Aggregate Demand

The aggregate supply & aggregate demand model (AS-AD) is nice because it’s flexible and clear. Often professors will teach it in levels. That is, they teach it with the level of output on one axis, and the price level on the other axis. This presentation is convenient for the equation of exchange, which can be arranged to reflect that aggregate demand (AD) is a hyperbola in (Y, P) space. Graphed below is the AD curve in 2019Q4 and in 2020Q2 using real GDP, NGDP, and the GDP price deflator.

The textbook that I use for Principles of Macroeconomics, instead places inflation (π) on the vertical axis while keeping the level of output on the horizontal axis. The authors motivate the downward slope by asserting that there is a policy reaction function for the Federal Reserve. When people observe high rates of inflation, state the authors, they know that the Fed will increase interest rates and reduce output. Personally, I find this reasoning to be inadequate because it makes a fundamental feature of the AS-AD model – downward sloping demand – contingent on policy context.

At the same time, I do think that it can be useful to put inflation on the vertical axis. Afterall, individuals are forward looking. We expect positive inflation because that’s what has happened previously, and we tend to be correct. So, I tell my students that “for our purposes”, placing inflation on the vertical axis is fine. I tell them that, when they take intermediate macro, they’ll want to express both axes as rates of change. I usually say this, and then go about my business of teaching principles.

But, what does it look like when we do graph in percent-change space?

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Kalshi cofounder Tarek Mansour recently shared this graph:

In hindsight it seems like an obvious graph to make, and a good way to teach Aggregate Supply / Aggregate Demand models, but I don’t actually recall seeing much like this. One obvious improvement is to include more countries. I do so below using data from Trading Economics, showing all 182 countries that have recent data on both annual GDP growth and inflation. I also flip the axes to be more consistent with the convention in economics:

This makes clear both the costs and benefits of including all countries. We see just how extreme some outliers are: hyperinflation in Venezuela, Sudan, Lebanon, and Syria; a severe contraction in Libya; and huge growth in Azerbaijan and the Maldives (errors in the data?). But all the more typical countries blend together. So here I zoom in on the more typical countries:

This makes clear the strong aversion to deflation that most countries have. Well over a hundred countries here, many with very low inflation, but only in South Sudan does inflation actually go negative. Real GDP growth does not exhibit the same sharp divide at zero, presumably because its much harder to central banks to fine-tune. Now I try to zoom and enhance one more time:

But things are starting to just get messy, so its time to drop more countries. Here I focus on the 30 largest economies (minus Turkey, which breaks the scale on inflation):

Here we see:

Japan is demonstrating stagnation/ low aggregate demand / “running cold”
Brazil, Stagflation (negative supply shocks?)
Poland, high aggregate demand / running hot
Saudi Arabia and Israel, high growth without high inflation (positive supply shocks?)

The US is on the higher end of inflation, and I still think we should be doing more about this, but in this graph we don’t look like a huge outlier. We’re all still working through Covid-related shocks. But the very latest quarterly data today (not reflected in these graphs) showed negative GDP growth in the US, sending us toward the “Stagflation” quadrant and making the Fed’s job much harder.