They are certainly not stupid. And they are certainly not ignorant either. I know that the ones I'm complaining about are smarter than me, and more knowledgeable than me. And that includes economics smarts and knowledge. Some of them make me feel totally inadequate on a daily basis (I read their blogs daily). Some of my best friends are microeconomists. But they just don't get macro!

I'm talking about money wages and employment. I can't be bothered to link to the posts I'm complaining about. And I can't be bothered to go through those posts and explain why their reasoning is wrong. Others have done this, and have failed. Or at least, have failed to make any impression on the 'microeconomic miscreants'. They seem to be preaching to the choir; and the choir is composed of macroeconomists.

I want to try a different tack. I'm not going to try to show that they are wrong. I want to try to understand why they keep going wrong.

But I'm not altogether sure why they keep going wrong. I have three theories, and am going to run through each in turn. Actually, I think we probably need all three theories to explain why microeconomists are just so confused about macro.

Just to set the microeconomic scene: draw demand and supply curves for labour. Suppose wages are above the equilibrium, so there's an excess supply of labour. Cut wages, and you move along the demand curve for labour, and employment expands. Or does it?

1. They don't understand that macroeconomic demand (and supply) curves are fundamentally different from microeconomic demand (and supply) curves.

Why do demand curves slope down? The microeconomist answers: income and substitution effects. Let's take them in turn.

If I cut the price of apples, holding money incomes constant, holding all other prices constant, then consumers are better off in real terms. They can afford to buy more goods, and if apples are a normal good, they will spend some of their increased real income on buying more apples.

This "income effect" is total rubbish in macroeconomics. If there are 100 apples sold, and I cut the price of apples by $1, then consumers of apples are $100 richer. But producers of apples are $100 poorer. No effect on aggregate real income. Sure, there might be distribution effects, but distribution effects are the last refuge of a .... person who can't think up a better argument.

And, if apples were the only good produced in the economy (as they would be if this were macroeconomic analysis), then it's even worse rubbish. What's on the horizontal axis of the supply and demand curve graph? Real income is the quantity of apples. It's GDP! And money income is the price of apples times the quantity of apples. It's what's on the vertical axis times what's on the horizontal axis. It's logical nonsense to draw a demand curve for apples holding money income constant, unless you draw a rectangular hyperbola demand curve for apples.

OK. What about the substitution effect? A fall in the price of apples, relative to the price of other goods, means consumers will substitute away from other goods and into consuming more apples. That makes sense in micro, where we draw the demand curve of apples holding the prices of other goods constant. But in macro, where the price of all goods is on the vertical axis, it doesn't make any sense at all. If the prices of all goods fall, what are they substituting away from? And why?



2. They don't understand the difference between a notional and constrained (effective) demand for labour.

Here's the simplest way to derive a labour demand curve for macro. Write down a short run production function Y=F(L) showing output as a function of employment, holding land, capital, and technology constant. Assume positive but diminishing marginal product of labour: F'(L)>0, F"(L)<0. Assume competitive firms maximise profits taking money wages W and prices P as given. The first order condition is that the marginal product of labour demanded equals the real wage: F'(Ld)=W/P.

That looks like a nice downward-sloping labour demand curve with the real wage on the vertical axis. But it isn't. It's only a "notional" labour demand curve. It only tells us how much labour a firm will want to hire if the firm is able to sell as much output as it wants. But if there's excess supply in the output market, firms won't be able to sell as much output as they want. They can only sell the quantity demanded, Yd. That's an additional constraint on the firm's maximisation problem. If that constraint is binding, the solution to the firm's maximisation problem is Yd=F(Ld): hire as much labour as is needed to produce the output demanded. W/P does not appear in that "constrained" (effective) labour demand function. For a given Yd, the labour demand curve is vertical.

Let's simplify the whole thing. Forget about diminishing marginal product. Make the production function Y=L. One worker produces one apple. Output and employment are the same, and are the same as real income. The notional labour demand curve is a horizontal line, because the marginal product of labour is one, at all levels of employment. Forget about firms. All workers are self-employed apple-growers. Their money wage and their price of apples are the same thing. The real wage is one.

How can there possibly be an excess supply of labour in such a world? If one worker tried to sell his apples for a higher price than the other workers, he might be unemployed. Nobody would want his apples. But then there would be an excess demand for other workers' apples, and an excess demand for their labour. There is no way the labour market/apple market as a whole could be in excess supply, because on average, the price of apples must equal the average price of apples, duh!

Which brings me to:

3. They don't understand monetary exchange.

This is the really important thing they don't understand.

Walrasian general equilibrium theory ignores monetary exchange. If there are n goods (n varieties of apple), then each person submits a list of demands or supplies for the n goods to the Walrasian auctioneer. That list has to conform to the person's budget constraint, which means that the values of goods demanded has to equal the values of goods supplied (Walras' Law). The income from the goods they want to sell must be sufficient to buy the goods they want to sell. All goods are bought and sold in one big market.

But macroeconomists assume monetary exchange instead (though some of them may not realise it, I admit).

If all apples were identical, there would be no need for trade. Each worker would eat his own apples. No worker could be unemployed; he could just grow as many apples as he wanted to eat, and eat his own apples.

Even if apples came in different varieties, or there were a tabu against workers eating their own apples, if barter were easy there could never be unemployment. The unemployed workers could all just get together and swap all the apples they wanted to produce and sell. In barter, a supply of apples is a demand for apples.

It is monetary exchange (or rather, the high transactions costs of barter that make monetary exchange essential) that is the root of all deficiencies in aggregate demand. Each worker's apples are sold in his own private market. And they are sold for money, the medium of exchange. To demand apples is to supply money in exchange. And if people want to hang onto their money, rather than buy apples with it, the demand for apples, and the demand for labour, will be deficient.

A deficiency of aggregate demand has got nothing whatsoever to do with a deficiency of income. Income is always sufficient. It's always the same as goods sold. A deficiency of aggregate demand is a deficiency of peoples' willingness to get rid of money. The "Paradox of Thrift", and the "Paradox of Toil", are merely corrupt versions of, or way-stations to, the Paradox of Money. Each individual can increase his stock of money by buying less; but in aggregate they fail, but cause unemployment as a side-effect.

The Aggregate Demand curve is a locus of points at which people in aggregate are just willing to hold the stock of money they do hold. If microeconomists don't think about monetary exchange they can't think about aggregate demand. Cuts in wages will improve or worsen unemployment due to deficient aggregate demand if and only if they increase or reduce people's willingness to get rid of money.