Sunday, May 27, 2012

Don't we want to think about that?


Marcus Nunes' A last ditch defense of Inflation Targeting still has my attention. Tryin' to work through what he says, so I can summarize it before I say what I think. I got stuck where he says "the short-run AS (SAS) curve was perceived as horizontal when output is below potential".

I like to read Nunes because he will often add a parenthetical phrase that works, for me, to make sense of a technical concept. Didn't happen this time. Here: here is the whole paragraph:

When placed in the dynamic Aggregate Supply (AS)/Aggregate Demand (AD) framework, this “cost-push view” as advocated by policymakers in the 1970´s suggests that the short-run AS (SAS) curve was perceived as horizontal when output is below potential.

"AS" is Aggregate Supply. "Short run", I can imagine what that is. "Cost-push", this is what fascinates me most about the article, because we need to look more at cost push. And "output below potential", I get that. I get all of that. It's the Aggregate Supply curve that stopped me cold.

What are the axes? If the curve is "perceived as horizontal" then I need to know what's on the vertical axis. Supply is a curve that slopes one way, demand slopes the other, where they cross is the perfect price or something, I get all that. But I didn't memorize the supply curve axis labels. I have to stop and work that out.

It rolled around in the back of my head a few days, then suddenly made sense. Nunes says it was thought that prices would not go up due to increased demand, if supply was below potential.

In other words, SAS is horizontal -- no change in prices when demand increases -- if supply is below potential. Or so it was thought in the 1970s.

So, price is the vertical axis and supply is the horizontal. Google brings up some images; these all show price on the vertical axis. Got it.


Wikipedia (out of context):

At low levels of demand, there are large numbers of production processes that do not use their fixed capital equipment fully. Thus, production can be increased without much in the way of diminishing returns and the average price level need not rise much (if at all) to justify increased production. The AS curve is flat.

As Wikipedia has it, "At low levels of demand ... the AS curve is flat." As Nunes has it, when output is below potential the AS curve is horizontal. As I have it, if supply is below potential, increasing demand won't raise prices. So it was thought in the '70s.

Now, I guess, we know better: Prices go up all the time, regardless of the output gap, regardless of demand.

That's why cost-push fascinates me.


Now I have a question. According to Nunes -- and the world -- prices *do* go up when demand increases, even when supply is below potential. Inflation is due to aggregate demand, the world says.

But, even when demand is below potential? Before the crisis, in the Bush years, the economy was really slow. Prices went up anyway. That was a demand problem?

Once upon a time, prices went up and down (as the red line shows). Now, prices only go up. (The red line almost never goes below zero.)

And, by one measure at least, economic growth since the 1970s has been substantially below the average of the past 200 years. Growth was better, back when prices went up-and-down. These days growth is less, and prices only go up.

Now, Aggregate Demand (AD) is relatively low. Demand is not sufficient to pull prices up. But now -- for decades before the crisis, I mean -- prices only go up. Doesn't this support a view that Nunes and the world reject -- the view that inflation was cost-push in the 1970s? And maybe, that inflation has been cost-push for quite some time?

Prices don't go up-and-down. Prices only go up. Prices are going up even while demand is relatively low. Doesn't that sound like there must be something other than demand that is pushing prices up? Doesn't it sound like cost-push?

Don't we want to think about that?

Sure, you can suppress the quantity of money and thereby keep demand, and inflation, and growth, at a low level. But that does not mean it was demand-pull inflation.

If there are cost-push forces at work, suppressing demand will not solve the problem. It will reduce or "moderate" economic growth. It will reduce or "moderate" inflation. But cost-push forces will continue to eat away at profits and living standards.

So the question that must be asked is whether, in our experience, inflation is cost-push or demand-pull. The question is easily answered, because the two inflations are related to two different economic conditions. Under demand-pull, incomes are plump and the economy is good. Under cost-push, incomes are lean and the economy is not good.

Don't we want to think about that?

7 comments:

Greg said...

In a world where bank credit is how everyone gets their financing the relationship between demand for the good and price of the good CAN be broken.

Think of it this way;

I own a business and I have a payment to the bank each month of 10,000$. I currently sell 2000 of x for 10$. When I only sell 1000 of x for a few months I cant lower the price or I dont make my payment to the bank. I must raise the price to keep my nominal income the same. The cost of bank financing wont change as quickly as I can change the price. As long as every business is in the same boat (most are) I wont be uncompetitive.

nanute said...

Arthur,
. Under demand-pull, incomes are plump and the economy is good. Under cost-push, incomes are lean and the economy is not good. Don't we want to think about that?
I think this raises another, perhaps more important, question: Under which condition is it more likely that raising prices is sustainable?

The Arthurian said...

Greg: "In a world where bank credit is how everyone gets their financing the relationship between demand for the good and price of the good CAN be broken."

So I think you are saying demand-pull can become irrelevant as an explanation of inflation, in an economy where there is excessive reliance on credit.

I can buy that. Good observation, too: "As long as every business is in the same boat (most are) I wont be uncompetitive."


Nanute, my point is that we cannot solve cost-push problems with demand-pull policies. But given a "good" economy and a "not good" economy, I suppose the "good" one is more sustainable. (This assumes that the "good" doesn't go bad during the sustainment period.)

So, demand-pull I would say is more sustainable than cost-push. The latter is a downward spiral.

But I have to add: I do not think of inflation as something to be sustained. What do you have in mind?

nanute said...

Art,
I was thinking along the lines of the late Bill Vickery's "5 F's". From #4:....The main difficulty with inflation, indeed, is not with the effects of inflation itself, but the unemployment produced by inappropriate attempts to control the inflation. Actually, unanticipated acceleration of inflation can reduce the real deficit relative to the nominal deficit by reducing the real value of the outstanding long-term debt. If a policy of limiting the nominal budget deficit is persisted in, this is likely to result in continued excessive unemployment due to reduction in effective demand. The answer is not to decrease the nominal deficit to check inflation by increased unemployment, but rather to increase the nominal deficit to maintain the real deficit, controlling inflation, if necessary, by direct means that do not involve increased unemployment. See #'s 5,&6 for more on this. As you say, policy considerations matter.

jim said...

To Greg,

Sorry, but your analysis just doesn't hold up. At least not for long.

If sales drop off 50% (your example) The successful business will be the one that lowers its price and captures
more of the market. Ultimately somebody has to go out of business (or sell something else).

That assumes customers are responding to price. Obviously, your analysis works well if customers are going to buy some fixed amount regardless of price.

Greg said...

Jim

I do think your example is true in an environment where there are the same number of potential customers but preferences may have changed. Im referring to an environment where all potential customers have dropped because of an economy wide fall in disposable income. In scenario two, classic econ theory would say that prices will drop but Im trying to show how that condition might not hold at least for a while. As Arts more recent post talks about costs to business drive their pricing decisions. The only cost that our neoliberal masters want to focus on is labor costs, thats why the rush to fire all public employees and push for an abolishment of min wage laws. Im saying its the cost of credit that is their biggest cost and it is very sticky. When you have to make a mortgage payment (or the businesses equivalent of mortgage) you can only drop your prices so low........ and you MAY have to raise prices in the face of falling demand so that your income stays the same, in order to pay the bank.

If I recall correctly, many businesses were punished by VCs and corporate raiders the last few decades because they had cash. Businesses were encouraged to lever up their credit and not be in cash much. When they are all near the redline of the company equivalent of mortgage/income ratio it doesnt take much of a downturn to put lots of them out of business. But before they go out of business many will raise prices some to keep their falling sales volumes from busting them seems to me.

Greg said...

"So I think you are saying demand-pull can become irrelevant as an explanation of inflation, in an economy where there is excessive reliance on credit."


Bingo! The cost of credit is the largest non labor cost for some of these businesses Ill bet