It amazes me but it appears from the largely negative reaction to a good piece by Larry Summers in the Financial Times, Economic Uncertainty is no Excuse for Inaction, about the importance of combining low interest rates with government spending to bolster both positive expectations and aggregate demand that there are plenty of otherwise sophisticated people who still do not understand the concept or denounce it for foolish partisan reasons. Have a look at the FT piece by Summers in todays edition of the FT and the comments of readers including myself) and later today when I return from my teaching I will develop the point at greater length. In the meantime just remember its not enough to produce the goods and potential services you have to sell them as well. Just like ABC, C+I+(G-T) +(X-M) = Aggregate Demand is a bedrock principle of the macro-economy.
Aggregate demand as Keynes pointed out in his General Theory is at the core of his critique of classical economic theory. From the time of Ricardo forward into the first part of the 20th century it had literally largely disappeared from discussion except in the work of Malthus, Marx, Hobson, Sylvio Gesell and certain other marginalized critics of unregulated capitalism.(See Keynes GT p. 32) the classical doctrine influenced as it was by Say’s law argued that except for brief periods of disproportionality between supply and demand all gluts could be cured by the adjustment of the price system since the cost of labour would with minimal friction adjust to the labour market clearing wage. Keynes takes great trouble at the outset of the GT to explain that every increase in output which generates additional income leads to increased consumer spending but not as much as spending as the increase in income itself. This then leads to the necessity for additional investment to supplement the increased consumption and thereby soak up the additional savings that have been generated. Otherwise the gap between supply and effective demand will grow. In the absence of the special assumptions of the classical school by which there is ”some force in operation” to fill the gap between the increased supply and D1 the economy can be stuck at an equilibrium at well below full employment. (GT, p.30) Hence the marginal disutility of labour and the real wage do not contrary to the classical assumptions establish the level of employment. Rather total effective aggregate demand and especially the propensity to consume and the rate of new investment are the determining factors.
Hence investment becomes a key component of aggregate demand. In Keynes’s original terminology D1 + D2 =D where D1 is consumption and D2 is investment and D is aggregate Demand. D= f(N) D1 is a function of employment and the marginal propensity to consume and D2 is a function of N, total employment but also influenced by the marginal efficiency of capital, itself influenced by expectations, animal spirits and uncertainty. In modern macroeconomics these are known as C+I. but in recent years in the new classical macroeconomics that dominated the profession the very notion of aggregate demand had been supressed since it was and is a bedrock principle of this school that markets always clear , what counts is aggregate supply Z=Φ(N) as Keynes described it and the elimination of market frictions.
The classical school according to Keynes operated with a version of Say’s law of markets which argued in its vulgar form that supply always created its own demand. (David Laidler, Thomas Sowell and other classically inclined economists dispute this, arguing that Keynes set up a straw man in his description of Say’s law. See also Samuel Hollander, Classical Economics,Uof Toronto press, pp.242-250) This meant according to Keynes that f(N) and Φ(N) would be equal for all values of N. As he stated in the classical world ”effective demand instead of having a unique equilibrium value , is a… range of values all equally admissible” (p.26,GT) . In such circumstances there is never an obstacle to full employment and the marginal disutility of labour sets the level.Unemployment then becomes either voluntary or the result of inadequate job search or ignorance about what the market clearing wage is. Keynes sets out then to demolish this notion to demonstrate that inadequate effective aggregate demand can result in involuntary unemployment.