Aggregate Supply

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Transcript Aggregate Supply

Aggregate Supply
Keynes vs Say
So….who is correct?
Timed Writing
Consider the following scenario:
Three young boys, acting like the rascals they are, throw a rock
through a bakery window. The window breaks and a crowd gathers.
Everyone in the crowd cries about the tragic loss of the window. But
then, someone sees a silver lining to the problem. “Ah hah!” says one
optimistic observer. “ Don’t worry! The money the baker will spend on
replacing the window will be used by the window maker to buy
something else and then that person will use it also!” The crowd was
very happy at this idea and began to agree that breaking the window
was probably a good thing after all! “ Yes sir!” says the optimist, “If the
window hadn’t broken, we wouldn’t be starting this economic boom!”
Why would a economist claim the reasoning of the optimistic person
What is Aggregate Supply?
Aggregate Supply (AS) measures the volume of goods and
services produced within the economy at a given overall price
There is a positive relationship between AS and the
general price level.
Rising prices are a signal for businesses to expand
production to meet a higher level of Aggregate Demand
(more on that later). An increase in demand should lead to
an expansion of aggregate supply in the economy.
Classical Ecnomics
There is intense disagreement between schools of economic thought
about how the macroeconomy should function.
The oldest of the current schools was conceptualized by JeanBaptiste Say.
Traditionally associated with supply-side
economics, Say is the inventor of the
aptly named, “Say’s Law”.
Say’s Law
Supply creates Demand
Say’s Law Explained
Supply Creates Demand
It is worthwhile to remark that a product is no sooner created than it, from
that instant, affords a market for other products to the full extent of its
own value. When the producer has put the finishing hand to his product,
he is most anxious to sell it immediately, lest its value should diminish in
his hands. Nor is he less anxious to dispose of the money he may get for
it; for the value of money is also perishable. But the only way of getting
rid of money is in the purchase of some product or other. Thus the mere
circumstance of creation of one product immediately opens a vent for
other products. (J.B. Say, 1803: p.138-9)
The act of producing creates the market for other products and therefore,
the market for its own product.
Lets simplify this….
Classical Economics Made
The market (economy) works very quickly. It is a perfect, well oiled and
efficient machine.
It adjust quickly to problems.
Surpluses in one area are balanced by shortages in other areas and so on.
Case Study: The Great Depression
Read your textbooks in US History. You will find the term,
“overproduction” attributed to one of the reasons of the Depression.
Classicists’ argue that there is no such thing as overproduction.
If there is a surplus of goods, prices must fall to accommodate the
additional supply that has not sold.
The reduced price will stimulate the appropriate level of demand.
Classical economics assumes market forces will correct itself.
But….not everyone out there agrees with it.
Classical Economics Criticized
Classical economics assumes that there is a natural,
economic tendency for all markets and economies to move
towards equilibrium.
This equilibrium is not just the intersection of demand and
supply but also the equilibrium levels of employment as well.
Critics claim that Classical thought oversimplifies the behavior
of individuals.
Critics argue that there is no such tendency in the market to
move towards this equilibrium.
The large-scale critique of Classical thought happened during
the Great Depression.
Keynesian Economics
Man creates his own supply (demand-side economics)
Keynes advocated a situation where government policy is
implemented in an attempt to move the economy towards full
Classical economists are extremely laissez-faire in their approach to
Case Study: Great Depression
Classical solution: Cut wages
Keynes said that people will resist wage cuts. This is because of various factors,
most important of which is because people see wages in nominal terms, not real
Keynes argued for counter-cyclical fiscal policies.
Policies that act counter to the business cycle.
Keynesian Criticisms
Critics of Keynesian theory point most squarely to the “crowding out
This is the notion that as government involves itself in the economy and
attempts fiscal policies, it ends up removing some of the possible
economic activity that would have otherwise been engaged in by private
This is largely because government does not produce. Therefore, any
money it gains is taken or borrowed from the economy. Thereby stifling
the funds available for private enterprise.
Who is Right?
Well. They both are.
The majority of economists today hold that Keynesian ideas are
primarily correct in the consideration of an economy in the short-term.
Classical thought is seen to represent how the economy works in the
To get even more confusing, we still haven’t discussed the monetarist
school of thought yet.
Still! We can illustrate both of these economists’ principles on the
AD/AS model.
The Aggregate Supply Model