Bills according to ECON102 (and científicos)

Not that I have a high esteem of my previous colleagues (the economists): the story of this Debate sufficiently illustrates how, with the exceptions indispensable to confirm the rule, the category has not made a great contribution to the understanding of current problems, being divided between people hiding their heads in the sand and people staring in the wrong direction. After all, even the story of the "bills" (the increase in energy costs) confirms this. When in March two years ago (2020), in this blog we feared the hypothesis that the pandemic could cause a flare-up of inflation due to supply-side bottlenecks , the communis opinio of the experts mostly saw risks on the horizon. of deflation, determined by the drop in demand (sin is said but not the sinner: here one …).

However, even if we can normally do without their opinion (the Christmas spirit leads me to spare you other examples), in this world of científicos (as the technicians were called in the distant and so close times of Porfirio Diaz ) it is not entirely it is useless to know how economists think. Let me clarify: knowing how economists think will almost never help us to understand directly how things will turn out, but very often it will help us to understand what the científicos know they know and therefore what their future moves will be, indirectly allowing us to understand how they could to end things (badly, obviously, in line with the refinement of their científico thinking).

In the glorious days of Samuelson (1941) to deride economists they were described as parrots that have been taught to repeat "supply and demand". In the meantime, partly because of Samuelson (or so Paul Davidson thinks , and if it interests me I agree with him) the task of mocking economists has become much, too much simpler.

This particular order of científicos is in fact divided into two families: the parakeets of demand and the cockatoos of supply.

Yes, today for the most part (ie excluding post-Keynesians) economists are parrots who repeat a single word. The "Keynesian" parakeets repeat "question, question, …"; the "neoclassical" cockatoos (those you call neoliberals, so to speak) repeat "offer, offer, …". Yet, as you well know, for Adam Smith (the author whom neoclassicals cite without having read it) demand was important, so much so that it determined, among other things, an important characteristic of supply, perhaps the most important: productivity. (which post-Keynesians are still aware of today, while Keynesians ignore it: here is the whole explanation, if it matters ). Conversely, for Keynes (the author whom Keynesians cite without having read it) the conditions of the offer were essential in determining the equilibrium of the system: it is enough to reread his analysis of the Great Depression , or to remember that in pulling the strings of reasoning Chapter XVIII of the General Theory starts from listing the factors that influence the shape of the aggregate supply curve.

But to the idiots savants who populate our departments The Wealth of Nations or the General Theory today would not seem like científicos books, because they lack mathematical formulas, and it is also for this reason that they do not read them: they do not satisfy their inexhaustible and inexhaustible need to feel intelligent doing things that seem difficult to them. In the age of academic hyperspecialization, rather than managing a world made up of two pieces, it pays to concentrate on one, and only one, of these pieces, cultivating it with sterile and maniacal persistence. So it happens that if you are a parakeet and a supply shock arrives (like in 2020), you will expect the consequences to be those of a demand shock, while if you are a cockatoo and a demand shock arrives (like in 2009) you will handle it. as if it were an offer shock.

Now, such "errors" naturally depend on an enormous amount of historical, sociological, epistemological, deontological motivations, and so on and so forth. The most relevant are also the noblest: the desire to attack the donkey where the master wants, and the desire to make a career. These reasons are transversal to many fields and therefore I do not hesitate to imagine that you will immediately understand their importance. In short, some "blunders" are more apparent than real, in the sense that perhaps, by remembering what was written in the books of the first year, and what they teach to ECON101, many colleagues, as we have repeatedly highlighted in this blog, could ( and they should have) done without annoyingly recommending the wrong recipe (for example, austerity during a negative demand shock). The fact is that in certain historical contingencies if you don't say what you have to say you don't make a career: they don't publish you ( they tried with me, as you will remember ), you don't enter the right network , etc.

En passant I point out that these mechanisms that we have seen so many times at work in the economic profession (made up of macroeconomists, microeconomists, labor economists …) are exactly those that we see today at work in the medical profession (made up of virologists, epidemiologists, immunologists …).

Nothing more, nothing less.

But beyond this human misery, which we all have in common (not only economists and doctors are human – perhaps in this period they are a little less so than others – we are all human, indeed: humanƏ), beyond this human fragility there is also another reason, more "technical", which explains the strange difficulty of parakeets and cockatoos in keeping in mind the two magic words: supply and demand. I think this difficulty partly depends on the extraordinary roughness of the model that all of us professionals use to hold the two pieces together. Today I want to explain to you what this model, the AS / AD (aggregate supply, aggregate demand) model is like, and what, using it, the científicos expect will happen following the increase in energy prices. If you get to the bottom, you too will be científicos . The explanation I will give you will do without formulas: for those who want to feel intelligent, I suggest they reread a canto of Dante. However, it will be essential to use graphics. Sorry. On the other hand, this is a technical blog and no one forces you to read it, especially in a week when many other concerns are hanging over us all.

The units of measurement

To begin with, it is useful to understand well which variables are represented by the model. It's not difficult, there are two:

on the abscissa axis, the volume of product (gross domestic product), indicated by the letter Y , and on the y- axis, the price level, indicated by the letter p.

First observation: Y is GDP, not GDP growth (economic growth), and p is the price level, not price level growth (inflation). The model is therefore static , which means, as we will see better by "filling in" this box, that the model most used by economists does not represent the two things that economists are most interested in: product dynamics (growth) and price dynamics. .

Eggnente, it already makes you cry like that, but this is only the first step of your descent into the abyss …

The long-term offer

In (micro) economics, the supply curve indicates which quantity q of a given good the entrepreneur finds convenient to produce given a certain price level. Normally, as the price increases, the entrepreneur is incentivized to produce more, and therefore the supply curve has a positive slope, that is, it is something of this type, where higher prices correspond to greater quantities:

The AS / AD model does not consider the quantity q of a single good but the aggregate Y of all the goods produced by a given country, and it does so assuming that in the long run the supply of goods, understood as the maximum quantity of goods it is possible to produce, it depends only on technology and on the supply of productive factors (capital and labor). The long-term aggregate supply, i.e. the country's productive potential, which depends on all these beautiful things (which are not represented in the model, i.e. they are exogenous), on the other hand, does not depend on the other thing that exists in the model, that is, from the price level. In other words, the long-run supply curve looks like this:

A vertical line placed at the (exogenous) level of potential GDP, which is the strange object I have talked about for example here and on which we held this conference . Wanting to take for granted the estimates of this gigantic whore (sorry: such it is and as such it must be defined) provided by the IMF, to give some substance to the graph, assuming that Y is measured in billions of euros, we could write:

that is: the long-term supply curve in 2021 is vertical at the level of 1749.17 billion euros, corresponding precisely to the (estimated) potential GDP.

By the way, since I told you I wouldn't use formulas, then I use them. The IMF does not directly provide the value of potential GDP, but that of the output gap (you can find it in this Excel sheet ), defined as the difference between actual and potential GDP expressed as a percentage of potential GDP:

so the potential GDP can be obtained by inverting the formula:

and with the 2021 data you get:

that is, according to the IMF in 2021 we would be 85.78 billion below our production potential (I believe the gap is much greater , as you know, but let's close the parenthesis here).

What is the significance of this vertical, ie "rigid" curve with respect to the price level? We can read it like this: in the long run it does not matter what the prevailing price level is, because the system will not be able to go beyond the level of production made possible by technologies, by the number of workers and by the stock of physical capital (machines, equipment, warehouses, etc.) available. Ad impossibilia nemo tenetur .

Aggregate demand

and reflects the fact that when the price p of a good increases, the quantity q we wish to consume decreases. By transposing the discourse on the macroeconomic level, what we are interested in representing is aggregate demand, that is, in essence, the purchasing power available to the entire national community (imagining a closed economy, without exchanges with foreign countries, otherwise we should also consider the purchasing power of citizens residing elsewhere). Unlike aggregate supply, which does not depend on prices for the reasons set out above, aggregate demand obviously depends on prices in the opposite way: if prices increase, the purchasing power of the monetary balances available to citizens (consumers, entrepreneurs) decreases. ) and therefore their expenditure (for consumption, investment) will necessarily have to decrease. The aggregate demand curve therefore looks something like this:

from the vaguely hyperbolic trend (in fact, the simplest analytical derivation produces an equilateral branch of hyperbola, but I do not bore you with this too), meaning that when prices tend to infinity (i.e. when it goes upwards) the the quantity of goods that residents can buy tends to zero, while if prices tended to zero, the quantity of goods that could theoretically be purchased would tend to infinity.

It's not that hard, if you think about it …

Assembly: the long-term equilibrium

Of course, now as good psittacines we have to put together supply and demand: in doing so we will identify a balance point. Something like this comes out:

Point E is equilibrium. At that point the price level ( p superseded) is such as to allow residents to purchase a level of product exactly equal to the potential product. If prices were lower, demand would be greater than potential GDP. But since potential GDP is, as you will recall, the level to which production can be pushed without generating price increases, any attempt to push demand to the right of the vertical supply curve barrier, pushing prices down, would raise prices. prices, bringing us back to E. If prices were higher, potential output would exceed demand, which would push prices down.

Think about it a bit, but in the meantime consider two things: the first is that the point E , the point of equilibrium, in a static model is a dead point. In E there is no growth (the product is exactly equal to the potential and it stays there), in E there is no inflation (the price level is exactly what allows residents to buy all the potential product with the money they have, and there it stays). A point of zero growth and zero inflation that is quite unrealistic.

The second thing is that if we had been in long-term equilibrium in 2021, our GDP would have been 1,749.17 billion. Instead it was 1,663.39 billion (according to the IMF). To take these figures for granted, it would seem that in 2021 we were not at the long-term equilibrium point, but a little below (and God forbid, given the slap we took)! Now, I will not go into how the shock caused by COVID should be represented in this model (I anticipate that if you are interested in a clear scholastic explanation it is here but of course the question is not simple , given that COVID is a complex phenomenon for such a simple model. ). I would first like to explain to you how this model represents the fact that the economic system may not always be in a long-term equilibrium position, a stable position in which no variable shows a tendency to move: this is done by introducing the supply curve of short period.

The short term

In graphical terms, this means that the SRAS is horizontal:

Assembly: the short-term equilibrium

Let's try to put all three pieces together. As they are made, the long-term curves will necessarily meet at one point, and only at that point (which is therefore, by construction, the long-term equilibrium). However, having three curves meet at the same point requires a little more luck.

Since we are científicos , we do like the científicos , that is, we pretend to have this fortune. The graph would look like this:

In this case, point E would be in equilibrium both in the long and in the short term, that is, at the price level p above, the actual GDP would coincide with the potential one. To use a term that some of you are familiar with, this is a situation in which the output gap is zero: there is no inflation, there is no need for expansionary policies (otherwise inflation would start), nor restrictive policies (otherwise would enter deflation).

Obviously this situation is not very realistic, even if the IMF statistics tell us that we will reach it in 2024 (when according to them the output gap will be zero). But we can use it as a convenient starting point to examine the effects of a typical short-term supply shock: an exogenous price increase caused by rising energy costs (the famous "bills"). What happens if the "bills" increase by 50% (as is happening)? What does the model tell us will happen? So what do the científicos think will happen?

GDP and bills

Meanwhile, consider that the rise in "bills" is not a long-term supply shock: it does not change either the technology, the available workforce, or the amount of machinery available. The AS curve will therefore not shift. It is not even a shock of demand: the increase in prices is exogenous to the demand, we are not the ones who have raised them in such a hot winter (on New Year's I was in Saracinesco sunbathing in a T-shirt 908 meters above sea level , which is not obvious in those parts …). The AD curve will not move either. In the model, the increase in "bills" determines an upward shift (ie towards higher prices ) of the short-term supply curve.

That is, something like this happens:

where, to facilitate (I hope) your reading, I have added some arrows:

So what? So what do our científicos expect to happen following rising energy costs? Simple: in their model the SRAS short-run supply curve will move up in SRAS ', simply because the increase in the cost of energy will cause the prices of every good and service to rise. The general price level will then rise to p ' , i.e. there will be inflation (along the path from p to p' ). Consequently, the new equilibrium will no longer be in E. The short-run supply curve will intersect the demand curve in E ' , at a lower level of GDP, Y' , that is , there will be recession (along the path from Y overridden to Y ' ).

A supply shock of this kind therefore simultaneously causes two things that no one likes very much, at least not in this combination: inflation (rises p ) and recession (falls Y ). Inflation, as you know, is already there . The recession must be interpreted. In this very simple model we are witnessing a decline in the level of GDP. In fact, however, the world is more complicated. At the moment we are still in a rebound phase after the slap of 2020-2021, for 2022 we are talking about a growth of 4%. Here, let's say that maybe on balance in 2022 the growth could not be 4%, but lower, with all that this entails, for example for debt sustainability. After all, we have already seen that the OECD weekly tracker shows some signs of fatigue , therefore: it is already happening.

And the científicos know it.

The moral of the story

The interview with Borghi today on the Truth (by the way: did you subscribe?) Stands out for its contents and iconographic equipment. The photo chosen perfectly sums up the moral of the story, which is more or less this: when the SRAS slides upwards, if you are a científico you will want to be everywhere, except the Government.

If I have been able to make you understand why, I am delighted.

If I have not succeeded, I am here to answer.

Good night!

This is a machine translation of a post (in Italian) written by Alberto Bagnai and published on Goofynomics at the URL https://goofynomics.blogspot.com/2022/01/le-bollette-secondo-econ102-e-gli.html on Mon, 03 Jan 2022 20:34:00 +0000. Some rights reserved under CC BY-NC-ND 3.0 license.