Aggregate Demand is not what you think

Scott Sumner has a new piece arguing that supply and aggregate supply are unrelated and misnamed:

The AS/AD model that we teach our students is misnamed, as it has nothing to do with the supply and demand model used in microeconomics. To take one simple example, the vast majority of industry supply curves are almost perfectly elastic (horizontal) in the long run. The long run aggregate supply curve is almost perfectly inelastic (i.e. vertical.) These are just completely unrelated concepts.

When people think about macroeconomics, they often tend to confuse concepts. Frankly, I think that is the reason for this situation. Just like aggregate supply, aggregate demand is a terrible term for the concept that we use in macroeconomics 101.

If an ordinary person thinks about macro, he will probably see “aggregate demand” and “quantity of goods and services purchased” as the same thing (or at least use these two concepts interchangeably). But there is an important nuance:
Suppose there is no change in AD but AS has declined. We are in a supply crisis(for example, you can call it the Black Death or the Covid-19 pandemic), and even if there is no change in AD, the amount of goods people buy in stores will decrease. However, the important point is that this is a decrease in equilibrium amount, we simply cannot talk about a decrease in AD.

Let’s start with the Black Plague and then come to the present-day. The Black Death caused Europe’s population to decline by 30%. In terms of the curves shifting to the left, the demand for almost every commodity has probably dropped considerably, and of course, supply curves have shifted to the left as well. Therefore, the relative price did not change significantly.

So how could the Black Death have almost no effect on aggregate demand? How do we explain this? There were far fewer people in the world, and the demand for each commodity has dropped dramatically. Shouldn’t the aggregate demand also decline?

At this point, the concepts I mentioned above get mixed up and force you to think wrongly. I do not claim that this is anomalous, the first thing that every person who sees the terms “demand” and “aggregate demand” would involuntarily do in his consciousness would be to encode aggregate demand as “the total quantity of goods purchased.” The term we have created forces us to reason wrongly.

Here’s what really happened: The Black Death or any other epidemic doesn’t have the power to kill money, so the money supply probably didn’t change (I’m talking about commodity money, of course). By lowering the speed it may have shaken AD, but as far as we know, this did not have a serious effect. What we do know is that the Black Death increased prices and quite possibly lowered real GDP. AD curve did not shift left due to Black Death.

And the same is true for the covid-19 recession. Production of supply chains had been significantly disrupted. However, there was not a big decrease in total demand. Instead, prices rose and real GDP fell.

Here’s what happened in both epidemics:

Most people understand what the concept of demand is at the level of individual products. And most people think that aggregate demand is related to the concept of demand at the level of individual products. It isn’t. They are unrelated. Considering ordinary use, the concept of aggregate demand actually has nothing to do with “demand.”

At the micro level “demand” is a kind of real concept, the amount of Samsung Galaxy Note 10 consumers want to buy at various prices. Aggregate demand is nothing like that. When we talk about AD, we are not talking about consumer goods. AD is a nominal concept related to money. Monetary policy determines the AD and only central banks have the tools needed to solve AD-related problems.

The piece in The Economist is quite important at this point:

But whether the understanding of supply shocks forged in the 1970s still applies is unclear. In practice, the distinction between shocks to demand and those to supply is fuzzy. In a paper published in 2013 that revisited the era of stagflation, Alan Blinder of Princeton University and Jeremy Rudd of the Federal Reserve argue that supply alone cannot explain the soaring unemployment of the 1970s. In fact, they say, price increases had demand effects that mattered more. They raised uncertainty, reduced households’ disposable income and eroded the value of their savings.

So what can be done with these terms that make us confuse concepts and reason wrongly? My suggestion is to call it nominal expenditure(s). If we use this term, we will have a much more useful and accurate term for the concept.

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