The Aggregate Demand/supply Model: A Premature Requiem?

Article excerpt

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. …