Output gaps and heterogeneity

What shape is the Short Run Aggregate Supply (SRAS) curve? The question might sound tediously esoteric but it is, in fact, central to current economic policy debate.

In the long run almost all economists agree that the supply curve is vertical. The quantities of factors of production (land, labour, capital) available at a given time are fixed and even combined in the most efficient way can yield only a given amount of output. In this long run analysis the only way to increase the supply of goods and services available, the essence of economic growth, is to shift the vertical supply curve to the right by either increasing the amount of productive factors, or increasing the efficiency of their combination (their Total Factor Productivity).

Some economists think this also applies in the short run. As a result they argue that any attempted expansion of demand via monetary or fiscal policy, shifting the demand curve to the right, will simply result in rising prices. Output and employment will be unaffected.

But does it actually apply in the short run? After all, we see many factors of production lying idle. Unemployment, at 7.7%, is higher than at any time between January 1997 and May 2009. 14.1% of shops were empty in September according to the Local Data Company, barely down from 14.2% in February. Here we are in the ‘output gap’, the difference between current output and what output would be if all those unemployed workers were put to work in all those empty shops.

Couldn’t monetary stimulus bring these unemployed workers and empty shops together to increase employment and output without causing inflation? Monetary expansion will not cause higher prices, on this thinking, because rather than bidding up the wages of workers already employed or rents of commercial premises already occupied, the idle ones will be employed instead. That is what Bank of England governor Mark Carney sees when saying that monetary stimulus will continue at least until unemployment falls to 7%. Isn’t this the economist’s hitherto mythical ‘free lunch’?

A problem with this approach is that it views the factors of production as largely homogenous. Every square foot of empty commercial property, whether boarded up corner shop or out-of-town retail unit, is lumped in with every JCB as ‘capital’. All unemployed workers, whether builders or estate agents, are aggregated as undifferentiated slack in the labour market. What this approach misses, as does much clumsy, aggregative, ‘modern’ macroeconomics, is heterogeneity.

As economist Benjamin Powell points out, “A tractor is not a hammer”. An economy experiencing a tractor boom may find itself with a glut of unemployed tractors when that boom busts. Hammers, on the other hand, would be relatively scarce. As a result the returns on employing each capital good, tractors or hammers, will differ.

Any monetary stimulus attempting to bring these tractors back into employment will not be confined to spending on tractors. Some, probably most, will be spent on hammers which are not currently idle and whose supply will not expand to accommodate this new ‘demand’ immediately. It will simply bid up hammer prices. And if hammer supply does expand, that expansion will be revealed as an unsustainable malinvestment when the monetary stimulus is withdrawn.

And, a tractor not being a hammer (capital goods being heterogeneous in other words), they are not substitutes. An increased demand for one from monetary stimulus need not result in a proportionate increase in demand for the other. Those idle tractors will remain idle as the hammer boom takes off.

Just as a tractor is not a hammer, Mesut Özil is not Miley Cyrus; labour is also heterogeneous. If the economy had overinvested in midfielders during a singing bubble and there were now too many to gain employment as such in a sustainable pattern of demand, any monetary stimulus designed to get these guys back to work would begin driving up the wages of relatively scarce twerking pop stars before a substantial number of those midfielders had found employment.

Those footballers, like the tractors, do not represent ‘slack’ waiting to be picked up by a few more dollars. They are just dead capital and unsuitable labour, the product of malinvestments.

The lesson is that there is no single Short Run Aggregate Supply curve for the ‘the economy’. In each example above, at a given point the SRAS curve for tractors and running backs was horizontal while those for hammers and pop stars were vertical. Attempts to drive the economy along one aggregated economy-wide curve towards full employment will hit choppy waters sooner than monetary policy makers, with their crude view of a few macro variables, think. They might find they have less room for manoeuvre than their models tell them.

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5 replies on “Output gaps and heterogeneity”
  1. says: Paul Marks

    The “monetary stimulus” (monetary expansion) IS inflation.

    Frank Fetter’s traditional definition of inflation (a rise in the money supply) was correct – and Irving Fisher’s belief that inflation was a rise in the “price level” (on a mathematical index) was mistaken.

    The only defence of the increase in “narrow money” (the money the Bank of England) is fear of a “deflationary collapse” of “broad money” (the banking credit bubble), and this is a very bad defence.


    It is all an interesting experiment.

    The present British government is ultra Keynesian – it is following policies of “monetary stimulus” (“cheap money”, “low interest rates”) and “fiscal stimulus” (wild deficit spending by government – that is borrowing simply incredible amounts of money) that make the “General Theory….” of 1936 seem rather moderate by comparison.

    What will the effect of this ultra Keynesian monetary and fiscal “stimulus” be?

    The establishment say it will produce prosperity.

    The Austrian School would suggest a rather different consequence.

    It is too late for us to influence the policy – the deed is done.

    So let us observe the results over the coming years.

  2. I have doubts as to whether the Aggregate Supply curve notion means anything at all. But assuming it does, I think most of its advocates (contrary to John Phelan’s suggestions) appreciate that that AGGREGATE curve contains within in a host of individual supply curves for individual products. I.e. they appreciate that when the economy is at capacity, there are individual industries, firms, etc which are nowhere near capacity.

    1. says: John Phelan

      It’s an interesting thing when you talk to economists about this. They say “Oh, of course we know there is not one SRAS curve” but then they go and act and prescribe policies as though there is.

  3. says: Craig Howard

    “What supports and employs productive labor, is the capital expended in setting it to work, and not the demand of purchasers for the produce of the labor when completed. Demand for commodities is not demand for labor.” — John Stuart Mill

    One of the most valuable lessons I’ve managed to learn.

  4. says: George Thompson

    Just wanted to point out to those who like me are neither Brits nor fans of bad music that Mesut Özil really is not Miley Cyrus. He is a German soccer (football in the Old World) player making big bucks in England and she is the former Hannah Montana making big bucks ‘twerking’ (whatever that is) for whoever will hire her.

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