Wednesday, November 28, 2012

It's not the Aggregate Demand

Formal insurance, i.e., insurance policies and contracts, makes up only a small portion of the total insurance in the economy.  The vast majority of insurance is informal: it is the claim to goods and services produced by others, as represented by money.  Besides present consumption value, money represents insurance that goods and services will be available should you need them in the future.  Consequently, what Keynes depicted as a shortfall of aggregate demand is only a "shortfall" in that we were not measuring it properly.  What Keynes saw as a shortfall of aggregate demand was actually an increased demand for insurance.  The increased demand for insurance is precisely why expansionary monetary and fiscal policies work.  To make the market clear, the supply and demand curves have to move.

The supply curve is the domain of fiscal policy: an insurance claim on future goods and services is wholly dependent on the productive capacity of the economy.  Investments in infrastructure, education (human capital), and other capital goods increase the future productive capacity of the economy, and thus the supply of insurance available for purchase increases.  By contrast, history has shown that pork barrel projects, despite Keynes hole-digging proclivities, do not produce any change because they do not increase future productivity (unless they're funded by expansionary monetary policy, but more on that later).  This is also why austerity can work--if the level of government spending is truly a significant drag on the economy, a reduction in government spending can also increase future productivity.  (As a side note, a dysfunctional government, because of its impact on the economy, can weigh down a recovery regardless of the policy direction it chooses.  Also, dysfunctional governments are a primary thing that people are insuring against.)

The demand curve is the domain of monetary policy: the price of insurance is raised by decreasing the value of insurance claims.  If the value of your insurance is worth less than the value of present consumption, you'll naturally switch into present consumption.  (Though as I've argued before, this depends on where you are on the saving preference curve.)  The switch into present consumption restores "aggregate demand," as defined by Keynes, but it merely changes the overall demand structure from more to less insurance.

In short, when people want insurance, they sell goods and services in the present to buy goods and services in the future.  To clear the market for insurance, you can either provide them with more goods and services in the future, or make future consumption less desirable.  In neither case is a shortfall of aggregate demand the problem.


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