A Real Theory of Aggregate Demand Shortages

Abstract

How can low consumer spending cause an inefficient recession or recovery? We propose a theory, in which aggregate demand shortages are the result of aggregate demand externalities stemming from financial frictions rather than nominal rigidities. In our theory, an economy can be demand constrained when, i) consumption goods and assets used as saving vehicles are not perfect substitutes, ii) productivity in the consumption goods sector can be improved or maintained via investment, and iii) external financing of this investment is subject to a tight enough borrowing constraint. In a demand-constrained equilibrium, a saving tax can increase consumption, investment, employment, output, and welfare. A tighter firms’ borrowing constraint implies more severe aggregate demand shortages in a demand-constrained equilibrium. We use stylized extensions of our benchmark model to show how financial shocks can create demand-constrained recessions. Our theory suggests that fiscal rather than monetary policy might become the primary policy tool to restore the efficiency under certain conditions. Demand management policies might be necessary over a long period of time. The "potential", i.e., the constrained efficient allocation, may depend on both supply and demand factors.