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"Arguing in My Spare Time" No. 3.14
Arnold Kling

May 24, 2000

As the Fed starts to take away the punch bowl, naturally there are some party-goers who are displeased. Among the most vocal complainers are some champions of the "New Economy."

One of the concepts I encountered in my first undergraduate course in economics was the trade-off between inflation and unemployment. About that time, the neoclassical school of economics was emerging to deny that such a trade-off exists. Today, the partisans of the New Economy also deny that there is a trade-off between unemployment and inflation.

If you assume that "the enemy of my enemy is my friend," then you might think that neoclassical economics and the New Economy gurus would be in agreement. In fact, the New Economy argument is utterly inconsistent with the neoclassical view.

The neoclassical view of the economy is that if the government expands demand, the ultimate result will be more inflation without more employment. In contrast, the New Economy view is that increases in demand lead to more employment without inflation. In technical terms, neoclassical economics asserts that the aggregate supply curve is vertical, while New Economy macro posits a supply curve that is horizontal.

I have seen the New Economy view articulated by Edward Yardeni ( and by Michael Cox and Richard Alm (see They argue that economists like me are stuck in old paradigms.

Yardeni emphasizes two arguments for the New economy view, and Cox and Alm emphasize a third. I will look at their arguments both individually and collectively.


There are a number of problems with this story.

1. The United States is not small. An increase in U.S. demand is not just a drop in the ocean of world supply.

2. Only a small portion of our economy is in a highly competitive world environment. Imports and exports account for less than 15 percent of GDP. There is very little trade in services, which is becoming the most important sector of the economy.

3. A small, open economy lives and dies by the foreign exchange rate for its currency. If the currency is too strong, demand for domestic output collapses. If the currency is too weak, prices rise. The U.S. economy does not behave this way. For the United States, changes in the value of the dollar are barely noticed by the average individual.

4. With a small, open economy, an increase in domestic demand "leaks out," increasing world output but leaving little change in domestic employment and production. In fact, in the United States, domestic employment and output have risen dramatically,

Endogenous Productivity

The reason that increases in demand "leak out" of a small, open economy is that as firms increase output, they have to increase employment and raise wages, and they become less competitive with foreign firms. Yardeni's second argument is that firms are able to increase productivity in order to keep prices from rising. He claims that the capacity to increase productivity is sufficient to meet any increase in demand.

However, why should companies wait until demand increases before pulling the productivity rabbit out of their hats? If you have an idea that will improve productivity, you should implement that idea regardless of the level of demand.

Moreover, if demand can be met simply with higher productivity, then there should be no need to increase employment. In fact, employment is high, unemployment is low, and companies complain of a "labor shortage."

Undiminishing Returns

The final argument for the New Economy, empasized by Cox and Alm, is that production no longer is subject to diminishing returns. An intellectual product, such as a software program or a new medication, is costly to develop. However, once developed, production and distribution costs at the margin are nearly zero. Such products are not subject to the law of diminishing returns.

Furthermore, in some industries there are increasing returns, due to network effects. The more users of AOL chat, the more valuable AOL chat is to its users.

If a company enjoys nondiminishing returns, then at the margin it will want to increase output as much as possible. In contrast, when there are diminishing returns, a company finds it more expensive to increase production, and therefore as demand goes up prices increase.

I am not as convinced as are Cox and Alm that nondiminishing returns imply that as demand increases, prices will fall. For example, it is not clear that AOL has any incentive to reduce prices as demand expands. They may even find room to increase prices.

Even conceding that some companies are characterized by nondiminishing returns, the economy as a whole still faces resource scarcity. There are limits to the amount of talent available to develop new products and services, even if those products and services themselves enjoy nondiminishing returns.

If the portion of the economy that is subject to the discipline of international trade is small, the portion that enjoys nondiminishing returns probably is even smaller. This is particularly true for measured inflation. Most of the goods and services that are included in the indexes of inflation come from traditional industries.

A Helicopter Drop

Apart from these specific issues, my overall objection to New Economy macroeconomics comes from classical monetary theory. That is, it comes from the tradition that says that the aggregate supply curve is vertical, not horizontal.

I may not have been one of Stanley Fischer's prized students in Monetary Economics at MIT, but I recall a few things from the course. One concept I remember learning was a thought experiment which he called the "helicopter drop."

Imagine that a helicopter were to drop money on the economy. Suppose that this were to double the money supply. What would be the ultimate outcome for macroeconomic variables?

The most logical long-term outcome for the helicopter drop would be a doubling of the price level, with employment, output, and the real money supply (the quantity of money divided by the price level) unchanged. This is the classical story.

In the New Economy paradigm, supply is perfectly elastic, due to a combination of globalization, endogenous productivity, and undiminishing returns. Therefore, a helicopter drop would not cause prices to double. Instead, if we truly buy into the paradigm, a helicopter drop would double the level of economic output.

I do not believe that Yardeni or Cox and Alm truly wish to defend a point of view that violates the postulates of classical monetary theory. That would mean going off the deep end. However, in order to avoid such a fate, they need to back off the diving board on which they have placed themselves. They need to say that they have, at best, an explanation for a favorable shift in aggregate supply, not a new shape for the aggregate supply curve.

If someone is looking for an explanation for the increase in productivity relative to trend, then stories about technology and innovation deserve a place at the table. However, an increase in productivity is not the same thing as a flat aggregate supply curve.

In particular, the New Economy partisans have not explained why wage inflation has remained subdued with 4 percent unemployment. Therefore, it is pretty difficult to argue that we can be confident that such wage moderation will continue. As a case for keeping the punch bowl at the party, the New Economy argument is more grandstanding than substance.