can be seen in the diagram below.
What the AS-AD framework shows is a trade-off between prices and output. The idea is that as aggregate demand increases both output and price will rise. As we can see the aggregate supply curve is quite flat at low levels of output while it is basically vertical at high levels. This indicates that at low levels of output an increase in aggregate demand will lead to large increases in output with very small increases in prices because the economy is assumed to have significant excess capacity, while at high levels of output an increase in aggregate demand will only affect prices as the economy is assumed to be at full capacity.
The AS-AD is not the worst framework imaginable. Indeed, some Post-Keynesians, like Paul Davidson, have advocated its use for didactic purposes. But there are many problems with it. For one, the downward-sloping aggregate demand curve that you see in the above graph is derived from an ISLM curve that assumes a linear relationship between the interest rate and output and a fixed supply of money by the central bank.
It is assumed that as prices rise the real interest rate increases because the real value of money falls and so higher prices lead to a fall in real output via the rise in the interest rate; this is what the downward-sloping AD curve depicts. Of course, this rests on the crucial assumption that the central bank sets a fixed supply of money. Yes, we can shift the supply of money in the model by shifting the money supply curve which will then shift the AD curve, but we cannot avoid the simple fact that the AS-AD model is not compatible with Post-Keynesian endogenous money theory.
Basically, any objections to the ISLM framework that Post-Keynesians might hold equally apply to the AS-AD framework. There is simply no getting away from this. If we want to imagine the price level in the macroeconomy as simply being based on the interaction of a giant aggregate supply and aggregate demand curve we must accept the ISLM. My sense is that Keen will not be very happy about doing this.
I would also say that the AS-AD framework does not properly incorporate expectations. Surely this is an enormous problem for anyone trying to model speculative dynamics as I assume that Keen is. So, what is the alternative? Well, as I’ve said before on this blog, I tried to create a new theory of pricing for my dissertation that avoids these problems. Perhaps it would be better suited to such models.
Here, then, is a pricing equation for the macroeconomy in line with the theory laid out in my dissertation. As will shortly be seen it provides us with many advantages which I shall run through shortly. (I have omitted some more complex properties of the final equation as they would take up too much time to discuss here and will be discussed in the full working paper that is hopefully to be published soon. I should note, however, that these properties lead to some very interesting conclusions when seen in the context of the work of Hyman Minsky).
As can be seen this is a framework that is not reliant on any notion of market equilibrium or supply and demand curves. Rather it is more akin to a Keynesian multiplier relationship. Or, to put that another way, it views price as the outcome of a stock-flow equilibrium process. We simply ‘plug in’ certain variables and we get price outcomes.
In the full framework the components of price are also broken down into various sectors — for example, financial asset prices are determined by the both the government sector (central banks etc. — think QE) and the private sector (financial market investors etc.) — which gives the framework even more flexibility.
The aggregate price level, which incorporates both asset prices and real prices which I distinguish in the paper as being those that contribute and those that do not contribute to Gross Domestic Product (yes, the framework is consistent with the national accounts) is determined both by the quantity of assets, real and financial, supplied (qZ) and the amount demanded. The latter is then broken down into the quantity of financial assets demanded based on future expected prices (Pef), the quantity of real assets demanded based on future expected price increases (Per) — these are the speculative components of demand — and finally, the quantity of assets demanded for ‘real’ consumption and investment, (Pr).
The framework incorporates the best parts of the supply and demand framework given allowances for quantity rather than price adjustments. This means that it can incorporate Post-Keynesian administered pricing theory without totally ditching supply and demand. It also incorporates Marshallian price elasticity concerns and expectations as they exist in both Post-Keynesian and behavioral economics. Taken together I believe that we can reduce price formation purely to these variables and to no more. I also believe that this framework can be applied to any price formation that takes place in any type of economy.
In the paper in which I present the theory I refer to it as a ‘general theory of pricing’ and in that regard I have the following quotation from Keynes in mind which he wrote in the forward to the German edition of the General Theory (which I discuss in further detail here),
This is one of the reasons that justifies the fact that I call my theory a general theory. Since it is based on fewer hypotheses than the orthodox theory, it can accommodate itself all the easier to a wider field of varying conditions.
As I said above, I don’t know if Keen has already done something different with his model. But so far as I can see he might well be better off with the above framework as it is extremely flexible both in the phenomena that it can explain and in the manner in which it can be used to simulate economic dynamics.
I think that Keen will appreciate this to an even greater extent if he considers the expanded version of this framework which includes a novel insight that I think has very important implications for Minskyian analysis. This insight I call the ‘paradox of speculative profits’ and I think goes a long way to explaining why financial fragility can become so acute while investors remain entirely oblivious. (Hint: this problem is built into the structure of asset markets just as the ‘paradox of thrift’ is built into the macroeconomy — i.e. it is structural). I will leave that insight, however, to emerge into the light of day when the paper finally appears in full. If Steve would like a look at the paper prior to its coming out I would be more than happy to send it to him.
Addendum: I would imagine that some commenters are going to jump on me here. “But Phil,” they will say, “a good part of this blog is taken up with your critiques of abstract modelling, why here are you seeming to promote it?” To this I would give two responses that are inherently linked.
First of all, I do not disagree with modelling per se. Rather I disagree with applied modelling as is done when models are applied to data for forecasting and so forth using Bayesian or objectivist probability methods (i.e. using econometric techniques). I have no problem with using modelling as a didactic tool provided that students are made to understand clearly that modelling and actual applied economic thinking are as different from one other as are dressing up and playing fireman as a five year old and actually working as a fireman.
Secondly, and tied to this, I think that the most valuable aspects of models are their components. If you dig into almost any worthwhile macroeconomic model, for example, you will find a Keynesian multiplier equation. I propose that this component is actually more important than the model itself in that it teaches something absolutely concrete about a very real economic relationship whereas the model likely drifts off into abstractions. What gives models their value is that they impart knowledge of these components to those who study them. In this regard I fully agree with Keynes who wrote in Chapter 21 of the General Theory,
The object of our analysis is, not to provide a machine, or method of blind manipulation, which will furnish an infallible answer, but to provide ourselves with an organised and orderly method of thinking out particular problems.
It is thus, to my mind, far more important to get the various components of a model right than it is to construct a model. But if others prefer to construct models I see it as my job merely to try to give them the correct components. Recall that it was the microchip that gave such awesome power to the modern day computer and not vice versa.