Friday, April 3, 2020

“We will not solve a supply crisis by increasing demand”

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Grandstand. One of the consequences of the coronavirus epidemic has been economic activity for some time. It then seems correct to think that economic policy must fight this economic depression by increasing what is called global demand, according to Keynesian-inspired economic theory. It would therefore be essential to increase public spending – and therefore increase the budget deficit – and, moreover, to practice an expansionary monetary policy. Unfortunately, these revenues are in fact incapable of achieving the desired objectives, and are likely, on the contrary, to create additional difficulties.

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First of all, the very concept of aggregate demand is meaningless. It is possible to realize this intuitively. Suppose there is an economy made up of only two individuals who each produce a good and trade between them. Everyone decides their productive efforts based on what they can get in return, and this leads them to determine a relative price between their two goods. If one of them increases his demand, he can only obtain satisfaction by accepting a higher relative price for the good he is buying, that is to say that he will have to offer a greater quantity of his own good.

Productive activity therefore depends on the evolution of relative prices. Taking into account existing technologies and personal preferences, individuals decide the level of their production according to what they want to buy and therefore relative prices. To speak of an increase in demand by an individual makes sense, but to speak of the “aggregate demand” of the two individuals does not make sense, since the increase in demand of an individual increases the relative price, and the increased demand from the other individual implies a decrease in that same relative price.

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What is true for an economy of two individuals is true for an economy composed of a large number of individuals, for example a country. If the state increases its demand for goods and services, it must finance it. If it increases taxes for this, it results in a decrease in demand expressed by taxpayers. If it finances its expenditure by borrowing, it reduces the savings available for private investment and therefore the demand for capital goods. There is no increase in “aggregate demand”, but only variations in the productive structures and the structures of consumer and investment goods. An economic recovery implies changes in the behavior of producers, in particular the adoption of new technologies with higher productivity. But this increase in production necessarily implies a corresponding increase in demand.

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