What Is Aggregate Demand Definition

Mercantilist Views of Aggregate Demand, Aggregate Demand Model

What Is Aggregate Demand Definition

Most of the mercantilists believed that individual thrift and saving were beneficial to the nation. Some, however, argued that saving caused unemployment and that greater consumption spending would increase economic activity and thus benefit the economy. The most forceful advocate of this view was Bernard Mandeville, who presented his views in an allegorical poem and several prose commentaries collected under the title The Fable of the Bees (the best edition is by F. B. Kaye, 1924). Mandeville maintained that prosperity and employment were furthered by spending, particularly on luxurious consumption, and that saving was detri­mental to the economy because it led to lower levels of output and employment. He criticized his contemporaries because their views about saving and prosperity were inconsistent: "To wish for the Increase of Trade and Navigation, and the Decrease of Luxury at the same Time, is a Contradiction."

Smith's Views of Aggregate Demand

Smith rejected the ideas of Mandeville and like-minded mercantilists. He praised frugality and saving; according to his analysis, it was capital accumulation that was the main determinant of prosperity and growth. He argued that the underconsumptionists, who believed that an insufficiency of consumption led to depression and low rates of growth, perceived the situation incorrectly because they failed to understand the process of saving and investment and its impact on the economy. For Smith, saving does not reduce aggregate demand but merely rechannels demand from consumer goods to investment goods.

Capitals are increased by parsimony and diminished by prodigality and misconduct. ... As the capital of an individual can be increased only by what he saves from his annual revenue or his annual gains, so the capital of a society, which is the same with that of all individuals who compose it, can be increased only in the same manner. . . . What is annually saved is as regularly consumed as what is annually spent, and nearly in the same time too; but it is consumed by a different set of people.

Malthusian Underconsumptionism

Those outside the field of economics usually associate Malthus only with his development of a theory of population. So did most economists until the writing of J. M. Keynes revived interest in Malthus's economic theories. In several pamphlets and particularly in his Principles of Political Economy, first published in 1820, Malthus set forth his economic theory, which differed from Ricardo's on a number of points. Our present interest is in Malthus's views on the economic consequences of saving, or capital accumulation. These views are set forth in his Principles, particularly in Book II, Chapter 1, "On the Progress of Wealth." (Book II, Chapter 1, refers to Malthus's second edition of Principles, which was published in 1836. This is the most readily available edition. The chapter is essentially the same as Chapter 7 of the first edition, published in 1820.)

Smith had concluded that economic progress depends on the size and effi­ciency of the labor force, the quantity and quality of natural resources, the institutional structure, and the amount of capital accumulation, which he considered the crucial determinant of economic development. Ricardo also regarded capital accumulation as the chief source of growth in the wealth of a nation. This analysis is based exclusively on the aggregate supply side: growth is limited only by the degree to which a nation can increase its supply of labor, capital, and natural resources. But what happens if aggregate demand for final output falls short of aggregate supply, producing less than full employment of resources, or depression?

The few mercantilists who had raised this possibility of underconsumption or overproduction were effectively silenced by Adam Smith's refutation of their positions. Nevertheless, the issue was again raised in the early 1800s. Lord Lauderdale (1759-1839), in An Inquiry into the Nature and Origin of Public Wealth (1804), and Jean Charles Sismondi (1773-1842), in Nouveaux principes d'economie politique (1819), questioned the ability of an economy to produce full utilization of its resources automatically. In 1820 Malthus also raised these questions, and a famous debate ensued between him and Ricardo. In Book II of the 1836 edition of his Principles, Malthus examined the alleged causes of economic growth and criticized each as being inadequate, maintaining that it was necessary to consider the demand side, or what he called "effectual demand." Malthus never stated precisely what he meant by effectual demand, and his understanding of the issues raised by Say's Law is certainly confused. Yet he perceived that there were difficulties in maintaining full employment of re­sources, even though he had no clear grasp of the exact nature of these difficulties.

In his discussion of the process of capital accumulation, Malthus presented both naive and more sophisticated analyses of the problem of maintaining full employment. His more naive argument is that labor does not receive the whole of the product, and so labor demand by itself is not sufficient to purchase all final goods at satisfactory prices. Labor has the will to purchase goods, he said, but lacks the purchasing power, whereas the capitalists have the purchasing power but lack the will. This is certainly correct, but if the capitalists return their savings to the market in the form of demand for producer goods, there will be no deficiency of aggregate demand. Malthus accepted the notion that saving does not mean hoarding and that savings will flow back to the market as investment spending. He sometimes suggested other functions for money and questioned the Ricardian view that money is only a medium of exchange and that no one withholds purchasing power, but he never developed these insights into a monetary explanation of depressions.

His more sophisticated insight into certain problems of the economy suggests that the saving-investment process cannot go on indefinitely without leading to long-run stagnation. He contended that there is an appropriate rate of capital accumulation that the economy can absorb and that too much saving and investment will cause difficulties. The process of saving leads to a reduction in the demand for consumer goods, and the process of investment leads to the production of more consumer goods in the future. Malthus recognized, more­over, that for full utilization of resources in a capitalist system to be maintained the total level of output and consumption must keep expanding. As the Red Queen says in Lewis Carroll's Through the Looking Glass, "Now here, you see, it takes all the running you can do, to keep in the same place."

Malthus concluded that because there was insufficient effectual demand from the laborers and capitalists, the gap must be filled by those in the society who consume but do not produce. These unproductive consumers are those who provide services (teachers, servants, and public officials, among others) and the landlords. Thus, one of the social functions of the landlords is to consume without producing and therefore to help prevent depression and the eventual stagnation of the economy.

Say's Law

The orthodox classical economists rejected the criticisms of Lauderdale, Sis­mondi, and Malthus. Their position was most forcefully and explicitly developed by J. B. Say, James Mill, and Ricardo, who argued that in the process of producing goods, sufficient purchasing power was generated to take these goods off the market at satisfactory prices. They maintained that overproduction, or what they called gluts, might occur in particular markets, but that it was impossible to have general overproduction for the entire economy. What declines in the general level of economic activity did take place would be of short duration, because the market would automatically return the system to a full utilization of its resources. Thus, the classicists insisted that in the long run there could be no excessive capital accumulation.

Admittedly, if an automobile is produced that sells for $20,000 and we deduct the payments made to the various factors of production, the residual will be zero. This is true by definition, because what is not wages, rent, or interest goes to the capitalists as profits. There is now $20,000 worth of purchasing power in the pockets of labor, landlords, and capitalists. The same holds true for the total economy; that is, the value of its yearly output is received as purchasing power by members of the economy. There can be no question, then, but that sufficient purchasing power is always generated to take produced goods off the market. The classicals recognized, moreover, that demand and supply might not mesh in particular markets and that there could be overproduction of particular goods— an excess of supply in a given industry. This glut in a particular industry is a manifestation of market forces at work, on either the demand or the supply side. But an excess supply in one industry means that there must be an excess demand for the goods of another industry. Assuming a system of flexible prices and mobility of resources, factors of production will leave the industry with excess supply and flow into the industry with excess demand. Thus, full employment of all resources is assured in the long run.

Although sufficient purchasing power is generated to take all goods produced off the market, what assurance is there that this purchasing power will be exercised in the market? The answer contained in Say's Law is often simply stated as follows: Supply creates its own demand. There can be no question but that supply creates a potential demand, but what is crucial is whether that potential demand is exercised in the market as effective demand. Ricardo, James Mill, and Say dealt with this issue by simply asserting that all potential purchasing power was returned to the market as demand for either consumer or producer goods. Essentially, they returned to the Smithian position that a decision to save is a decision to invest. They denied the possibility of hoarding—no one locks gold in a box. Money was only a medium of exchange in their system; thus, they denied any possible monetary causes of depression or stagnation. Though the classical defense of Say's Law has some weak links, Malthus never clearly perceived these difficulties. He tried to disprove the theory while accepting all the assumptions necessary for its proof. He did suspect that the theory was incorrect, but he was never able to articulate this insight into a sound criticism or an alternative theory of the determinants of the level of income and rate of economic growth.

The Bullion Debates, Henry Thornton, and Ricardo's Monetary Theory

Ricardo's views on Say's Law were developed in debates that occurred in the early 1800s; these debates were called the Bullion Debates. At issue was what was the cause of the Napoleonic wartime inflation. The Bullionists argued that the cause of the inflation was the monetary expansion that occurred during the wars. The Anti-Bullionists maintained that the causes of the inflation were more complicated, but that they included real causes such as harvest failures. They favored the Real Bills Doctrine: the doctrine that if the issuance of money were related to short-term financial commercial operations (such as the financing of inventories), there could be no overissuance of money. When monetary growth did not exceed the needs of real trade, the causes of inflation are not in the monetary sector. Robert Torrens (1780-1864) was a major supporter of the Anti-Bullionist position, and his Essay on Money and Paper Currency (1812) is a good statement of this position.

In this debate, Ricardo soon became a major expositor of the Bullionist position, which is similar to a modern-day monetarist position—inflation is always a monetary phenomenon. For Ricardo, the "action" in the economy was in the real sector; his monetary theory reflected that view. Money was simply a veil hiding the real economy; his writings in the debate were designed to remove that veil.

Ricardo's authority led to his views' overshadowing those of Henry Thornton (1760-1815), a far more subtle and, when it came to monetary matters, more thoughtful, economist. In his most famous book, The Paper Credit of Great Britain (1802), Thornton set out a remarkably sophisticated analysis not only of the relationship between money and prices, but also of the path through which money affects prices. Thornton traced the effect of money through the interest rates and lending practices of banks, and in doing so he recognized the potential for monetary disequilibrium affecting the real economy, and hence for money to affect the real economy. Money was more than a veil to Thornton. In his discussion he even recognized the distinction between real and nominal interest rates. But as often happens in economics and other fields, these more sophisti­cated views fell by the wayside and the received classical monetary theory remained a simplistic theory centered around the version of the quantity theory of money favored by Ricardo, in which monetary forces are simply a veil hiding real forces.

Technological Unemployment

In the third and last edition of Principles, published in 1821, Ricardo added a new chapter, "On Machinery," in which he analyzed the effect on the economy of the introduction of machinery. His previous view had been that the introduc­tion of labor-saving machinery would not result in unemployment and would be beneficial to the entire society. There was a growing concern on the part of labor that new machinery would create unemployment. Ricardo did not deal directly with this issue in the first two editions of Principles, but he concluded in his Essay on Profits that the introduction of machinery would raise the real wages of labor. In a speech in Parliament in 1819 and in a letter to his friend McCulloch, he maintained that the introduction of machinery did not reduce the demand for labor.14 Ricardo evidently changed his mind on this issue after reading and critically evaluating Malthus's Principles. In his new chapter "On Machinery," Ricardo stated: "That the opinion entertained by the labouring class, that the employment of machinery is frequently detrimental to their interests, is not founded on prejudice and error, but is conformable to the correct principles of political economy."

Ricardo's discussion of the possibility of technological unemployment is not as inconsistent with his position on the impossibility of general gluts as the preceding quotation would imply. He believed that if newly introduced machin­ery is financed by the diversion of circulating capital into fixed capital, the wages fund will be reduced and unemployment will occur. He did not discuss how long this unemployment would persist or how changes in the market might bring about a new position of full employment. If the newly introduced machinery is financed out of savings rather than circulating capital, then no unemployment will occur. It seems clear, then, that Ricardo's views on the possibilities of unemployment caused by labor-saving machinery were changing and that he never fully reconciled these views with his defense of Say's Law.