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GDP, and Say’s Law

Aggregate supply

YS = f(L, K) in the classical model where L is determined in the labor market while K is exogenous

The aggregate supply YS is defined as the amount of finished goods and services firms in a country will want to sell under given conditions. In the classical model the aggregate supply is determined by production function, YS = f[L, K).

The amount of capital in the classical model is an exogenous variable; it is not determined within the model but assumed to be given. Although we typically assume that K is constant - which is reasonable in the short run - it need not be constant. K may increase over time, but we must know K at any point in time.

The amount of labor, however, is an endogenous variable that is determined in the labor market. This means that YS is determined entirely by the labor market in the classical model. The following chart illustrates.

Determination of aggregate supply.

Fig. 10.3: Determination of aggregate supply.

Aggregate demand and Say’s Law

YD = Ys in the classical model (Say’s law)

The aggregate demand YD is defined as the quantity of nationally produced finished goods and services that consumers, government and the rest of the world want to buy under given conditions. One of the key elements of the classical model is Say’s Law. According to Say’s Law the aggregate demand is always equal to the aggregate supply: YD = YS.

Say’s Law is sometimes stated as "supply creates its own demand". The motivation for this statement is something like this. If production (Y) increases by one billion, the national income will also increase by one billion. This means that individuals will have exactly one more billion for spending - just enough to buy the increase in production. Thus, YD will also increase by one billion. An increase in the supply of one billion has created an increased in the demand by the same amount.

In the classical model, observed GDP Y will be equal to the aggregate supply: Y = YS. GDP is determined entirely by the firms and there is no need to model aggregate demand. It is always the case that Yd = Y = Ys = f(L, K).

How not to justify Say’s Law

At first, Say’s Law may seem "obvious". However, it is not - actually, it is highly controversial. The reason it may seem obvious is that you have probably learned from microeconomics that in equilibrium, demand is equal to supply. If you are outside equilibrium, prices will adjust and you will be taken back to equilibrium.

This is not the motivation behind Say’s Law which is not an equilibrium condition. In the classical model, YD and YS are real variables that do not depend on the price level. This may strike you as odd. YS depends only directly on L and K and indirectly on the real wage. If the price level increases in the classical model, the wage level will increase by the same amount leaving the real wage unchanged. As for aggregate demand, if the price level and the wage level both increase (by the same amount), there is really no change for the consumers. If all prices double while you income doubles, there is no need to adjust you demand.

The justification for Say’s Law is not as an equilibrium condition through price adjustments. No price adjustment in the world will equilibrate aggregate demand and aggregate supply in the classical model. Instead, the justification is based on income effects rather than on price effects: higher supply == higher income == higher demand.

The reason why Say’s law is so controversial is the following. Suppose that consumers and investors fear that the economy will slow down. They might then decide to save a substantial part of their income and aggregate demand may not be equal to aggregate supply. This is really the starting point for Keynesian economics which we will meet in the next chapter.

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