Wednesday, May 9, 2012

Macro Economics: Supply and Demand and Such

This is almost a followup to the earlier post on inflation, but at times I'll be neglecting some of the complications I mentioned earlier.  If I were a paid teacher I'd feel embarrassed about my pedagogy here, but as I'm just a blogger I'll shrug and move on.

When you read in the news that the price of, say, hats has gone up recently do you have any reason to think that there were more or less hats sold recently?  You might think about an individual store raising its prices, resulting in less sales, but things like that seldom happen with a general prices level.  Generally, there are going to be two possible explanations.  It might be that hats suddenly became much more fashionable, and everyone wanted one.  Since people are willing to pay more for hats, shop owners will charge more - and the higher hat prices will cause people to produce more hats too (demand has risen).  Or it might be that a horrible felt plague has killed off all the felt plants and now the poor haberdashers aren't able to make hats for everyone who wants one. Since different people are willing to pay different amounts of money for hats, sellers are able to sell all their hats even if they raise their prices and just cater to the people willing to pay more for their hats (supply has fallen).  So just observing that prices have risen doesn't tell us whether quantities sold have risen or fallen.  Likewise, seeing the price decrease doesn't tell us if demand has fallen or if the supply has risen.

Economists studying the macro-economy, the overall production of everything rather than the production of just hat makers say, have concepts related to supply and demand called - sensibly enough - aggregate supply and aggregate demand.  These work a bit differently than supply and demand for any given good or service, because they're so inter-related.  A person might choose to spend their money on hats or not, but at least over the long run they're going to spend it on something - probably.  And to the extent that everyone is buying stuff people the money they spend ends up in  someone's pocket, and then people have more money to buy stuff with.  These complications make macro economics more confusing than micro economics, and so there's consequently a lot more debate among economists about the later than the former.

But everyone (except the Austrians) seems to agree that aggregate supply and aggregate demand are still useful concepts, so we have that at least.  But what sort of things make people spend more or less in aggregate?  Headware fashions aren't really big enough to show up at the scale of a country's GDP.  It turns out that there are several things that end up making people all over a country spend more or less in general.  Lets take the Wealth Effect.  Generally when people feel that they have a bunch of money to spend, even if its not money but stock or houses or whatever, they're more likely to spend what they do have.  So if house prices crashed across the nation you'd expect that people would buy less stuff, and that prices of things would decrease (deflation).  Conversely, you can have supply shocks big enough to effect the macro-economy too, if say a war in the middle east disrupts the oil supply or such.  When that happens you expect that people will buy less stuff, but that prices will go up in general (infaltion).

Except there are some added complications about deflation that make it particularly bad for a couple of reasons.  One relates to central banks and interest rates which I might get into in some future blog post, but the other is sticky wages.  If you study psychology and human biases, sooner or later you ought to come across the concept of loss aversion (or you should find a new place to study).  People tend to be much more sensitive about losing things they have than they are about getting new things that they don't have, at least in economic circumstances when you're talking about money.  And people are very unhappy about taking pay cuts when a company becomes less profitable.  So much so that companies will usually fire 10% of their workforce rather than give everyone a 10% paycut.  It may suck for the 10% that get fired, but they aren't going to be around to complain, and thought he remaining 90% will be upset, they'll usually be less upset (or at least less likely to leave) than if they had gotten a paycut.   You can look at graphs of yearly pay changes for, say, US workers and you'll see this big bell-curve around whatever the inflation rate is, but at 0% there'll be a huge spike and below 0% there'll be almost nothing.  

And its important to see there, that even a purely nominal drop in aggregate prices without any real component can end up effecting the real economy, because if people get layed off they aren't making stuff any more, and the overall real economy shrinks.  I think I'll have to do another post later about what is generally done in these sorts of situations, but that'll be another post.

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