Tuesday, December 15, 2009

Do Aggregate Demand - Aggregate Supply diagrams mean anything?

Krugman refers to a paper by Gauti Eggertsson. This itself is based on simple Aggregate Demand – Aggregate Supply diagrams: much the same as micro economic supply – demand diagrams for apples, etc.

These AD-AS diagrams appear in many text books but I regard them as meaningless. Will someone please please please explain what they mean?

For example Eggertson says (p.13) “A tax cut shifts down the AS curve. Why? Now people want to work more since they get more money in their pocket for each hour worked.”

This is bunk. First, people in low wage countries work much the same hours as people in wealthier countries, thus in the long run this tax cut will not influence hours people want to work (though there could be a short term temporary effect). Second, assuming the Eggertson exercise is budget neutral, government must make up for the tax cut somehow. For example it may increase indirect taxes. But this puts wage earners back where they started in real terms!

Alternatively the tax cut is NOT budget neutral: i.e. it represents a net increase in the deficit. Which in turn means the real effect comes from the increased deficit.

So what does the AD-AS diagram amount to in this case? NOTHING !!

Does anyone know of any instance in which AD-AS diagrams actually mean anything?

P.S. Thought my suspicious were well founded. See here.

P.P.S. (21st December) This argument is now turning into World War III.

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