Say's Principle and Macroeconomic Analysis

In his 1936 treatise, Keynes formulated Say’s Law as proposing that “supply creates its own demand.” It is not clear exactly what Keynes meant by this. The statement implies an assumption of equilibrium where all excess demands are zero. That is, if supply creates its own demand, then quantity demanded of a good and the quantity supplied must be equal.  This is at worst a misrepresentation of Say’s Identity and at best an incoherent statement that appeared in one of the most popular economics treatises in history.

What is Say’s Law and why does it matter? In A Treatise on Political Economy, Say argues

A man who applies his labour to the investing of objects with value by the creation of utility of some sort, can not expect such a value to be appreciated and paid for, unless where other men have the means of purchasing it. Now, of what means do these consist? Of other values of other products, likewise the fruits of industry, capital, and land. Which leads us to a conclusion that may at first sight appear paradoxical, namely, that it is production which opens a demand for products.

Ultimately, goods must pay for goods. If an agent wishes to purchase a product, he or she must either exchange another good directly for the desired good or else acquire by exchange money to purchase the item. Confusion arises when money must be integrated into the framework. Unfortunately, Say does not do a good job of explaining the significance of money within this schema.

Thus, to say that sales are dull owing to the scarcity of money, is to mistake the means for the cause; an error that proceeds from the circumstance, that almost all produce is in the first instance exchanged for money, before it is ultimately converted into other produce: and the commodity, which recurs so repeatedly in use, appears to vulgar apprehensions the most important of commodities, and the end object of all transactions, whereas it is only the medium. Sales cannot be said to be dull because money is scarce, but because other products are so. Should the increase of traffic require more money to facilitate it, the want is easily supplied, and is a strong indication of prosperity – a proof that a great abundance off values has been created, which it is wished to exchange for other values.

Say’s description implies that he understands that there can be an excess demand for money that raises money's price. That increase in price will encourage an increase in the available money stock. Having brushed off the problem of insufficient demand by relying on an invisible-hand process, Say give a less than satisfactory supply-side argument for explaining general gluts.

It is because the production of some commodities has declined, that other commodities are superabundant. To use a more hackneyed phrase, people have bought less, because they have made less profit; and they made less profit for one or two causes; either they have found difficulties in the employment of their productive means, or these means have themselves been deficient.

Say describes here a misallocation of resources that only adjustment of price, and subsequently, of the capital structure can fix. It is possible however, that the processes that coordinate market activity might be interrupted by extreme swings in demand for money. It is this problem for which Leijonhufvud and Clower’s extension of Say’s Law as “Say’s Principle” (they refer to it as SP) provides a clear explanation.

Leijonhufvud and Clower describe Say’s Principle first in terms of individual agents. The core of their claim goes that “the net value of an individual’s planned trades is identically zero.” Individual agents make decisions concerning the allocation of their money. An agent may decide to spend all available money on goods and hold no cash on hand or he may decide to withhold some amount of money for safe-keeping. In the latter case, the agent has a positive portfolio demand for money. Algebraically, the authors represent this elementary budget constraint in a system of exchange where such a constraint is implied by secure property rights:

               P_xd_x + p_yd_y + d_m– s_m,0 = 0

In order for an individual's plans to be coherent, planned expenditures plus planned holdings of money (portfolio demand) must equal the stock of money available to the agent. The authors explain further in terms of common interpretations,

‘No one plans to supply anything of value without also planning some use for the proceeds from the sale, which may include simply planning to hold money until a later decision is made to purchase other commodities.’ This statement is correct and sensible.”

‘Confronted with given prices, each transactor must plan to supply commodities of sufficient value to finance all his planned net demands.’ This statement is also correct.

If you have not intuited this by now, Say’s Principle is simply an observation of agent action given a budget constraint.

When money is not included as the “mth commodity”, it is possible that excess supplies of goods can exist. However, when money is included we find that all excess supplies are equally offset by excess demands for goods. This is of special significance if one is to understand macroeconomic fluctuations. Distortionary representations of Say’s Principle connect the identity to an equilibrium assumption. This seems to be what Keynes was implying. Say’s Principle does not imply equilibrium absent a process to correct expectations. SP is an observation. Movement toward equilibrium requires some minimum threshold of convergent expectations amongst the population of agents as well as some combination of flexible prices and an endogenous money stock.

Money is different from all other goods in that it comprises one side of every monetary exchange. For this reason, we may separate economic goods into two categories for the sake of analysis. There is 1) money and then there are 2) all other goods. The value of goods in the second category are enumerated in a given currency unit. An excess supply of any good occurs when agents plan, in aggregate, to purchase less of the commodity than is available at a given price. This leads, by definition, to an excess demand for the “mth” good, money, meaning that at given the current constellation of prices, agents demand more money than is available. This will tend to push the price of money – the amount of goods that money exchanges for – upward and, conversely, the prices of commodities downward. This does not mean that the price of all commodities will necessarily fall, but that there will be deflationary pressure as the real stock of money (M/P) is others unable to facilitate exchange of goods until either prices have fallen or the nominal money stock (just M) rises. Until the problem is corrected, there will be a fall in output and employment of both labor.

We can illustrate Say’s principle with graphs of the money stock and of aggregate supply and demand. Those of you reading last week should recognize these graphs.

This represents an economy where agents have elected to increase the nominal value of their dollar holdings. Before prices adjust to reflect this change, there will be 1) and excess demand for money and 2) an excess supply of goods. Not enough money exists to facilitate exchange until prices drop. Eventually, prices must drop in order to clear available inventories. If the general fall in prices takes an extended period of time to occur, then there will be a depression: an extended fall in real output. This comes with an increase in unemployment and a fall in living standards for those agents not prepared for the depression.

   

Two solutions to this problem have been discussed. Either prices can fall to alleviate growing inventories or the money stock can increase. This has policy implications. 1) A central bank can attempt to alleviate, either in whole or in part, fluctuations in demand for money. The most popular formulation of this proposal is that the central bank should attempt to stabilize MV by adjusting M to offset changes in V. Leijonhufvud and Clower note some historical skepticism about this approach:

. . . Its use raises other issues. To whom is ‘the engine of inflation’ to be entrusted? What limits to that party’s discretionary use of the throttle would it be advisable to impose? . . . Reliance on the automatic solution, in this [classical] view, is argued to be the lesser of two evils.

Perhaps a better solution to this problem is to enact policies that enable the money stock to automatically fluctuate according to changes in demand for it. This might include the removal, or at least minimization, of barriers to liquidity that discourage asset owners from converting those assets into cash (i.e., the capital gains tax and legal restrictions applied to particular classes of assets). Another significant element in promoting a robust economy is the facilitation of expectation formation in regard to public policy. Government agencies are “Big Players” whose plans and actions are considered by agents in the formation of their own expectations (Koppl 2002). If “Big Players” act unpredictably, agents will be less able to coordinate. If these “Big Players” are unable to accommodate this need due to the nature of the political process, then there may be a case for a shrinking of the scope of influence for these government agencies. Of course, this is not to deny that it is possible that changes in government structure might also accommodate this need, but this is even more difficult of a task to accomplish.

I leave you with Say’s perspective concerning this problem.

. . . Wherever , by reason of the blunders of the nation or its government, production is stationary, or does not keep pace with consumption, the demand gradually declines, the value of the product is less than the charges of its production; no productive exertion is properly rewarded; profits and wages decrease; the employment of capital becomes less advantageous and more hazardous; it is consumed piecemeal, not through extravagance, but through necessity, and because the sources of profit are dried up. The laboring classes experience a want of work; families before in tolerable circumstances, are more cramped and confined; and those before in difficulties are left altogether destitute. Depopulation, misery, and returning barbarism, occupy the place of abundance and happiness.