The importance of aggregate demand

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.


About haroldchorneyeconomist

I am Professor of political economy at Concordia university in Montréal, Québec, Canada. I received my B.A.Hons (econ.&poli sci) from the University of Manitoba. I also completed my M.A. degree in economics there. Went on to spend two years at the London School of Economics as a Ph.D. student in economics and then completed my Ph.D. in political economy at the University of Toronto. Was named a John W.Dafoe fellow, a CMHC fellow and a Canada Council fellow. I also was named a Woodrow Wilson fellow in 1968 after completing my first class honours undergraduate degree. Worked as an economist in the area of education, labour economics and as the senior economist with the Manitoba Housing and Renewal Corporation for the Government of Manitoba from 1972 to 1978. I also have worked as an economic consultant for MDT socio-economic consultants and have been consulted on urban planning, health policy, linguistic duality and public sector finance questions by the governments of Manitoba, Saskatchewan,the cities of Regina and Saskatoon, Ontario and the Federal government of Canada. I have also been consulted by senior leaders of the British Labour party, MPs from the Progressive Conservative party, the Liberal party and the New Democrats on economic policy questions. Members of the Government of France under the Presidency of Francois Mitterand discussed my work on public sector deficits. I have also run for elected office at the municipal level. I first began to write about quantitative easing as a useful policy option during the early 1980s.
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7 Responses to The importance of aggregate demand

  1. Roger Sandilands says:

    I agree with you and posted a positive comment on Larry Summers’s FT article today.

    Roger Sandilands
    Emeritus Professor of Economics
    University of Strathclyde, UK

  2. Thanks . Your comment in which you point out that the circumstances warrant monetization of a portion of the debt through central bank purchase of it as a temporary measure to prevent crowding out is something i have advocated for a long time. It is also interesting that Ralph Hawtrey supported this strategy. Readers ought to look at your book on Lauchlin Currie. Currie was a Canadian economist who was a key member of FDR’s economic brain trust and also an important advisor to Marriner Eccles. He played a major role in moving FDR in a more Keynesian direction. Harold Chorney

    • Marianna says:

      The closest thing about MET is how firmly its rooted in a proper understanding of Says Law. Recessions, then, are always a phenomenon of coordination failure. This can happen in one of two ways: either producers make stuff which people dont want (which we shouldnt expect to happen systematically), leading to specific excess supplies/demands in specific industries, or a shortage of money, which is the only explanation for a general glut. As I mentioned in a previous comment, real factors still matter. A negative adverse supply shock can cause a business cycle. Price stickiness is the issue here. The cool thing here is emphasis on markets: we can riddle out nominal vs. real causes by looking at expectations as embodied in asset prices.

  3. Roger Sandilands says:

    Yes. Hawtrey is popularly associated with his so-called “Treasury View” that fiscal deficits crowd out the private sector and are therefore ineffective.
    What is less well known is that Hawtrey was well aware that there are exceptional times – and the current crisis is surely such a time – when fiscal deficits can be a necessary part of recovery if monetary policy alone would otherwise be subject to a Hawtreyan “credit deadlock”.
    This deadlock is not to be confused with a Keynesian “liquidity trap” in which monetary policy is supposedly irrelevant because all of the new money would simply be hoarded in idle balances. By contrast, a “credit deadlock” is when banks cannot find credit-worthy borrowers and so it becomes extremely difficult to maintain or increase the circulating money supply except with help from governments actually themselves spending it directly into circulation.
    But the key thing for Hawtrey (as for Lauchlin Currie who was Hawtrey’s teaching assistant at Harvard in 1927-28) was that fiscal policy needed help from central banks if the deadlock was to be broken, just as much as central banks needed help from Ministries of Finance. The abject failure of the Bank of Japan to cooperate with the Ministry of Finance is why Japan has had two lost decades despite huge accumulations of debt to finance big deficits. This was because these deficits were financed not through the printing press but through the issue of debt to a massively deleveraging society in the years following the asset market crashes of 1990-91.
    David Laidler corresponded with Currie on all this, leading to an excellent paper, “Hawtrey, Harvard and the Origins of the Chicago Tradition”, Journal of Political Economy, December 1993. Also see Laidler’s _Fabricating the Keynesian Revolution_ (Cambridge U.P., 1999). Note the double-entendre.
    (Currie, by the way, was also FDR’s White House assistant for economic affairs, 1939 until FDR’s death in 1945.)

    • We can see a similar dogmatic resistance to facilitating recovery in Europe by the actions of the European Central Bank and the European political leadership which has resisted until quite recently monetizing more European debt (and even here they have done so minimally in an indirect way what they could have better accomplished directly) and permitting more stimulative deficits. Harold Chorney

      • Carolyn says:

        The political economy/public choice story is that German bankers have a lot to gain from the crisis, since they actually have some capital which they can trade for increased political influence in the EU going forward.

    • Enicleiaa says:

      Thanks for your generous comment and the link to the paper on Hawtrey and Cassel, two of my heroes. I am hoping to post a revised version of the paper on SSRN in the not too distant future. I will let you know when its ready. Keep doing the terrific job that you are doing on this blog.

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