How do you know if AD is too high?

This set of twitter comments caught my eye:

I agree with all three comments.  Nonetheless, it might be helpful to explain this issue in my own way.  Here are three claims:

1.  There is no such thing as the “true” elasticity of aggregate demand.

2.  It is possible for aggregate demand to be appropriate, even when NGDP growth is unusually high.

3.  In this particularly case, however, the fast growth in NGDP is indicative of excessive AD.

Let’s take the three claims one at a time:

1. I prefer to define AD as a rectangular hyperbola, where at each point along the AD curve the total nominal expenditure (i.e., P*Y) is exactly the same.  In that case, the elasticity of aggregate demand is always exactly one.  But many economists define AD in a different fashion, and end up with a different estimate of the elasticity of aggregate demand.  So if someone asked me, “What’s the actual elasticity of AD?”  I’d respond, “How are you defining AD?”  It depends what you are holding constant along a given AD curve.

2.  Suppose Kuwait’s NGDP is 50% oil and 50% other goods and services.  Also assume that 5% of Kuwaiti workers produce oil and 95% of Kuwaiti workers produce other goods and services.  Now assume that global oil prices double almost overnight.  Should Kuwait’s central bank maintain a stable NGDP?  I’d say no, as doing so would require a big reduction in non-oil nominal output.  Because 95% of workers are in the non-oil sector, and because nominal wages are sticky, this would result in much higher unemployment.  It would probably make more sense for Kuwait to target aggregate nominal labor income.

3.  Clearly the Kuwaiti example has some bearing on the recent events in the US.  We produce a lot of oil and the price of oil has recently doubled.  Nonetheless, the recent NGDP data in the US does seem to correctly indicate that there is excessive aggregate demand.  We know this because we also see signs of excessive demand in other indicators such as rapid nominal wage growth and high job vacancies, which are not distorted by oil prices.

To conclude, fast growth in NGDP doesn’t always signal excessive AD.  But in the case of the US, fast and above trend NGDP growth is almost always is an accurate signal of overheating.

We shouldn’t be wasting time trying to figure out some mythical concept like the “true” elasticity of AD.  Instead, we should focus on what sort of path of nominal spending produces a stable economy.