Academic journal article American Economist

Does the Aggregate Demand Curve Suffer from the Fallacy of Composition?

Academic journal article American Economist

Does the Aggregate Demand Curve Suffer from the Fallacy of Composition?

Article excerpt

Introduction

The aggregate demand curve, the cornerstone of much macroeconomic analysis, poses both theoretical and pedagogical problems at the Principles of Economics level. This paper contends that these problems are due to the fallacious use of microeconomic principles to teach and draw conclusions about the macroeconomy. Many economists have addressed their concerns about the validity of the Aggregate Demand/Aggregate Supply (AD/AS) framework. For example, Colander (1995) discusses the model's inconsistencies and questions whether the aggregate demand curve is independent of aggregate supply. The interdependence of AD and AS is also addressed in Cebula (1972; 1987) and in Fields and Hart (1990). Clower (1994) goes even further as to question the existence of an "effective" aggregate demand curve. However, the above mentioned papers simply address the inconsistencies of the stories told to justify the AD curve. This paper addresses whether or not any of the stories can be justified.

The conventional wisdom has held that if the microeconomic motivations are made explicit, and if relationships are carefully specified, one can use microeconomic principles to teach and draw conclusions about the macroeconomy. The aggregate demand problem discussed in this paper is a classic example of a fallacy of composition. The ambiguities and inconsistencies inherent in these fallacies are not lost on principles students and this is very likely the source of the great confusion and misperceptions that students experience with the concept of Aggregate Demand.

A simple example illustrates the fallacies we ask students to believe. The aggregate demand schedule shows that, ceteris paribus, as prices increase, the quantity of goods and services demanded in the aggregate falls. This is not questioned in the microeconomic case, where a higher price for a good causes both a substitution and an income effect away from the good. However, in the macro sense, there may be neither an income nor a substitution effect.

Students often glance over an aggregate demand curve and use their logic to conclude if prices are generally higher, there is an income effect which means that consumers cannot afford to buy as many goods. However, we know that this concept is fundamentally flawed. First, there is the case of a perfect (a.k.a. pure) inflation, where all prices and all incomes rise by the same percent. We know that this would cause no real effects. All consumers buying power would remain the same and all producers would maintain the same profit margin, all lenders would receive the same real interest rate, and all borrowers would still be paying the same real interest rate.

With other than perfect inflations, we know that changes in relative prices can redistribute income. If wages rise less than prices, then workers lose buying power, but producers gain profits which increases the income of shareholders. If real interest rates fall because nominal rates rise less than the increase in inflation, new borrowers gain since they pay less in interest. New lenders lose since they receive less in real terms for the use of their money. In the case of existing loans, with a fixed nominal rate, borrowers gain since they pay interest and principle with dollars which are worth less. The gain of borrowers is offset by the loss of lenders.

The Stories We Tell

Colander (1995) identifies four main explanations' or four stories we tell, used to justify the inverse relationship between the price level and aggregate demand. These are (1) the Pigou effect, whereby a rise in prices causes a decrease in real wealth, (2) the Keynes effect, where a rise in the price level decreases real money balances, causing a rise in real interest rates which, in turn leads to a fall in durable consumption and investment purchases, (3) the international price level effect, where a rise in prices decreases the international competitiveness of domestic goods, and (4) the intertemporal price effect, where higher prices cause people (consumers, businesses, and financial institutions) to substitute from consumption now to future consumption. …

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