Sunday, May 8, 2011

Keynes on the Special Properties of Money

Keynes in the General Theory (1936) showed that fiat money and even commodity money have special properties:
“… money has, both in the long and the short period, a zero, or at any rate a very small, elasticity of production, so far as the power of private enterprise is concerned, as distinct from the monetary authority;—elasticity of production meaning, in this context, the response of the quantity of labour applied to producing it to a rise in the quantity of labour which a unit of it will command. Money, that is to say, cannot be readily produced;—labour cannot be turned on at will by entrepreneurs to produce money in increasing quantities as its price rises in terms of the wage-unit. In the case of an inconvertible managed currency this condition is strictly satisfied. But in the case of a gold-standard currency it is also approximately so, in the sense that the maximum proportional addition to the quantity of labour which can be thus employed is very small, except indeed in a country of which gold-mining is the major industry.
Now, in the case of assets having an elasticity of production, the reason why we assumed their own-rate of interest to decline was because we assumed the stock of them to increase as the result of a higher rate of output. In the case of money, however—postponing, for the moment, our consideration of the effects of reducing the wage-unit or of a deliberate increase in its supply by the monetary authority—the supply is fixed. Thus the characteristic that money cannot be readily produced by labour gives at once some prima facie presumption for the view that its own-rate of interest will be relatively reluctant to fall; whereas if money could be grown like a crop or manufactured like a motor-car, depressions would be avoided or mitigated because, if the price of other assets was tending to fall in terms of money, more labour would be diverted into the production of money;—as we see to be the case in gold-mining countries, though for the world as a whole the maximum diversion in this way is almost negligible” (Keynes 1936: 230–231).
Money has a zero or very small elasticity of production. This means that a rise in demand for money and a rising “price” for money (i.e., an increase in its purchasing power) will not lead to businesses “producing” money by hiring workers.

Even under the gold standard, when money was a type of producible commodity, production of gold or silver in significant quantities was severely limited to certain countries and brief times. For example, if the UK was hit by a deflationary depression in the 1880s, with a rising purchasing power for money as demand for it increased as a hedge against future uncertainty (that is, a rise in its value due to deflation), could UK businesses just hire unemployed workers to “produce” gold in the UK? They could not.

The property of zero or very small elasticity of production also applies to liquid financial assets. If consumers decide to buy less producible commodities and increase their holding of money or ownership of financial assets, unemployment will result in some sectors as demand for commodities declines. The price of financial assets will rise and it is possible that the price of money could also rise. But private businesses cannot hire the unemployed to “produce” or “manufacture” more money or financial assets to exploit profit opportunities in the high-price liquid assets (Davidson 2010: 255–256).

A further point is that money and financial assets have zero or near zero elasticity of substitution with producible commodities:
“The elasticity of substitution between all (nonproducible) liquid assets and the producible goods and services of industry is zero. Any increase in demand for liquidity (that is, a demand for nonproducible liquid financial assets to be held as a store of value), and the resulting changes in relative prices between nonproducible liquid assets and the products of industry will not divert this increase in demand for nonproducible liquid assets into a demand for producible goods and/or services” (Davidson 2002: 44).
The gross substitution axiom is a fundamental assumption of neoclassical economics and the Austrians appear to tacitly assume the axiom as well. But the gross substitution axiom is wrong, and all inferences made from it in economic theories are also wrong.

This is also one of the reasons why Say’s law, in its various forms, does not work.

BIBLIOGRAPHY

Davidson, P. 2002. Financial Markets, Money, and the Real World, Edward Elgar, Cheltenham.

Davidson, P. 2010. “Keynes’ Revolutionary and ‘Serious’ Monetary Theory,” in R. W. Dimand, R. A. Mundell, and A. Vercelli (eds), Keynes’s General Theory after Seventy Years, Palgrave Macmillan, Basingstoke, England and New York. 241–267.

Keynes, J. M. 1936. The General Theory of Employment, Interest, and Money, Macmillan, London.

58 comments:

  1. If consumers decide to buy less producible commodities and increase their holding of money or ownership of financial assets, unemployment will result in some sectors as demand for commodities declines.

    If consumers decide to increase their holding of money, demand indeed declines, but only to cause price deflation (and also some termporary unemployment, especially if wages are fixed by eg national minimum wage laws), which in turn increases demand and employment back to its previous level (lower prices mean people buy more with less amount of money and also have less motivation to hold money) which in turn halts the price deflation, cycle closed. At the end of the day (literally, days rather than weeks, assuming no government meddling like during Great Depression), everything will be cheaper in terms of nominal prices, but exactly same in terms of real prices, with exactly same employment as before.

    To me THAT is modern understanding how Say's law works in action, but maybe I'm wrong?

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  2. "If consumers decide to increase their holding of money, demand indeed declines, but only to cause price deflation ..., which in turn increases demand and employment back to its previous level"

    It will not automatically increase demand for producible commodities at all (i.e., the goods and services, the production of which employs most people).

    Why?
    Because “The elasticity of substitution between all (nonproducible) liquid assets [including money] and the producible goods and services of industry is zero. Any increase in demand for liquidity (that is, a demand for nonproducible liquid financial assets to be held as a store of value), and the resulting changes in relative prices between nonproducible liquid assets and the products of industry will not divert this increase in demand for nonproducible liquid assets into a demand for producible goods and/or services” (Davidson 2002: 44).

    Your error is precisely inability to take this and fundamental uncertainty seriously and the fact that business expectations are subjective.

    And what happens if you get a so-called "secondary deflation" as Hayek later called it? What if there is a deflationary spiral?

    E.g., in an economy with badly shocked expectations and a debt deflation, GDP contraction could go on for years, or when growth returns, the economy will be mired in a suboptimal equilibrium state with high involuntary unemployment.

    "To me THAT is modern understanding how Say's law works in action, but maybe I'm wrong? "

    Whenever money is held for the speculative and precautionary motives in an economy with shifting liquidity preference and subjective expectaions, Say's law does not work.
    The special properties of money also prevent any such working of Say's law.

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  3. The elasticity of substitution between all (nonproducible) liquid assets [including money] and the producible goods and services of industry is zero.

    But even if true, the demand for the producible goods increases simply because after price deflation people can buy more producible goods using exactly same money, so people don't need to substitute their demand for money by even one bit.

    Then note that if price deflation did not affect demand for money in _nominal_ terms, then people would in fact keep _increasing_ their _real_ money holdings, even though they were fixed in _nominal_ terms. That would require some sort of eternally increasing uncertainty?

    Therefore normally people would continue to _decrease_ their _nominal_ money holdings, just to keep their _real_ value constant. So again people don't need to substitute their demand for money by even one bit, but demand still increases.

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  4. "But even if true, the demand for the producible goods increases simply because after price deflation people can buy more producible goods using exactly same money, so people don't need to substitute their demand for money by even one bit."

    Deflation is precisely what causes deferred purchasing. Economies with collapsing asset bubbles, financial meltdown, and debt deflation collpse, what you describe does not happen.

    And what if there is mass unemployment and a collapse in income and demand? And what if people have excessive personal debt? What if they are deleveraging? What if the economy is still affected by uncertainty?

    Again: real world capitalism has these features, not the fantasy world you imagine.

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  5. And what if there is mass unemployment and a collapse in income and demand?

    The real world fact is, the real purchasing power of fixed nominal amount of money increases together with price deflation, so real demand (and hence employment) increases _automatically_, period, cycle closed. So, the bigger collapse in demand (and hence employment), the faster higher demand kicks back in (and hence employment), unless, obviously, government starts to print money. Then yes, a big collapse in demand is averted, but subsidizing the rich (mortgage takers, financiers) with new fiat money obviously takes a toll on economic progress and, best case scenario with most industrious nations, leads to eternal progress of "slightly lower than the OECD average" like Japan ;)

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  6. There wouldn't generally be problems of severe price deflation if prices have not been artificially bid up by either ex nihilo fiat money or fractional reserve lending in the first place. There would be few if any asset bubbles without fiat or FRB money and any that might arise would be the problem of the individual investors who foolishly bid up the prices. Without asset bubbles, there is little likelihood of a major deflation.

    The fact that gold and silver do not grow on trees means that a person cannot fake his/her real savings as denominated in those commodities. One can only lend one’s true savings or use one’s true savings as collateral. People will be very careful with their money and the price, investment and capital structure will not be distorted by phony prices.

    The elasticity of substitution between all (nonproducible) liquid assets [including money] and the producible goods and services of industry is zero.

    Isn’t that obvious? If someone is in the mood to hold money and not spend, spending isn’t a substitute for saving and holding money. How deep.

    Thus the characteristic that money cannot be readily produced by labour gives at once some prima facie presumption for the view that its own-rate of interest will be relatively reluctant to fall.

    Good. The market rate of interest should be what it is. A high true authentic market rate suggests a high rate of return on investment.

    Keynesianism: Solving "problems" that don't exist while being the very source of those problems.

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  7. "so real demand (and hence employment) increases _automatically_, period, cycle closed"

    Total garbage. There is nothing "automatic" about it.

    "There would be few if any asset bubbles without fiat or FRB money"

    Rubbish. You could still get asset bubbles by international capital flows through capital accounts. You could still get asset bubbles through gold rushes and surges in the money supply owing to mining of gold.

    And as pointed out before, banning FRB would require violation of private freedom and liberty. By demanding that FRB be abolished you have already shown your position is incoherent.

    Modern real world capitalism has always had FRB - that is the reality, not the fantasy, imaginary, non-existent world of Austrian economics.

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  8. I don't propose to ban anything, much less FRB. However, a FRB note is not the same thing as a warehouse receipt for 100% reserve specie. If the depositor and payee understand that, they can value such an FRB note however they like. However, if they are made to believe that it is the same thing as a warehouse receipt for 100% reserve specie, they have been defrauded.

    And, of course, assets booms might occassionly occur during a gold rush. So what? Buy a bubble asset, you go bust. Live and learn.

    Most of the time, prices will be steadily falling and no one will be misinformed to think that rising wages or prices are natural or an entitlement. So, no "sticky" wages or prices.

    BTW, wages and prices cannot be "sticky". People are just too dim to demand a reasonable price or wage during a deflationary period after an artificial Keynesian boom. Live and learn and get the Keynesians out of your money business.

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  9. "I don't propose to ban anything, much less FRB"

    Then your version of capitalism will have FRB and the potential for asset bubbles and debt deflation.

    With FRB there will be inflationary booms, just as there was in the 19th century.

    All points in the analysis above stand.

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  10. You suffer from a terminal case of the ergodic axiom. Just because there were some problems with a mono-culture of government FRB notes 120 years ago does not mean that there will be such problems in a competitive private money environment in the future. If FRB causes problems (as I think it might), people are smart enough to avoid those problems and use less problematic forms of money.

    I truly fail to understand how you can think people will be so completely moronic about their own personal financial situation but smart enough to select and elect the proper bureaucrats to control them with SWAT teams. There is no reason whatsoever to think that is true.

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  11. Total garbage. There is nothing "automatic" about it.

    But it's basically the definition of price deflation. You assume people increase their money holdings. Very good. So as a result there has to be price deflation whose other side of the coin (that's why it's automatic, unless you don't comprehend what price deflation actually means) is appreciation of money, both that which people have decided to hold and that which people have decided to spend. Since money that people have decided to spend appreciates in real value, their real demand automatically rises, no substitution required. Also money that people have decided to hold appreciates in real value, so they spend some of it too, no substitution required.

    Unless I guess you assume the uncertainty keeps rising, but there must ultimately be some limit where this stops? I mean, the world is pretty much absolutely uncertain even at the best economic conditions. I think I can understand one-off temporary jump in uncertainty, but indefinite rise of uncertainty? But then even if true, money supply is finite. Even if people suddenly decided to hold _all_ of their money, prices would fall to virtually zero and incentives to spend would also become infinitely enormous. Are you saying there are no substitution effects even if produced goos become virtually free of charge?

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  12. "Since money that people have decided to spend appreciates in real value, their real demand automatically rises, no substitution required"

    The statement "their real demand automatically rises" is one of pure fanasty.
    Again, what if deleveraging and debt deflation are going on?

    "Unless I guess you assume the uncertainty keeps rising, but there must ultimately be some limit where this stops?"

    Yes, after severe recessions or depressions. The economy will return to positive GDP growth, but will be mired in suboptimal equilibrium, as America in the 1890s.

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  13. The statement "their real demand automatically rises" is one of pure fanasty.

    You just keep repeating that, but please explain me how can real demand _not_ rise during price deflation? Price deflation equals money appreciation, so demand must rise, unless, again, people keep increasing their (not only real, but also nominal) money holdings, but then again, this must ultimately stop since money supply is finite.

    Yes, after severe recessions or depressions.

    Yes what? Uncertainty keeps rising indefinitely or there must be some limit where this stops?

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  14. "Price deflation equals money appreciation, so demand must rise, unless, again, people keep increasing their (not only real, but also nominal) money holding"

    They do not need to keep increasing it, liquidity preference can rise rapidly and stay at a high level, causing a continuing failure of aggregate demand.

    Also, in periods of recession people lose their jobs and income - how can large numbers of unemployed increase demand for commodites when they have no real income.

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  15. Bob Roddis,

    If someone is in the mood to hold money and not spend, spending isn’t a substitute for saving and holding money. How deep.

    I'm also willing to agree with LK that in regular situations spending may indeed be poor substitute for holding money, but note LK describes pretty apocalyptic scenarious with various "mass" "collapses" of whatever imaginable etc. I mean, if price deflation is severe enough, spending has to, ultimately, become more attractive than money holding. In other words, what if you can buy a kingdom for a dollar? Spending still no substitute for holding? Absurd.

    I'm just pointing that out to you so you don't accept what LK says too easily. Still I have no intention to argue about it with LK because my argument above applies also to that hypothetical world of zero elasticity of substitution between producible goods and money.

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  16. liquidity preference can rise rapidly and stay at a high level, causing a continuing failure of aggregate demand

    That's precisely what I thought your assumptions were: "_stay_ at a high level" rather than increase continuously forever, so that's settled. If so, then again, price deflation -> money real value appreciation -> increased demand. This comes from the simple assumption that people suddenly want to hold more money (but finitely more, in real terms), nothing else.

    how can large numbers of unemployed increase demand for commodites when they have no real income

    But how money supply is dependent on employment? Money does not start to disappear into thin air just because unemployment rises. Whoever holds the money at the time will be creating the renewed demand. I have not said it would be all exactly same people as before or exactly same produced goods as before.

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  17. "Money does not start to disappear into thin air just because unemployment rises"

    If significant deleveraging is going on during the recession/depression, money in the broad money stock will be destroyed.

    The broad money stock is endogenous, repayment of debt destroys broad money.

    This is why M3 was contacting in the US recently.

    http://www.telegraph.co.uk/finance/economics/7769126/US-money-supply-plunges-at-1930s-pace-as-Obama-eyes-fresh-stimulus.html

    http://www.shadowstats.com/charts/monetary-base-money-supply

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  18. If significant deleveraging is going on during the recession/depression, money in the broad money stock will be destroyed.

    Okay, but _not_ because of higher unemployment.

    Even so, alright, so money supply is decreasing, not only by increased holdings, but also broad money stock deflation, so you get even faster price deflation -> even faster money real value appreciation -> even faster increased demand...

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  19. Joanna Liberation wrote:

    I mean, if price deflation is severe enough, spending has to, ultimately, become more attractive than money holding.

    I was also thinking that in my mixed free banking environment of warehouse receipts and FRB notes that if the LK scenario of a bubble collapse actually occurred from use of FRB notes, those holding the warehouse receipts could and would just swoop in and pick up low price bargains. Problem solved. The FRB people would be shamed and would learn a lesson.

    People quickly learn about and understand profit opportunities. They tend to not understand bureaucratic jargon and obscurantism.

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  20. Bob Roddis,

    those holding the warehouse receipts could and would just swoop in and pick up low price bargains

    That's just common sense. But note that even if that never happened (as LK would imagine), if people kept the increased real money holdings no matter how severe deflation would be, demand rises in simple proportion to deflation and increased money holdings, thanks to the simple fact that the real value of money people have _not_ chosen to hold appreciates. They have _not_ chosen to hold it, so they spend it. Since it has appreciated, they generate higher demand in simple proportion to price deflation.

    Unless I guess LK has some hidden assumptions I don't know of. I thought the hidden assumption might be eternally increasing uncertainty (people would keep increasing real value of their money holdings indefinitely), but no, we are on the same page here with LK, so no clue.

    Then I'm not sure what LK's solution to print money is supposed to help. It does indeed prevent price deflation, replaces it with inflation, but only by subsidizing the rich using inflation tax paid by the poor (in terms of net transfers). It's not only immoral according to liberals themselves, but it's also economically inefficient. In that case, the rich become the parasites living off the poor producers (again, in terms of net transfers). As with any parasitic situation, economic efficiency must suffer, hence Japan's case of two decades of progress at "slightly lower than the OECD average", and that is best case scenario with probably most industrious nation there is.

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  21. "They have _not_ chosen to hold it, so they spend it. Since it has appreciated, they generate higher demand in simple proportion to price deflation."

    And it has already been made clear that in these deflationary depressions, there is mass unemployment - people lose their income.

    Indebted people go broke or get saddled with burdensome debt repayment.

    You don't get enough effective demand to return to what neoclassicals call full employment equilibrium in these cases.

    The shock to business expectations may last for nearly a decade, as in 1890s America which had high involuntary unemployment.

    "Then I'm not sure what LK's solution to print money is supposed to help"

    The solution is fiscal policy, not monetary stimulus, which is impotent in such circumstances.

    Borrowing money from private markets in deficit spending is not "printing money".

    Yet again nothing but ignorant caricature.

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  22. people lose their income

    But incomes are not falling from heaven, every income is someone's _spending_. For every guy that loses his income (employee), there is some other guy (employer) who now has more money to spend by exactly same amount. So higher unemployment cannot possibly change total demand. BTW, I am perfectly aware that this fallacy is incredibly popular on TV, I am just hoping you are more sophisticated than that.

    Indebted people go broke or get saddled with burdensome debt repayment

    Yes I'm getting it, the apocalypse, but you can't expect me to freeze in wonder just because you start throwing apocalypses around, especially that apocalyptic scenario is precisely what I refer to from my comment one here. In cases where total money supply does decrease, like in debt deflation, how does that change the fact that faster price deflation simply means proportionately faster increase in real demand as I've shown above?

    The shock to business expectations may last for nearly a decade

    That's precisely what I assume: a fixed shock lasting indefinitely. But _not_ a shock that indefinitely increases in amplitude! Such peculiar shock, which might indeed explain your position, is _not_ the hidden assumption of yours, that we've already settled, so I'm all the more interested in the true one.

    The solution is fiscal policy, not monetary stimulus, which is impotent in such circumstances.

    Taxes do not matter, they are just an accounting mechanism to keep state expansion under at least some rudimentary control. You know very well the state could well end the pretence tomorrow, eliminate all taxes, and simply start printing money to cover its spending. Even with zero taxes we would have precisely same situation as now if you keep spending intact, so fiscal policy has no effect on anything whatsoever, only government spending does (ie parasitic government consumption of goods it has not produced). In other words, taxes are perfectly equivalent to money printing. Indeed, that's why we say money printing is inflaction _tax_.

    Borrowing money from private markets in deficit spending is not "printing money".

    And how exactly are you going to pay that debt off? By taxes? Again, equivalent to money printing.

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  23. "For every guy that loses his income (employee), there is some other guy (employer) who now has more money to spend by exactly same amount."

    This is total rubbish.

    (1) Again shifting liquidity preference of individuals, banks, busineses all destroy this. Money becomes idle.

    (2) A rise in demand for safe financial assets will divert money onto secondary asset markets, an non-employment inducing demand.

    (2) Deleveraging and debt deflation contract the money supply

    "In other words, taxes are perfectly equivalent to money printing"

    = idiocy.

    so fiscal policy has no effect on anything whatsoever, only government spending does

    Confused rubbish.

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  24. Again shifting liquidity preference of individuals, banks, busineses all destroy this. Money becomes idle.

    More money becoming "idle" (ie money holdings increase) is merely your _assumption_, not your _conclusion_ (demand declines). Repeating the assumption over and over cannot, by itself, magically explain your conclusion.

    non-employment inducing demand

    Right, and I have already shown how higher unemployment cannot have any effect whatsoever on total demand.

    Deleveraging and debt deflation contract the money supply

    Right, and I have already shown how money supply contraction merely speeds up the price deflation, hence also the demand increase.

    idiocy

    Well I would be grateful if you can share your genius with me. Precisely why government cannot simply print all the money it needs and finance exactly same consumption (army, courts, police etc) and transfers from producers to parasites? (redistribution of wealth). Inflation, yes, so what, keynesians are okay with inflation aren't they?

    Confused rubbish

    Fiscal policy may (not sure) have some impact on tax incidence (as opposed to inflation tax incidence), but I can't see why it would change anything whatsoever in terms of total demand? Taxes are money transfers, how can they create or destroy total demand?

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  25. Taxes are money transfers, how can they create or destroy total demand?

    It is precisely money diverted from non-employment inducing demand on financial asset markets or from people's holding of money due to the speculative or precautionary motive that does create demand for commodities (= goods and services that employ most people).

    http://socialdemocracy21stcentury.blogspot.com/2011/01/f-h-hahn-in-candid-moment-on-neo.html

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  26. "Precisely why government cannot simply print all the money it needs and finance exactly same consumption (army, courts, police etc) and transfers from producers to parasites? (redistribution of wealth)"

    Modern Monetary Theory says that, even though deficits are not “financially” constrained, they face real constraints in available resources, capacity utilization, the unemployment level, the exchange rate, the external balance, and inflation rate.

    Taxes function to free up real resources for use by government or people employed by it, and to regulate aggregate demand by fiscal policy. Bond issues by the central bank (which would still happen under an MMT system) function to control interest rates and mop up excess liquidity.

    http://socialdemocracy21stcentury.blogspot.com/2010/07/galbraith-versus-krugman-on-deficit.html

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  27. It is precisely money diverted from non-employment inducing demand on financial asset markets or from people's holding of money due to the speculative or precautionary motive that does create demand for commodities

    Wow so not only you have some hidden assumption that magically decreases demand just because of increased money holdings (which I still can't figure out), but also you explicitely assume that tax incidence falls precisely on the increased money holdings. Wow wow wow, cool. Even if that all were true, how can it create new demand? This would be precisely the inverse process to what I've described previously. Money holdings decrease -> inflation -> _decreased_ real purchasing power of money that people have decided to spend -> _decreased_ demand (ie back to original before inflationary spending starts).

    even though deficits are not “financially” constrained, they face real constraints in available resources

    I have nowhere said that goverment can print money to be _infinitely_ wealthy, this is just your straw man, I have merely said government can print enough money to get whatever income it currently gets via taxes.

    Taxes function to free up real resources for use by government or people employed by it

    And such tax incidence assumption comes from where? The world becomes magically less uncertain because there are taxes? Funny.

    Bond issues by the central bank (which would still happen under an MMT system) function to control interest rates and mop up excess liquidity

    They do mop up stuff all right. If you tax or print enough money, you can spend it to mop up whatever. That's basically the idea of government spending, mopping up whatever stuff government wants, giving nothing in exchange (as compared to a minimal state). In this case government first borrows money and then pays it off with interest financed by again either money printing or taxes. So okay, we have another transfer from the poor (where tax incidence mostly falls, not only with inflation tax but also taxes like income tax, but this is another story) to the rich financiers (who earn the interest out of taxes or thin air), but again can't see how is that supposed to affect total demand?

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  28. Say's law works when total factor payments received for producing a given volume (or value) of output are used to purchase that volume (or value) of output (Thomas Sowell, Classical Economics Reconsidered, Princeton University Press, Princeton, N.J. 1994: 39–41).

    That does not happen because
    (1) money has a store of value function and money is held idle both by the precautionary and speculative motive, and

    (2) money tied up in purchasing financial assets on secondary markets is not money used to purchase output.

    (3) in deflationary depressions, it precisely when people's/household's/banks'/businesses' liquidity preference shifts to holding more money or safe financial assets, incrasing the amount of idle money. With high unemployment, people lose their income and cannot increase demand significantly, even if deflation increases purchasing power of money; debt deflation and debt deflation make matters worse

    Money spent on commodities (goods and services that employ virtually all people) is employment-inducing demand.

    Money spent on financial assets on secondary markets is non-employment-inducing demand. That is idle money. The banks, big money market funds and pension funds thus have a vast amount of money that is essentially idle.

    When they switch to purchasing newly issued government bonds, an equivalent or near equivalent amount is sent by government in deficits, on purchasing commodities or paying people who will purchase commodities.

    This is employment inducing demand.

    Easy to understand.

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  29. LK, your points 1-3 (especially 1) have finally made me realize what your hidden assumption is. And I can't believe you actually believe in it.

    You seem to have taken the "store of value" concept way too far in some methaphysical direction that reminds me of labor theory of value. Money is indeed a "store of value" from market actor perspective, but not economy as a whole (large part of fiat money does not even exist in reality). The value of a unit of money is dependent _solely_ on total money supply in relation to total produced goods and available services supply. So even if money itself gets "tied up" in holdings or wherever, its value _cannot_ be "tied up", because in reality there is nothing to be "tied up" in the first place. As a market actor, your approach would be valid, but you are supposed to be an economist. And as an economist, you should know that money's value, especially fiat money's value, is not inherent to money itself.

    If you assume money's value magically disappears just because money itself disappears (or left idle), then yes, that would explain all that demand declining. So is that basically what contemporary keynesist believe? Really? Wow.

    Also, I have not read Keynes' General Theory, but would be interested to know if the part you quote here is characteristic to the whole work?

    Basically the first 4/5th is pretty obscure elaboration of the simplest fact that money cannot be readily produced. Wow, the definition of money, groundbraking. If something can be readily produced, it can't be money in the first place. "Readily" did change over time, 1000 years ago some spices might not have been as "readily" produced as nowadays with speedy global markets and communication, but the basic idea stays the same. Mises or Rothbard would have said it in one short sentence, but I guess then they wouldn't sound so educated as Keynes... probably another reason why Mises has "lost" the debate in the 30s...

    Then out of the blue we get a sentence like if money could be grown like a crop or manufactured like a motor-car, depressions would be avoided or mitigated because, if the price of other assets was tending to fall in terms of money, more labour would be diverted into the production of money

    Depressions would be avoided if there was no money? Wow, awesome! Probably we would have avoided the creation of 99.999999% of all wealth and living standards for 99.99999% of human beings currently living on Earth too, but sure, depressions, what depressions?

    LK, as an expert, is Keynes so mind blowing throughout the whole General Theory? If so, I may indeed have to read it for fun one time.

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  30. "If you assume money's value magically disappears just because money itself disappears (or left idle), etc etc ..."

    It's value doesn't "disappear." Demand for producible commodities declines when more money becomes idle.

    Money has a store of value role = it stores purchasing power so that purchasing power can be used in the future.

    I really don't see much reason to reply to this latest claptrap.

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  31. It's value doesn't "disappear." Demand for producible commodities declines when more money becomes idle.

    But when more money becomes idle, there is also price deflation, so real value of money people have decided to spend must increase accordingly (and by exactly same value of money people have decided to hold). The only way to get your conclusion of permanent demand decline (rather than the quick cycle of decline followed by equally large increase I describe) is to assume real value disappears together with money itself.

    Money has a store of value role = it stores purchasing power so that purchasing power can be used in the future.

    Wow so you do believe that! Contemporary economist believes that something is actually a store of value. It stores it, like really actually stores it, not just depends on external factors like its own supply or supply of goods that can be traded for it. Awesome...

    I really don't see much reason to reply to this latest claptrap.

    No I really really want to thank you for this exchange. I mean, I have not expected to hit all the metaphysical assumptions so soon with keynesians, but it's anyway been a surpringly long exchange. I have read about keynesian assumption earlier, but you know, kind of never believed people actually believed in all that stuff. And here you are! Very exhilirating ;)

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  32. "But when more money becomes idle, there is also price deflation, so real value of money people have decided to spend must increase accordingly (and by exactly same value of money people have decided to hold).

    Just because money's purchasing power has increased by deflation does not mean people will actually start using again in sufficient quanities by purchasing commodities to restore full employment.

    As I said, people/banks/businesses may still - in in these periods do - prefer to hold money as hedge against future uncertainty, and money may be diverted to non-employment inducing demand for financial assets on secondary markets.

    "Wow so you do believe that! Contemporary economist believes that something is actually a store of value. It stores it, like really actually stores it, etc. etc."

    That money can store purchasing power is a basic fact. None of my comments above deny that inflation/deflation or supply affect its purchasing power over time.

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  33. GDP = private consumption + gross investment + government spending + (exports − imports).

    private consumption = purchasing of commodities

    gross investment = purchasing of capital goods, inventory stocks or construction of new houses

    GDP excludes spending on financial assets or financial instruments.

    Why? Because that spending is not spending on output. It is non-employment inducing demand, just as the neoclassical Frank Hahn noted:

    http://socialdemocracy21stcentury.blogspot.com/2011/01/f-h-hahn-in-candid-moment-on-neo.html

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  34. Just because money's purchasing power has increased by deflation does not mean people will actually start using again in sufficient quanities by purchasing commodities to restore full employment.

    It does mean that, precisely because you assume people increase their money holdings to a higher, but _finite_ level. From that very assumption, they _spend_ the rest of their money. And total value (purchasing power) of that money increases basically in exactly direct proportion to the increased money holdings thanks to price deflation, so demand increases back to its original level.

    As I said, people/banks/businesses may still - in in these periods do - prefer to hold money as hedge against future uncertainty, and money may be diverted to non-employment inducing demand for financial assets on secondary markets.

    Right, those are the assumptions we share, and again, the permanent decrease in demand does _not_ follow.

    That money can store purchasing power is a basic fact. None of my comments above deny that inflation/deflation or supply affect its purchasing power over time.

    Using the concept of "storage" is misleading here because you use it to "prove" that the purchasing power of money holdings (or deflated debt) somehow disappears into thin air. But it doesn't. Instead, it gets automatically transferred to the "busy" money via price deflation. Intuitively when "storage" gets destroyed, whatever it stores gets destroyed too, but it does _not_ work that way with money and as an economist you should know that. No value nor purchasing power whatsoever gets destroyed when money gets destroyed. You can burn half of all money out there and total purchasing power will not decrease not even by one iota.

    It is non-employment inducing demand

    Okay, you keep repeating that even though I have already shown that unemployment has nothing to with total demand.

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  35. "And total value (purchasing power) of that money increases basically in exactly direct proportion to the increased money holdings thanks to price deflation,"

    Prices are not significantly flexible in modern economies.

    Even in the 19th century, there were wage and price rigidities.

    Real world capitalism is one with stickiness of wages and prices.

    Your analysis and assuptions are fit only for the fanasty world of Austrian economics.

    And even if prices adjusted perfectly, it still doesn't follow that people would significantly increase spending on commodities in depressions or recessions, owing to the myriad of factors I have listed above.

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  36. Easy there, Lord Keynes.

    I am not exactly pro-Austrian either, and I have found Rothbard's arguments against fractional reserve banking in "What Has Government Done With Our Money?" to be really wanting when I first read it, BUT -

    Let's cut the Austrian School some slack, because Joanna Liberation is not necessarilly a spokesperson for Austrian economics. You yourself have argued that JL has misrepresented Austrian thought in one earlier blog post.

    The fact that people hold on to funds even under falling prices, due to future uncertainty, has been acknowledged by Rothbard in that same treatise on money I reference above.

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  37. I am certainly not a spokesperson of Austrian Economics, more of a layman's common sense whose utmost care is in correct assumptions and logic. I'm not even an economist professionally, so LK you can easily discard my arguments simply on the lack of authority no problem. I basically read some Rothbard's Man, Economy, and State with Power and Market a few years ago and I don't even feel I remember much, except I have finally found the lucid clear-cut logical thinking with self-evident assumptions in economics that I always try to apply in any other area, be it philosophy, physics, computer science or even plain life (which gets me into trouble more often than not unfortunatelly). However in economics I have always had an impression that everyone's talking fairy tales. I'm all the more happy that LK calls my analysis "the fanasty world of Austrian economics", looks like I should be at least roughly on the same page with Rothbard even when I'm doing thinking largely on my own.

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  38. LK: And even if prices adjusted perfectly, it still doesn't follow that people would significantly increase spending on commodities in depressions or recessions, owing to the myriad of factors I have listed above.

    Prateek Sanjay: The fact that people hold on to funds even under falling prices, due to future uncertainty, has been acknowledged by Rothbard in that same treatise on money I reference above.

    If people don't increase their spending with falling prices _proportionately_ that means people _further_ increase their money holdings and we are back to square one, the process I've described simply works faster then. In fact, they increase their real money holdings even when they do increase their spending proportionately because the real value of their money holdings keeps increasing under price deflation too. So people will ultimately have to start spending part of their money holdings just to keep its real value intact (and still no substitution required). But even if they don't, again, that does not matter, people may increase their money holdings all they want (but always to a finite level, because money supply is finite) and they will merely make price deflation and the process of demand returning back to its original level faster. That's why I've called it _automatic_ because it is _not_ dependent on the decisions people make. In fact, the more people work against the process, the faster it will be. Self-regulating as self-regulating can be, any way I look at it. You seem to fail to draw certain conclusions from your assumptions. For example, you say that "it still doesn't follow that people would significantly increase spending". Okay, so be it, but you conveniently forget that that could only mean even _further_ price deflation. Only that (purposeful?) omission lets you to jump to your conclusion of permanently declining demand.

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  39. Refuting your entire last post:

    Real world capitalism is a system with stickiness of wages and prices.

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  40. Real world capitalism is a system with stickiness of wages and prices.

    That "refutes" way more than my last post. That "refutes" the most basic economic law, the law of supply and demand. Without that, indeed, anything is possible, fairy tale world welcome to! And from wikipedia I see that sticky prices do "play an important role in Keynesian thought". But then you yourself refer in this very post to "deflationary depression in the 1880s". So how can there be a _deflationary_ depression if prices are so sticky?

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  41. You're talking about 19th century gold standard capitalism. There were indeed periods of inflation and deflation in the 19th century. That is in NO way incompatible with the assertion that wages and prices are not perfectly flexible in modern capitalism.

    Yes, wages and prices were relatively more flexible back then compared to today, but there were still real rigidities and processes that prevented capitalism from working in the way you and supporters of Say's law think it works.

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  42. So what exactly makes prices less flexible today than in 19th century? Fast transport and globalization? Instant communication and information flow? Millisecond trading platforms? Wow that all sounds as if prices are way more flexible than in the 19th century. Unlesss... wait, more government meddling? Minimim wage laws? Labor code laws? Is that it?

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  43. You forget the monopolies, cartels and oligoplistic nature of many corporations in many capitalist nations, as noted by John Kenneth Galbraith year ago. There are thus many markets where prices of commodities are set by oligoplistic price makers/price setters, not price takers, where the prices of products are simply caused by demand/supply dynamics.

    And it wasn't government that caused oligoplistic markets: this is the way capitalism developed since the late 19th century. If anything, governments have acted, to some extent, to break up monopolies and oligoplolies (e.g., United States antitrust law).

    Futhermore, even if all prices and wages were perfectly flexible there would still be failures of aggregate demand and Say's law would not work.

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  44. And capitalism - and any logically consistent libertarianism - could not object to workers freely organising themelves in unions and engaging in collective bargaining. Don't go blaming government for that.

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  45. There are thus many markets where prices of commodities are set by oligoplistic price makers/price setters, not price takers, where the prices of products are simply caused by demand/supply dynamics

    Okay, so there exist voluntary (free market) cartels that purposefully set prices in such a way as to _not_ sell all of their products and services in order to achieve monopoly prices. But you say competition is not to pop up with lower prices if they do so? I mean, the most powerful free-market (ie not controlled centrally under one government) cartel I know of is OPEC, but it still has not prevented the fall of gas prices to fall from $145 to $39 in the latter half of 2008. In other words, gas prices cannot really be kept above market prices even by OPEC. But you say there are more powerful free-marekt cartels than OPEC? Such as?

    And capitalism - and any logically consistent libertarianism - could not object to workers freely organising themelves in unions and engaging in collective bargaining. Don't go blaming government for that.

    Minimum wage laws and labor code laws have nothing to do with "workers freely organising themelves in unions and engaging in collective bargaining". Protip: laws are passed by legislative branch of government, not by "free organizations of workers".

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  46. Futhermore, even if all prices and wages were perfectly flexible there would still be failures of aggregate demand and Say's law would not work.

    Was there supposed to be some new argument that got accidentaly left out or an invitation to a "yes it is, no it isn't" play?

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  47. "Was there supposed to be some new argument that got accidentaly left out ..."

    You have already been directed to the "arguments":

    http://socialdemocracy21stcentury.blogspot.com/2011/01/f-h-hahn-in-candid-moment-on-neo.html

    http://socialdemocracy21stcentury.blogspot.com/2010/10/myth-of-says-law.html

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  48. Note again in my argument I have explicitely _not_ used gross substitution assumption. I have also _not_ used Say's law as such (like in a sentence "this works that way because of Say's law" etc). I did start this exchange by describing a process that I think _might_ be what Say _might_ have had in mind when writing down his "law", but I don't care much about particular economist opinions and laws, even those of Say or Rothbard, if they do not make sense to me on their own merit. I merely care about plain common sense and that is is all I've been using in my argument here so directing me to posts which may or may not refute gross substitution assumption or Say's law is irrelevant.

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  49. If LK read more Axel Leijonhufvud his blog would be much improved.


    P.S. The real (classical) liberal economists critique of unions has nothing to do with their ability to collectively bargain in a free market setting, and any economist with a hint of familiarity with the critique of unions knows that. So are you creating a straw man, or being intellectually dishonest?

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  50. I read an article by Davidson where he stated that the Classicals implicitly believed in perfect information and that people act rationally (not in a Misesian sense). Contrary to Austrian rhetoric, I wonder if Austrian's assume the same thing. At some point in their argument, they seem to throw in pixie dust to clear markets. I often wonder if this is a reinsertion of Classical axioms. But how would you prove this?

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  51. Davidson shows here how O'Driscoll and Rizzo assume tacitly the classical axioms:

    Paul Davidson, “The Economics of Ignorance or Ignorance of Economics?,” Critical Review (1989) 3.3/4: 467–487

    Paul Davidson, “Austrians and Post Keynesians on Economic Reality: Rejoinder to Critics,” Critical Review 7.2/3 (1993): 423–444.

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  52. @Joanna Liberation

    Just caught up on this discussion while searching for the exact quote by Keynes on money characteristics. Let me add my 2 cents in the discussion.

    In a recession prices of goods and services will fall. That's a given. In order for demand to rise people either have to have larger aggregate income than aggregate price level or use stored savings in order to take advantage of lower prices. But the deflated prices are the result of lower demand in the first place so only the second option is possible since aggregate income is decreased because of lower wages and/or higher unemployment. Income matches spending anyway.

    Let's see now if people would indeed be willing to use their increased savings. First of all, since their income is now lower than before (in aggregate) their saving potential in the next run of the business cycle is lowered by the same amount. In order for the deflationary spiral to not continue they have to forgo saving in the next business cycle run and instead use all their income for consumption plus a part of their savings (which would drive production and maybe prices back up). We are assuming at this point that companies will forgo investment until they see their inventories increasing again. For starters it is not unreasonable to assume that in such a deflationary environment with lowered production levels, income, deflated prices of goods and property and hight unemployment, people would be a bit reluctant to increase their consumption, even if it's only because they are assuming that prices will fall even more!

    Let's assume a closed economy without government sector. In such an economy ALL money is in the form of private debt. Our problem though is that the interest is sticky and CANNOT be negative. As a result we might be having a deflationary episode in goods and property values and income coinciding with an inflationary episode in real debt burden.

    Since the private sector's present income is not enough to service it's increased debt burden (since a larger part is needed to service the interest paid) and previous savings are used instead (or consumption is forgone), i don't see any reason for the private sector to increase it's demand due to price deflation. In general, unless the interest rate can move along with the deflation rate and become negative Say's law would not work.

    Comments welcome.

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  53. I would like to say a few more words on the second property of money, that of 'zero or near zero elasticity of substitution with producible commodities'.

    In current fiat economies all of the money supply is created and provided by government and banks (actually it is created by the central bank but anyway). The rest of the private agents may use this currency to perform financial transactions and maybe a neo-classical economist could argue that they only use their money in order to buy other products and services, either immediately (consumption) or in the long run (investment).

    The problem though is that the private sector also carries debt and tax obligations which it can only pay using currency. Government and banks are not buyers of products but only of currency. This is especially true in the case where the government is running a budget surplus (it is accumulating, rather destroying currency more than it is spending). This is also true for banks, which might have expenditures (wages, consumption etc) but on the long run try to earn a profit which is accumulated as capital in order for them to be able to increase their assets (loans) through their capital requirements. That is different from other companies which typically invest their retained profits in expansion of production.

    So private agents in aggregate can only acquire currency from the government or banks, which are carried as tax or debt obligations with these institutions (apart from the case of a budget deficit) but these institutions are net buyers of currency.

    In other words, the private sector might be able to perform business transactions with each other by means of product/services exchange but it cannot do the same with banks and government although it carries a large burden of obligations with these institutions. As a result, in aggregate it cannot substitute money with other commodities.

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  54. Lord Keynes, can you explain why:

    “The elasticity of substitution between all (nonproducible) liquid assets and the producible goods and services of industry is zero. Any increase in demand for liquidity (that is, a demand for nonproducible liquid financial assets to be held as a store of value), and the resulting changes in relative prices between nonproducible liquid assets and the products of industry will not divert this increase in demand for nonproducible liquid assets into a demand for producible goods and/or services” (Davidson 2002: 44).

    is true?

    I think that the resulting changes in relative prices between nonproducible liquid assets and the products of industry CAN (though not always, it will depend on the case) divert this increase into a demand for producible goods and/or services. Is Davidson assuming anything else which is not included in his quotation? Or am I misunderstanding something?

    The only way in which the demand for non-producible assets will not prompt a diversion into producible goods and/or services is by people valuing more the possession of this assets (great uncertainty, postponing consumption because they expect further deflation, etc.) than the low prices made available by this demand. I acknowledge that this scenario, in the short run, will bring unemployment and a debt recession (which will certainly have long run effects), but this reasoning will still have to hold good.

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  55. "The only way in which the demand for non-producible assets will not prompt a diversion into producible goods and/or services is by people valuing more the possession of this assets (great uncertainty, postponing consumption because they expect further deflation, etc.) than the low prices made available by this demand. "

    The operative words are "any increase in demand for liquidity (that is, a demand for nonproducible liquid financial assets to be held as a store of value)..."

    Why would you hold producible goods as a store of value?

    “If the gross substitution axiom was universally applicable, however, any new savings that would increase the demand for nonproducibles would increase the price of nonproducibles (whose production supply curve is, by definition, perfectly inelastic). The resulting relative price rise in nonproducibles vis-a-vis producibles would, under the gross substitution axiom, induce savers to increase their demand for reproducible durables as a substitute for nonproducibles in their wealth holdings. Consequently nonproducibles could not be ultimate resting places for savings as they spilled over into a demand for producible goods ...

    Samuelson’s assumption that all demand curves are based on an ubiquitous gross substitution axiom implies that everything is a substitute for everything else.

    In Samuelson's foundation for economic analysis, therefore, producibles must be good gross substitutes for any existing nonproducible liquid assets (including money) when the latter are used as stores of savings ...”
    Samuelsonian economics and the twenty-first century, p. 189ff.

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  56. I'm not talking about the case of using real commodities (producible goods) as a store of value, that's a different story. What I'm talking about is that the resulting relative price rise in nonproducibles vis-a-vis producibles would induce savers to increase their demand for reproducibles, not just as a store of value, but because their propensity to consume is increased due to the resulting lower prices.

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  57. "What I'm talking about is that the resulting relative price rise in nonproducibles vis-a-vis producibles would induce savers to increase their demand for reproducibles, not just as a store of value, but because their propensity to consume is increased due to the resulting lower prices. "

    Because of negatively sloping demand curves? But that's another myth:

    “Economists can prove that ‘the demand curve slopes downward in price’ for a single individual and a single commodity. But in a society consisting of many different individuals with many different commodities, the ‘market demand curve’ is more probably jagged, and slopes every which way. One essential building block of the economic analysis of markets, the demand curve, therefore does not have the characteristics needed for economic theory to be internally consistent.” Steve Keen, 2001. Debunking Economics: The Naked Emperor of the Social Sciences, Zed Books, New York and London. p. 25.

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  58. I get it. Macroeconomics is tricky!

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