Hayek on Aggregate Demand in a Depression

Gottfried von Haberler describes Hayek’s views on the role of aggregate demand in an economy, and the two instances where Hayek admitted that aggregate demand was able to affect the level of employment:

“In later writings Hayek (1974, 1975) has clarified and somewhat modified his views, coming to grips with the problem of secondary deflation. He still rejects what he believes is the basic mistake of Keynesian economics, namely, ‘that employment is a direct and simple function of what is called aggregate demand, and that by keeping aggregate demand at a sufficiently high level we can lastingly secure full employment’ (1975, p. 4). In a later publication he goes so far as to say that ‘the whole notion that he [Keynes] has made popular, macroeconomics,’ must be ‘set aside.’

Hayek now says there are two exceptions to the rule that changes in aggregate demand do not affect the level of employment. The first one was ‘an accidental historic situation.’ In 1925 Britain made the mistake of returning to the gold standard at the prewar parity, which meant that real wages were too high. ‘In this situation,’ he wrote, ‘the restoration of employment required a reduction of real wages which could he achieved by a general rise of prices’ (1974, p. 4).

‘The second situation in which it is true that an increase of employment requires an increase in aggregate demand,’ Hayek (1974, p. 5) now maintains, ‘is found in the later stages of a depression when, in consequence of the appearance of extensive unemployment, the economy frequently is subjected to a cumulative process of contraction. … of secondary deflation, which may go on for a very long time.’” (Haberler 1986: 426; reprinted in Haberler 1991).

Yet it seems difficult to see why an increase in aggregate demand would increase employment in a depression, but not in a recession, or indeed in any situation where extensive unemployment and idle resources exist.

One can only marvel at the inconsistency in Hayek’s thought. And what was Hayek’s explanation for the repeated instances we see in the real world in which government fiscal stimulus is followed by increased private investment and falling unemployment?

BIBLIOGRAPHY

Haberler, G. 1986. “Reflections on Hayek’s Business Cycle Theory,” Cato Journal 6: 421–435.

Haberler, G. 1991. “Reflections on Hayek’s Business Cycle Theory,” in John Cunningham Wood and Ronald N. Woods (eds.), Friedrich A. Hayek: Critical Assessments (vol. 4). Routledge, London. 249–262.