Explaining Aggregate Demand and Aggregate Supply
By Arnold Kling
I am constantly amazed by bloggers and commenters who sneer that I do not understand macroeconomics in general or aggregate demand in particular. Often, the most sneering comments come from people who have no clue about the way economists use supply and demand.* Here is a simple tutorial.
1. Non-economists think of demand and supply as separate and fixed. There is no mechanism to regulate them. Instead, if there is a shortage (of oil, or nurses, or what have you), there is no notion that the price system will change this. Non-economists have no problem talking about a “shortage” of jobs (“we’re not creating enough jobs!”), as if jobs are something that are “demanded” by households and “supplied” by businesses or government.
2. To economists, supply and demand are regulated by price. When market conditions change to increase the demand for oil, the price of oil goes up, until demand is curbed and supply is induced sufficiently to eliminate any incipient shortage.
3. For example, in the late 1990’s, I heard a talk by a non-economist, speaking to a group of management recruiters, in which he argued that they faced a labor shortage that would last for decades. I explained what was wrong with this thinking in this essay, reprinted in my book Learning Economics.
4. When it comes to aggregate supply and demand, the regulating mechanism is what is called the real wage rate, which means the wage rate adjusted for the general level of prices (or the cost of living). When prices go up, the real wage rate falls, and vice-versa. When the real wage rate falls, firms hire more workers, raising output and employment. That is the aggregate supply that goes along with aggregate demand.
5. This aggregate supply mechanism assumes that wages stay fixed while prices move. This sticky wage hypothesis is at the center of the whole mechanism. But it raises all sorts of questions. Why are wages sticky? For how long do they remain sticky? How is it that the same workers who refuse to take lower nominal wages at a fixed level of prices are happy to see the same nominal wages at higher prices? Thousands of journal articles have dealt with these questions.
6. My point is that aggregate demand is not some deus ex machina that controls output regardless of anything else. The theory of aggregate demand and supply depends on the supply mechanism, which is quite tenuous.
An alternative tradition in macroeconomics, which includes Clower, Leijonhufvud and which Tyler Cowen and I have been pushing, looks at macro as a more general adjustment problem. I call it PSST, for patterns of sustainable specialization and trade. The advantage of this is that it ties to some of the most well-developed, reliable economic theory, including the theory of international trade. It also ties in with theories of entrepreneurship and Schumpeterian dynamics.
I focus on patterns of trade to try to avoid being shoehorned into defending a notion that the economy faces a skills mismatch. Yes, you are more likely to find a job these days if you are a nurse than if you are a construction worker, but that is not the whole story. The whole story is the need for the economy to grope its way toward new configurations that exploit comparative advantage.
*I want to particularly exempt Scott Sumner from this. He understands aggregate demand and supply exactly as I understand it. Paul Krugman is perfectly capable of understanding it, also, as in his article on the euro, where he wrote,
Milton Friedman offered an analogy: daylight saving time. ..By requiring that everyone shift clocks back in the fall and forward in the spring, daylight saving time obviates this coordination problem. Similarly, Friedman argued, adjusting your currency’s value solves the coordination problem when wages and prices are out of line, sidestepping the unwillingness of workers to be the first to take pay cuts.
Note that it is the unwillingness of workers to take pay cuts that is the key to aggregate supply.