"Deficiencies of aggregate demand are always and everywhere a monetary phenomenon". There's an excess supply of newly-produced goods, and an excess demand for money. But what exactly does an excess demand for money mean? And what does it mean for the effectiveness of monetary policy?

Aggregate demand for goods is a demand for those goods in terms of money. At least, that's true in a monetary exchange economy, where all goods are bought and sold for money -- the medium of exchange. If we have a deficiency of aggregate demand, as most macroeconomists believe we currently do, that means that Say's Law ("supply creates its own demand") is currently, as an empirical matter, false.

In a barter economy, where people offer to buy goods by offering to sell other goods, Say's Law would be true. The excess supply of some goods would be matched by an equal value of excess demand for other goods.

In a monetary exchange economy it is well-understood that Say's Law can be false. There can be an excess supply of goods, if it is matched by an equal value of excess demand for money.

That last sentence is true, but misleading. The reason why it is misleading is not well-understood at all. In a monetary exchange economy there is no such thing as a unique excess demand for money. There are as many excess demands for money as there are markets. And the aggregate of those excess demands for money does not represent the quantity of extra money that people want to hold.

Let me briefly re-cap one of the conclusions of the "disequilibrium macro" literature of the 1970's. I mean Clower, Patinkin, Leijonhufvud, Barro-Grossman, Benassy, Dreze, etc. (I am going to avoid taxonomic debates over exact definitions of "Say's Law", Say's Principle", Walras Law" etc., because there seem to be as many taxonomies as there are economists who have thought about these issues carefully.)

People (and firms and governments) face budget constraints. If people formulate their demands and supplies of goods reflecting that budget constraint, then we get Walras Law. The individual's planned purchases of goods must be financed by planned sales of goods, including money. So the value of each individual's excess supplies of goods must equal his excess demand for money. Aggregate across all individuals (plus firms and governments) and we get Walras' Law: the value of the excess supplies of goods must equal the excess demand for money.

So Say's Law is false, because it forgets money, and Walras' Law is true, because it remembers to include money.

But that's not right either. Or rather, it would only be right if we are talking about notional excess demands and supplies. A notional demand or supply of apples is the amount of apples that people would want to buy or sell if they ignored any constraints on the quantity of other goods they were able to buy and sell. Notional demand and supply functions are what you get when you maximise utility subject to the budget constraint and subject to no other constraints on how much you can buy or sell.

Walras' Law is true if it is interpreted to be speaking about notional excess supplies and demands.

But if we are out of equilibrium, there will be excess demands in some markets, and/or excess supplies in other markets, and people will not be able to buy or sell as much as they want to, because they won't always be able to find willing buyers or sellers. They will be quantity constrained. The insight of Clower and Patinkin was to recognise that quantity constraints in one market will spillover into demands and supplies in other markets. If I want to buy apples, but can't because there's an excess demand for apples, I might decide to buy pears instead. If I want to sell labour, but can't because there's an excess supply of labour, I might decide to buy less carrots.

In disequilibrium, people (and firms and governments) face quantity constraints as well as budget constraints. If people formulate their demands and supplies of goods to maximise utility subject to their budget constraint and subject to quantity constraints, we get constrained (or effective)demand and supply functions, not notional demand and supply functions.

I go to the supermarket with $10 in my pocket planning to buy $10 worth of apples and no pears. Those are notional demands. Excess demand for apples $10, and excess supply of money $10. Walras' Law applies. But when I get to the store there are no apples, so I re-maximise my utility function, including that quantity constraint, and decide to buy $10 of pears. Excess demand for apples $10 (because I still want the apples). Excess demand for pears $10 (because I can't buy apples). Total excess demand for goods (apples plus pears) $20. But what's the excess supply of money corresponding to that excess demand for goods? $20? But I only have $10 in my pocket.

I go to the labour market with $0 in my pocket, planning to sell my labour for $100 and then visit the supermarket and buy $100 of groceries. These are notional demands and supplies. Excess supply of labour $100, excess demand for groceries $100, excess demand for money $0. Walras' Law applies. But when I get to the labour market I can't sell my labour, so I re-maximise my utility function including that quantity constraint, and don't go to the supermarket. Excess supply of labour $100, excess demand for groceries $0. But what's my excess demand for money? $100? But I don't want to hold money; I want to spend it on groceries. But the supermarket never gets that signal.

In a Walrasian economy there is one big market, where everything can be traded for everything else, so we submit all our demands and supplies in one big unified decision, maximising utility subject to the budget constraint only. But in a monetary exchange economy, with N goods (excluding money) there are N markets (where each of the N goods trades for money), and we face N decisions. (Benassy's "multiple decision hypothesis", rather than Clower's "dual decision hypothesis", because Clower thought in terms of only two markets: goods and labour). In each market, we maximise utility, subject to the budget constraint, and subject to any quantity constraints in all the N-1 other markets.

In a Walrasian economy, with one big market, and a unified decision, Walras' Law is true. The sum of the excess supplies for goods will equal the excess demand for money (though it is hard to see what "money" could mean in such an economy"). But in a monetary exchange economy, with N markets, there are N decisions, and N different definitions of the excess demand for money, each corresponding to one of those N decisions. In each of those N markets the excess supply for that good will equal the excess demand for money in that market. So if we add up the excess supplies of goods and excess supplies for money we will find they are equal. But that total excess demand for money across all markets won't correspond to any economically meaningful concept. It does not represent the extra amount of money that people want to hold.

Now, what's all this got to do with monetary policy in the current recession (if anyone's still reading)?

If the problem is a deficiency of aggregate demand, then firms have an excess supply of output. They want to sell more output at current prices but cannot. Households have an excess supply of labour. They want to sell more labour but cannot. Firms' constraint on sales affects their demand for labour, so their demand for labour is less than their notional demand. Households' constraint on selling labour (plus their lower shares of firms' profits because firms are sales-constrained) affects their demand for output, so their demand for output is less than their notional demands.

So the output market shows an excess supply of output matched by an excess demand for money (by firms). But firms don't want to hold that money; they want to spend it on labour and distribute the remainder to households as profits. And the labour market shows an excess supply of labour matched by an excess demand for money (by households). But households don't want to hold (all) that money; they want to spend (most of) it on output.

What's happening in the bond market? Just as in any of the other N markets, bonds are bought and sold for money. Any excess supply of bonds must be matched by an excess demand for money in that market. But suppose the bond market is in equilibrium, either because interest rates adjust quickly, or because people are indifferent between holding additional bonds and additional money. Then there is no excess demand for money in the bond market.

If you accept my description in the above two paragraphs, then the current recession is a monetary phenomenon. In a barter economy, the households with an excess supply of labour could exchange their labour directly with firms who have an excess supply of output. But in a monetary exchange economy they do not do this, for obvious reasons. We have money, not barter, because an individual worker and firm do not have a double coincidence of wants.

Since the underlying problem is monetary in nature, fiscal policy, if successful, must be a continuation of monetary policy by other means. It is an attempt to reduce the demand(s) for money. It works, if it does work, either by reducing the private demand(s) for money (increasing velocity), or because the government has a lower demand for money than the private sector, so switching demand from the private to government sector increases the average velocity of circulation.

There is an excess demand for money in the output market. And another excess demand for money in the labour market. But this does not mean that firms and households want to hold more money; if they got it they would want to spend it (or most of it). So the central bank would not need to create anywhere near as much money as those excess demands for money would indicate. It is logically conceivable that a single $1 would be sufficient to eliminate trillions of dollars excess supply of goods.

And the fact that the bond market is clearing (or the fact that the one portion of the many bond markets in which central banks currently choose to operate is clearing) tells us nothing about the excess demand(s) for money in the rest of the economy -- in all of the other N-1 markets. If central banks operated in the market for pears, an equilibrium in the market for pears would mean zero excess supply or demand for money in that market, but would tell us nothing about the excess demand or supply of money in the market for apples.

Just because one market is satiated with money does not mean that the economy as a whole is satiated with money. In a monetary exchange economy, there are as many different excess demands for money as there are goods (excluding money). If central banks "run out of ammunition" in one market, they can just switch to one of the other N-1 markets.

And the market for very short term and very safe and very liquid bonds is a very peculiar market for central banks to be operating in anyway, just because they are so close to money. If we used apples for money, it would be like the central bank operating in the market for pears. At the right relative price, apples and pears might become perfect substitutes, and open market operations might become irrelevant.

Just trying to get my head back into monetary theory and policy after a 2-week vacation.