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The aggregate demand/supply model: a premature requiem?

Two recent articles [Barro (1994) and Geithman (1994)] have argued that the aggregate demand/aggregate supply approach is incorrect and/or inappropriate for explaining macroeconomic theory (or theories) to students. The purpose of this brief note is not to criticize the positions of Barro and Geithman; in fact, we believe both authors make some valid points. However, we argue that while its underpinnings are somewhat complex, a carefully defined aggregate demand/aggregate supply model may in fact be quite useful in illustrating the critical differences and commonalities among various theoretical explanations of how the macroeconomy works.(1)

Definitions of Aggregate Demand and Aggregate Supply

It appears that some of the confusion regarding aggregate demand and supply models has arisen because different writers have defined aggregate demand and aggregate supply differently. We shall present definitions of aggregate demand (AD) and aggregate supply (AS) that are different from some of those in the literature, but which we believe are most useful to illustrate a number of fundamental issues in macroeconomics. In this context, aggregate demand is the relationship between the real quantity demanded of newly produced final goods and services in an economy and the general price level, under the constraint that if the aggregate quantity supplied were equal to the quantity depicted on the horizontal axis, the aggregate quantity demanded would be equal to it.(2) With this definition, the aggregate demand curve is a set of coordinate points (aggregate quantity demanded, aggregate price level) that represent equilibrium points in the Keynesian demand model. Thus, the AD curve is actually an aggregate demand-side equilibrium curve.

With this definition of aggregate demand and following where others have tread, we must turn to reasons other than the income and substitution effects used to justify the slope of the demand curve for a single product. On an aggregate basis, if all prices in the economy rise proportionally, money incomes will also, and therefore there is no reason for the traditional income and substitution effects found in an individual product market. Thus, the downward slope of the aggregate demand curve has usually been justified by the real balances effect (the Pigou effect) and the interest rate effect (the Keynes effect).(4) The former effect occurs because a decrease in the general price level increases the real wealth of those holding financial assets. Of course, the real wealth of debtors is correspondingly decreased, but traditionally it has been argued that the government, a net debtor, is not affected by such declines in wealth. It is argued that the interest rate effect occurs because as prices fall, the quantity supplied of money in real terms exceeds the quantity demanded. As a result, actions are taken in the financial markets that cause interest rates to fall. Correspondingly, the quantity demanded of consumption goods and investment goods rises.

We turn now to aggregate supply, which we define as the relationship between the real quantity supplied of newly produced final goods and services in an economy and the general price level. Underpinning this definition of aggregate supply is the assumption that relative input costs and output prices are adjusted so that there is no excess quantity demanded or excess quantity supplied of any factor of production at any point on the aggregate supply curve. Although the aggregate supply curve has been defined in a variety of ways, the above definition, where the aggregate supply curve represents equilibria in the input markets, appears most useful in illustrating the differences in the various explanations of the macroeconomy.(5) Thus, it is really an aggregate supply-side equilibrium or a factor market equilibrium curve.

Some economists draw this (so called, long-run) aggregate supply curve as a vertical line, indicating the maximum quantity of goods and services that an economy could produce. However, such a concept seems tenuous, unless it refers to not only all equipment but all units of labor working to their capacity limits. In the case of labor, we would argue that few of us work to our absolute capacity limits, although we may think so at times. The quantity of labor we supply may equal the quantity demanded of it, but that typically represents a different level of effort than the maximum possible.

The long-run aggregate supply curve may be argued to be upward sloping because of an effect similar to that of the real balances effect on the quantity demanded. In the case of aggregate supply, as prices rise, people holding financial assets find that their real wealth has fallen. Consequently, they are willing to work longer hours and perhaps additional people (the elderly or spouses, for example) will enter the labor force. The reverse effect occurs when prices fall.(6) In this context, full employment means only that the quantity demanded of labor is equal to the quantity supplied of labor at the going market wage rate. In other words, no involuntary unemployment exists at the going wage rate. Nevertheless, higher levels of employment (i.e., hours of labor supplied) could be consistent with equilibrium in the labor market given a different aggregate price level.

Applying the Model

Now, many critical issues of disagreement among macroeconomists may be illustrated with the aggregate demand and supply curves and a discussion of the behavior of aggregate prices. We may present a straightforward classical model with an intersecting aggregate demand and supply curve as shown in Figure 1 and argue that flexible product and input prices will change in response to either a shift in aggregate demand or supply, establishing a new equilibrium at a new aggregate price level and level of aggregate output. For example, if an increase in pessimism on the part of investors results in a decrease in aggregate demand from [AD.sub.1] to [AD.sub.2], the aggregate price level falls, and a new equilibrium is established at a lower price level, [P.sub.2], and a lower level of aggregate output, [Y.sub.2]. It is critically important to this model to remember that based on the underpinnings of the aggregate supply curve, the input markets are still in equilibrium - the quantity of each input supplied is still equal to its quantity demanded. It follows that the quantity of labor supplied is voluntarily smaller at [Y.sub.2] than at [Y.sub.1].

On the other hand, there are those economists who have observed that the aggregate markets at times appear not to adjust so smoothly to changes in aggregate demand, for example in the United States during the 1930s. They have personally lived or know of family and friends who have lived through times when they simply could not find jobs, although they were willing and able to work, even at wage rates lower than those currently prevailing in the labor market. They believe that a great deal of human suffering occurred during those periods, and that many of those unemployed found it impossible to find new employment, at least in a short run that was sufficiently long to cause severe hardship in some cases. Much of macroeconomic theory is concerned with various explanations of how this latter situation could possibly occur and what should be done about it.

One common "Keynesian" explanation is that at least some prices, perhaps particularly the price of labor, are rigid so that the new equilibrium at [P.sub.2] and [Y.sub.2] cannot be reached. In the most extreme case, prices do not fall at all, so that the aggregate quantity demanded falls to [Y.sub.3], shown in Figure 2. If prices are prevented from falling, then to avoid excessive inventory buildups suppliers must reduce the quantity supplied, although they would be willing to supply a larger quantity at the prevailing market prices. This situation is one of equilibrium only in the very limited sense that the quantity actually supplied of final goods and services is equal to the quantity demanded. However, it is truly a disequilibrium situation in that the economy is not at a point consistent with its aggregate supply curve. (In the labor market, demand has fallen and workers are laid off, but the wage rate has not adjusted to a new, lower equilibrium. Thus, there is involuntary unemployment.) Moreover, if prices and wages are completely rigid, increases in demand will result in increases in aggregate quantity supplied up to the original aggregate output level of [Y.sub.1] as indicated by the dotted line between points B and A in Figure 2. See, for example, [AD.sub.3] and [Y.sub.4] (Point C). These points are clearly and easily illustrated with the aggregate demand and supply curves. [However, the aggregate demand/aggregate supply model does not imply that ([Y.sub.1], [P.sub.1]) is in some sense superior to ([Y.sub.2], [P.sub.2]). Neither is a disequilibrium situation, and involuntary unemployment is not present in either one.]

At this point, then, one can concentrate on a discussion of whether prices (including wage rates) are or might be rigid, at least in the short run. Explanations offered for a situation where prices are rigid do, of course, include such things as oligopolistic final output markets, union behavior, and efficiency wage theories, to name a few. The corresponding issues from a policy perspective include, first, how long it will take the markets to readjust to an equilibrium situation. (It is hard to imagine that prices will never change appropriately, but it is realistic to expect that they will not adjust instantaneously.) A second issue is the nature and magnitude of the social costs of any involuntary unemployment during the transition period as well as the possible policy options and their corresponding costs to alleviate this unemployment. For example, an increase in aggregate demand resulting from an increase in government spending could eliminate such involuntary unemployment, but it will have other implications for the economy in the long run. If market structure is considered to be the problem, the government could engage in efforts to make the markets more competitive.

A third, undoubtedly extreme, situation apparently alluded to by Keynes is that after a decrease in aggregate demand, the aggregate demand and aggregate supply curves do not intersect at any positive aggregate price level.(7) Such a situation, however unlikely, can again be easily illustrated with this model as in Figure 3.

One may also utilize this model to discuss in a simple way the more recently advanced macroeconomic theories involving dynamic path adjustment models that include considerations of the impact of lack of information and inaccurate expectations. Such models of imperfect market coordination frequently represent a blending of Keynesian and classical positions.(8)

Conclusions

The pedagogical usefulness of the aggregate demand/aggregate supply model can be much enhanced if AD is defined so that points lying on it are consistent with IS/LM equilibria and if AS is defined so that points on it are consistent with equilibria in factor markets. When these definitions are employed, the aggregate demand and aggregate supply model is quite useful for illustrating the fundamental differences in the positions of "classical" economists as compared with those whose outlook is more "Keynesian" in nature.(9) Revealing such differences is the easy part. However, aggregate demand/aggregate supply analysis obviously cannot tell us the answers to such critical issues as how long it will take an economy to readjust to an equilibrium situation and the social costs involved with letting the markets adjust at their own speed compared with the social costs of any policy actions that the government might take. The answers to those questions are unique to each situation, and the decisions that are finally made will almost certainly involve value judgments on the part of policy makers.10

Notes

1. In another recent article, Colander (1.995) has proposed a somewhat different aggregate demand/aggregate supply model. Although his model has a number of interesting and useful features, we suggest that the aggregate supply curve in the model proposed here perhaps better reflects the notion of a long-run aggregate equilibrium supply relationship that would be an appropriate supply-side counterpart to the aggregate equilibrium demand relationship as it is usually presented. We use the terms "classical" and "Keynesian" loosely in the following discussion with, for example, no attempt to distinguish between "Keynesian," "Post Keynesian," and "New Keynesian." Certainly, this language could be made as precise as one wished to illustrate the nuances of the various points of view.

2. Note that at this point we have said nothing about the behavior of the aggregate supply curve, but only that these points on the aggregate demand curve represent "Keynesian" model equilibria if the aggregate quantity supplied were equal to the aggregate quantity demanded as shown on the horizontal axis. Thus, we would argue that Colander's (1995) objection that such an AD/AS model specifies two different and inconsistent aggregate supply functions is not appropriate in this case. It has been suggested that the aggregate demand-side equilibrium curve could be called an aggregate goods market equilibrium curve. However, this terminology could be used only with the understanding that the curve implies nothing about the behavior of aggregate supply.

3. Colander (1995, pp. 170-171, 174) presents a simple derivation of this aggregate demand curve from the Keynesian aggregate expenditure curve. A more complete model of the aggregate demand curve can be obtained as the locus of real output levels consistent with IS/LM analysis equilibria at different aggregate price levels. However, these points are not necessarily consistent with aggregate supply, as defined below.

4. The international price level effect and the intertemporal price level effect are two other effects that are often cited to explain the slope of the AD curve. See Colander (1995, p. 171).

5. See Colander (1995) for a discussion of some alternative definitions of the aggregate supply curve.

6. Of course, one could argue that the real wealth of debtors would increase when prices rose and fall when prices fell, so that the net effect would be zero. However, as argued above, governments are frequently substantial net debtors, and they may not respond to changes in real wealth in the same way as other participants in the economy.

7. See, for example, Davidson, p. 453, and Keynes, pp. 257-281.

8. See, for example, Meltzer (1995), Wright (1995), Gerrard (1995), and Mankiw (1993).

9. The aggregate demand/aggregate supply model can also be utilized to illustrate other issues; for example, the effects of a change in aggregate supply.

10. It is also clear that the aggregate demand/aggregate supply approach by itself is limited in the consideration of other issues such as extreme structural unemployment where potential workers do not possess skills that are desired by the economy at even a subsistence wage rate.

References

Barro, Robert J. "The Aggregate-Supply/Aggregate-Demand Model." Eastern Economic Journal, Vol. 20, No. 1 (Winter 1994), pp. 1-6.

Colander, David. "The Stories We Tell: A Reconsideration of AS/AD Analysis." Journal of Economic Perspectives, Vol. 9, No. 3 (Summer 1995), pp. 169-188.

Davidson, Paul. "Would Keynes Be a New Keynesian?" Eastern Economic Journal, Vol. 18, No, 4 (Fall 1992), pp. 449-63.

Geithman, David T. "A Note on Teaching the Aggregate-Supply/Aggregate-Demand Model." Eastern Economic Journal, Vol. 20, No. 4 (Fall 1994) pp. 475-477.

Gerrard, Bill. "Keynes, the Keynesians, and the Classics: A Suggested Interpretation." The Economic Journal, Vol. 105 (March 1995), pp. 445-458.

Keynes, J.M. The General Theory of Employment, Interest, and Money. London: Macmillan and Co., Ltd., 1936.

Manikiw, N. Gregory. "Symposium on Keynesian Economics Today." Journal of Economic Perspectives, Vol. 7, No. 1 (Winter 1993), pp. 5-22.

Meltzer, Allan H. "Information, Sticky Prices, and Macroeconomic Foundations," Federal Reserve Bank of St. Louis Review, Vol. 77, No. 3 (May/June 1995), pp. 101-118.

Wright, Randall. "Commentary." Federal Reserve Bank of St. Louis Review, Vol. 77, No. 3 (May/June 1995), pp. 119-125.

Lila J. Truett and Dale B. Truett, Professors in the Division of Economics and Finance, College of Business, The University of Texas at San Antonio
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Author:Truett, Lila J.; Truett, Dale B.
Publication:American Economist
Date:Mar 22, 1998
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