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Nominal GDP >>> Aggregate Demand

Summary:
In the past, I’ve called for replacing the aggregate demand curve with a curve representing a given level of nominal spending. Under this approach, a positive nominal spending shock occurs when NGDP growth is above target, and vice versa. It seems to me that the Covid economy provides a perfect example of why “aggregate demand” is not a useful way to think about the forces shaping the macroeconomy.  Over the past two years, prices have risen by more than normal while real GDP growth has been well below trend.  In the standard AS/AD model, this looks something like the following: (To be clear, the drop in output over the past two years is relative to trend; in absolute terms RGDP is up slightly.) So from an AS/AD perspective it looks like the US was hit by a

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In the past, I’ve called for replacing the aggregate demand curve with a curve representing a given level of nominal spending. Under this approach, a positive nominal spending shock occurs when NGDP growth is above target, and vice versa.

It seems to me that the Covid economy provides a perfect example of why “aggregate demand” is not a useful way to think about the forces shaping the macroeconomy.  Over the past two years, prices have risen by more than normal while real GDP growth has been well below trend.  In the standard AS/AD model, this looks something like the following:

Nominal GDP >>> Aggregate Demand

(To be clear, the drop in output over the past two years is relative to trend; in absolute terms RGDP is up slightly.)

So from an AS/AD perspective it looks like the US was hit by a negative supply shock.  But it’s equally true that the inflation is being driven by surge in demand for goods (as opposed to services.)  You could say that the increased demand for goods has caused a supply shock, as our economy cannot suddenly turn on a dime and produce far more goods and far fewer services.  

You can see how terms like “supply” and “demand” don’t do justice to the complexity of the situation.  No matter how many times we say that aggregate demand is not the same thing as industry “demand”, people will continue to confuse the two concepts.  Consider the following word salad from Investopedia:

Aggregate Demand Controversy

Aggregate demand definitely declined in 2008 and 2009. However, there is much debate among economists as to whether aggregate demand slowed, leading to lower growth or GDP contracted, leading to less aggregate demand. Whether demand leads to growth or vice versa is economists’ version of the age-old question of what came first—the chicken or the egg.

Boosting aggregate demand also boosts the size of the economy regarding measured GDP. However, this does not prove that an increase in aggregate demand creates economic growth. Since GDP and aggregate demand share the same calculation, it only indicates that they increase concurrently. The equation does not show which is the cause and which is the effect.

I have no idea what any of that means.  Surely they can’t be equating AD and real GDP?  In fact, it’s even worse.  In the previous paragraph they equate AD with real consumer spending (i.e. C/P.)  By that definition, a burst of technological progress which shifts the AS curve to the right will cause aggregate demand to increase, even if the aggregate demand curve never shifted.

It’s as if Investopedia was confused as to whether an increase in GDP caused more C+I+G, or whether an increase in C+I+G caused more GDP.  At least that’s what I think they are saying here:

Since GDP and aggregate demand share the same calculation

All this confusion could be eliminated if we changed the language of macroeconomics to something like a NS/RO model—nominal spending and real output.  Nominal GDP and real GDP most certainly do not “share the same calculation”.

With that framing, the Covid economy is much easier to explain.  Over the past two years, nominal spending has grown at a normal rate, whereas real output has been depressed by structural problems.  Going forward, nominal spending over the next year is likely to be too high to maintain an average inflation rate of 2%.  If I am correct, then by the end of 2022 we will have had a period of elevated inflation associated with both above normal nominal spending and structural problems in production. 

Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment". In May 2012, Chicago Fed President Charles L. Evans became the first sitting member of the Federal Open Market Committee (FOMC) to endorse the idea.

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