Macroeconomic perspectives on demand and supply

Posted 2023-03-13 20:40:21

Key points

Keynes’ Law states that demand creates its own supply.
Say’s law states that supply creates its own demand.
Many mainstream economists take a Keynesian perspective—emphasizing the importance of aggregate demand—for the short run and a neoclassical perspective—emphasizing the importance of aggregate supply—for the long run.

Introduction

Macroeconomists over the last two centuries have often divided into two groups: those who argue that supply is the most important determinant of the size of the macroeconomy and those who argue that demand is the most important factor in the size of the macroeconomy.

Say’s Law and the macroeconomics of supply

Economists who emphasize the role of supply in the macroeconomy often refer to the work of a famous French economist of the early 19th century named Jean-Baptiste Say. Say’s Law states that “Supply creates its own demand.” As a matter of historical accuracy, it seems clear that Say never actually wrote down this law and that it oversimplifies his beliefs, but the law lives on as useful shorthand for summarizing a point of view.

The intuition behind Say’s Law is that each time a good or service is produced and sold, it generates income that is earned by someone—a worker, a manager, an owner, or those who are workers, managers, and owners at firms that supply inputs along the chain of production. The forces of supply and demand in individual markets will cause prices to rise and fall. The bottom line remains, however, that every sale represents income to someone, and so, Say’s Law argues, a given value of supply must create an equivalent value of demand somewhere else in the economy.

Because Jean-Baptiste Say, Adam Smith, and other economists writing around the turn of the 19th century who discussed this view were known as classical economists, modern economists who generally subscribe to the Say’s Law view on the importance of supply for determining the size of the macroeconomy are called neoclassical economists.

If supply always creates exactly enough demand at the macroeconomic level, then—as Say himself recognized—it is hard to understand why periods of recession and high unemployment should ever occur. To be sure, even if total supply always creates an equal amount of total demand, the economy could still experience a situation where some firms are earning profits while other firms suffer losses. Nevertheless, a recession is not a situation where all business failures are exactly counterbalanced by an offsetting number of successes. A recession is a situation in which the economy as a whole is shrinking in size—business failures outnumber the remaining success stories, and many firms end up suffering losses and laying off workers.

The idea represented by Say’s Law—that supply creates its own demand—does seem a good approximation for the long run. Over periods of some years or decades, as the productive power of an economy to supply goods and services increases, total demand in the economy grows at roughly the same pace. However, over shorter time horizons of a few months or even years, recessions or even depressions occur in which firms, as a group, seem to face a lack of demand for their products.

Keynes’ Law and the macroeconomics of demand

We could say that the alternative to Say’s law, with its emphasis on supply, is Keynes’ Law. Keynes' Law states that “Demand creates its own supply.” As a matter of historical accuracy, just as Jean-Baptiste Say never wrote down anything as condensed as Say’s Law, John Maynard Keynes never wrote down Keynes’ Law. But, the law is a useful simplification that conveys a certain point of view.

When Keynes wrote his great work The General Theory of Employment, Interest, and Money during the Great Depression of the 1930s, he pointed out that during the Great Depression, the capacity of the economy to supply goods and services had not changed significantly. US unemployment rates soared higher than 20% from 1933 to 1935, but the number of possible workers had not increased or decreased much. Factories were closed and shuttered, but machinery and equipment had not disappeared. Technologies that had been invented in the 1920s were not uninvented and forgotten in the 1930s.

Thus, Keynes argued that the Great Depression—and many ordinary recessions as well—were not caused by a drop in the ability of the economy to supply goods as measured by labor, physical capital, or technology. He argued the economy often produced less than its full potential not because it was technically impossible to produce more with the existing workers and machines but because a lack of demand in the economy as a whole led to inadequate incentives for firms to produce. In such cases, he argued, the level of GDP in the economy was not primarily determined by the potential of what the economy could supply but rather by the amount of total demand.

Keynes’ Law seems to apply fairly well in the short run of a few months to a few years, when many firms experience either a drop in demand for their output during a recession or so much demand that they have trouble producing enough during an economic boom. However, demand cannot tell the whole macroeconomic story, either. After all, if demand were all that mattered at the macroeconomic level, then the government could make the economy as large as it wanted just by pumping up total demand through a large increase in government spending or by legislating large tax cuts to push up consumption.

Economies do, however, face genuine limits to how much they can produce, limits determined by the quantity of labor, physical capital, technology, and the institutional and market structures that bring these factors of production together. These constraints on what an economy can supply at the macroeconomic level do not disappear just because of an increase in demand.

Combining supply and demand in macroeconomics

We can come to two insights by examining Say’s Law, with its emphasis on macroeconomic supply, and Keynes’ Law, with its emphasis on macroeconomic demand, together.

The first—which is not exactly a hot news flash—is that an economic approach focused only on the supply side or only on the demand side can be only a partial success. Both supply and demand need to be taken into account.

The second insight is that since Keynes’ Law applies more accurately in the short run and Say’s Law applies more accurately in the long run, the tradeoffs and connections between the three goals of macroeconomics—growth in the standard of living, low unemployment, and low inflation—may be different in the short run and the long run.

Summary

Keynes’ Law states that demand creates its own supply.
Say’s law states that supply creates its own demand.
Many mainstream economists take a Keynesian perspective—emphasizing the importance of aggregate demand—for the short run and a neoclassical perspective—emphasizing the importance of aggregate supply—for the long run.